To correctly tax the amounts paid we must first consult company law and correctly account for the amounts paid.
Distributions made in excess of distributable reserves are not lawful as they are not compliant with Part 23 of Companies Act 2006. Section 847(2) of Companies Act 2006 governs the consequences of unlawful distributions. Where the participator “knows or has reasonable grounds for believing” all or part of the distribution was unlawful they are liable to repay the unlawful amount to the company.
In an owner managed business section 847(2) will usually apply as the director/shareholders ought to be reasonably aware of the profits available for distribution and therefore would have reasonable grounds to believe all or part of the dividend was unlawful.
Applying section 847(2), the unlawful part of the dividend(s) will be recognised in the company’s financial statements as amounts due from participators.
In this situation, the unlawful dividend is treated as a loan made and Corporation Tax Act 2010 section 455 applies as close company has advanced money to a participator. If the unlawful part of the dividend(s) is not repaid within 9 months of the end of the accounting period in which the distributions were made, a section 455 corporation tax charge may arise.
If the participator is also an employee (including employed directors) the amount shown in the accounts as due from the employee is a loan as defined by Income-tax (Earnings and Pensions) Act 2003 to which the benefits code applies. The company may have p11d reporting obligations and a Class 1A NIC liability on the loan. The employee may also have an income tax liability on the cheap loan.
The unlawful element of any distribution recognised as a loan and retained by the participator creates a constructive trust (established in Precision Dippings Ltd v Precision Dippings Marketing Ltd [1986]). As the company has not relinquished legal title to the cash paid to the participator, the unlawful distribution is void and is not taxable dividend income for the participator.
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