Dealing with your profit: how to pay out a dividend

Paying out a dividend is a common way for a company to return cash to its shareholders. They can also be a useful way of providing additional income to an owner/ manager as well as a means of rewarding investors or moving money within a group's companies. There is a legal process to be followed when paying out a dividend governed by the Companies Act 2006 (the 2006 Act). It is important that this process is borne in mind as failing to adhere to that process could leave directors exposed to potentially serious consequences.

There are certain tax considerations for both the company and its shareholders to consider and these should be looked at separately.

Types of dividend

• Interim dividends – these can be paid at any point during the company's financial year and are typically declared by directors.
• Final dividends – paid out once a year after the annual accounts have been prepared. In normal circumstances, these are recommended by the directors and subsequently "declared" by the shareholders.

The process

1. Sufficient distributable reserves

The 2006 Act requires dividends to be paid out of "profits available for the purpose". This can be calculated by taking the company's accumulated realised losses from the company's accumulated realised profits. If the value of the available profit is unable to meet or exceed the value of the proposed dividend, then it should not be declared or paid.

2. Justification by reference to accounts

A set of accounts must be made available by the directors evidencing the sufficient distributable profits.

There are three types of account that can be used for this purpose

• The company's latest annual accounts
• If those annual accounts do not show sufficient distributable profits, justification must be made in reference to more up-to-date accounts known as interim management accounts
• If the dividend is being declared in the company's first accounting period, "initial accounts" must be prepared.

3. Duty to consider company's current and prospective financial position 

The accounts produced by directors only provide evidence of sufficient distributable reserves up to a certain date prior to the decision to pay the dividend.

As such, directors must consider carefully the company's:

• present financial position at the time of the decision in the event that anything has changed since the date of the accounts; and
• its future financial position should the dividend be paid. It must be the case that the directors are satisfied that, even if there remain sufficient distributable profits to pay the dividend, the company will still be able to meet its ongoing debts and liabilities, actual or contingent.

It is worth noting that the company must also have the cash to pay the dividend. 

4. Articles of association

It is common that articles of association contain provisions about dividends therefore these should be checked for any restrictions or duties that might be in place.

For example, it may be that dividends can only be paid on fully paid shares. Or the payment of dividends may be restricted to a certain class of share. Usually, shareholders are entitled to receive dividends in proportion to the number of shares that they hold - but the articles should be checked. The articles may also specify a particular way in which dividends have to be authorised.

5. Directors' duties

Directors must comply with their general duties as set out in the 2006 Act when deciding whether to declare a dividend. These include duties to:

• act within their powers to promote the company's success for the benefit of its members as a whole;
• exercise reasonable skill and care; and
• declare any interest in the proposed payment (this will be relevant, for example, if a director is also a shareholder).

6. Documenting the decision

Board minutes should be prepared recording the process of declaring a dividend. These should refer to the financial information relied upon by the directors and that the relevant directors' duties have been duly considered.

Declaring an unlawful dividend

If any of the above steps are neglected the dividend may be unlawful. There are a number of consequences that could follow:

• Any shareholder that was a recipient of the unlawful dividend will be obliged to repay it (or the amount which is unlawful) if they were aware of the process not being followed or had reasonable grounds to believe that. This is something of which those shareholders who are also directors should be particularly aware .
• A director who authorised the payment of the dividend may be in breach of directors' duties and can be held personally liable to repay the company, even if they are not a shareholder.

If you require any advice on this matter, then please get in touch with your usual Brodies contact.