The ultimate aim of a company is to make a profit. Of course, company directors and entrepreneurs are driven by more than money. They want to ensure that their products and/or services improve people’s lives for the better. They may even desire (and many in fact achieve) making the world a better place overall.
This applies for all except cases of insolvency. One of the overarching duties of a director is to ensure the company makes an annual profit for the benefit of the organisation and its shareholders.
When a company is in rapid growth mode (especially in the early years), many owners choose not to distribute profits, but instead plow capital into the company to drive growth. Believe it or not, Laura Tenison, founder of the children’s clothing chain ‘JoJo Maman Bebe’, took no profits out of her company for 18 years in order to grow the business organically.
Companies that don’t pay dividends might instead use that money to start a new project, acquire new assets, repurchase some of their shares or even buy out another company.
For more mature companies, distributing profits, either through share buybacks or cash distributions can encourage investors to buy more of that company’s shares. The market also views the paying of dividends as a sign of positive company growth, encouraging greater investor confidence.
The best methods for making distributions
All profits made by a company in the UK are subject to 20% Corporation Tax*. Any profit left over is available to be either reinvested or distributed to shareholders. The two main ways of distributing profits are:
- Issuing dividends – this is the most tax efficient way to distribute profits as no National Insurance is payable. However, from April 2016, all shareholders were required to pay tax on any dividends received over £5,000.
- Share buyback – this involves the company buying one or more shareholders’ shareholding in the company and paying for the shares with the company’s profits. This is a fairly complex way to distribute profits and the shareholder may be liable for Capital Gains Tax.
*as at December 2016
The procedure for distributing profits
When it comes to distributing dividends, if Model Articles have been adopted and not amended, a company’s articles of association provide that:
- its directors may recommend a final dividend (i.e. one to be paid after the financial year to which the profits being distributed relate), which is then declared by obtaining the approval of the shareholders, provided the amount declared does not exceed the amount recommended by the directors, and;
- its directors may decide to pay an interim dividend (i.e. one to be paid during the course of the financial year to which the profits being distributed relate), which needs no further shareholder approval
The shareholders of a private company may approve a final dividend by written resolution or at a general meeting. Members of a public company (one listed on the Stock Exchange) will normally approve a final dividend at an annual general meeting.
Once a final dividend is declared (i.e. approved by the members) it becomes a debt that is immediately due from the company to its members and payment can be enforced.
Unlawful dividend payments
In January 2016, clothing company Next plc committed what it called a “procedural oversight” which resulted in the three special interim dividend payments of February 2014, February 2015 and November 2015 and the ordinary dividend payment of January 2015 an infringement of the Companies Act 2006.
The company should have filed interim accounts with Companies House before the distributions were made so that it could demonstrate that it had sufficient reserves to pay them. However, it did not do this, meaning it had to call an Extraordinary General Meeting (EGM) to put a resolution to the shareholders to address the mistake.
Dividends can only be paid if profits are available for distribution. This must be proven through a company’s accounts. Usually, the last set of annual accounts filed at Companies House can be used for this, however, interim accounts can be relied on if these accounts no longer show sufficient profits.
Next plc failed to file their interim accounts before the dividend was paid, a requirement which applies to all public companies. This meant that the four dividend payments referred to above were unlawful.
An unlawful payment of a dividend is a serious matter. There are repercussions not only for that company and its directors, but also for the recipient of the distribution. In addition to being unlawful, a distribution may also be paid in breach of the company’s articles of association or any shareholders’ agreement if there is one, which would give rise to a breach of contract. Furthermore, directors of a company who are party to the payment of an unlawful distribution are jointly and severally liable to repay it. Given that the total amount of the four dividend payments totalled over £300 million, it is doubtful that any of the Next plc directors slept well once the procedural error was discovered.
At the EGM, the directors asked the shareholders of Next plc to approve both the use of the profits to pay the dividends and a waiver of any claims the company may have had against the shareholders who received the dividends and the directors who approved them.
In summary
It is crucial for both directors and shareholders to ensure that the distribution of an organisation’s profits are distributed correctly. Failure to do so can result in harsh consequences for all parties. If an error is made, as in the case of Next plc, seeking expert legal advice is vital to ensure the mistake is swiftly corrected.
Saracens Solicitors is a multi-service law firm based opposite Marble Arch on the North side of Hyde Park in London. We have years of experience in advising both private and public company directors and shareholders on the distribution of profits. For more information, please call our office on 020 3588 3500.