Dividends are a popular way for company directors and shareholders to take money out of a business — but they can’t just be paid whenever there’s cash in the bank.
Under UK law, dividends can only be paid if the company has sufficient distributable profits. If not, the dividend is considered illegal, and both the company and the recipient could face consequences — including tax charges and director liability.
Here’s what you need to know if your company has issued a dividend that shouldn’t have been paid — and what happens if it isn’t repaid.
What Counts as an Illegal Dividend?
The Companies Act 2006 sets out a clear definition: dividends can only be paid out of accumulated realised profits, minus any accumulated realised losses.
That means a dividend is only legal if, at the time it’s declared, there are sufficient retained profits available — not just cash in the bank.
You can still pay a dividend during a loss-making year if previous years’ retained profits cover it. But if retained losses wipe out current profits, you cannot legally make a distribution — even if the current year’s accounts show a profit.
If a dividend is paid when there weren’t enough distributable profits to support it, the payment becomes an unlawful distribution — often referred to as an illegal dividend.
Tax Implications for the Company
If a dividend is declared illegally, it is considered void. The shareholder is treated as not having received a dividend.
If the shareholder knew (or should have known) that there weren’t enough profits to cover it, they are legally required to repay the amount back to the company.
If that repayment doesn’t happen, and the recipient is a director or employee, HMRC may treat the dividend as a loan to participator. This falls under Section 455 of the Corporation Tax Act 2010.
Under the loans to participators rules:
- The company will face a tax charge of 33.75% of the gross amount of the loan
- This charge is due nine months and one day after the company’s year-end
- Even if the company is making a loss, the tax is still payable
- If the loan is eventually repaid, the tax is refunded by HMRC
The takeaway: if the dividend isn’t legitimate and not repaid, it can result in a substantial tax bill for the company.
Implications for the Shareholder or Director
If the amount received is treated as a loan instead of a dividend, it may trigger further tax complications:
- If the loan exceeds £10,000, and no interest is charged, it’s considered an employment-related benefit
- This creates a benefit in kind and must be reported on a P11D
- HMRC applies a notional interest rate (currently 3.75% p.a.)
- The company must also pay Class 1A National Insurance on the benefit
However, there is an exemption:
- The loans to participators rules don’t apply if:
- The loan is less than £15,000
- The individual is a full-time working director
- They own less than 5% of the company’s share capital
If the loan is formally written off by the company, it is still treated as if the loan had been repaid — but this may trigger further tax consequences for the director.
What If the Company Enters Liquidation?
In more serious cases — particularly when a company becomes insolvent — directors can face personal liability for any illegal dividends paid out.
Liquidators or administrators will typically review all transactions made in the three years prior to insolvency. If they find dividends were paid when the company didn’t have sufficient profits, they can pursue repayment from the directors personally.
The time limit for pursuing recovery of illegal dividends is six years from the date of declaration or the date of payment — whichever is later.
A Word of Warning from HMRC
HMRC actively reviews accounts filed with corporation tax returns, including distributable reserves. Thanks to iXBRL tagging, they can easily identify when dividends have been declared while the company had negative reserves — and they often challenge these as unlawful distributions.
Practical Advice for Business Owners
Before declaring a dividend:
- Always check your retained profit position, not just your bank balance
- Ensure your accounts are up to date
- Keep a paper trail for the board minutes and dividend vouchers
- Take advice if you’re unsure — especially in loss-making periods
If HMRC has queried a dividend — or you’ve already paid one without checking your reserves — it’s essential to act quickly and seek professional support.
Need Help Navigating Dividend Rules or Facing an HMRC Challenge?
If you’re unsure whether a dividend was paid correctly or facing a potential tax charge for an illegal distribution, you’re not alone. It’s a common issue — but one that can carry serious financial and legal consequences if left unresolved.
Contact Jon and the team today. We’ll review your position, help you fix past mistakes, and make sure your next dividend is declared the right way.
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