Dividends are distributions of a company’s profits to its shareholders. They represent a return on the shareholders’ investment and are one of the two main ways shareholders benefit from owning shares – the other being capital growth.
Dividends can only be paid out of distributable profits, which are broadly the company’s accumulated realised profits less accumulated realised losses. This rule, set out in the Companies Act 2006 (Part 23), prevents companies from returning capital to shareholders disguised as dividends.
Types of Dividends
| Type | Description |
|---|---|
| Interim dividend | Paid during the financial year, usually declared by the directors without shareholder approval |
| Final dividend | Proposed by the directors after the year end and approved by the shareholders at the annual general meeting |
| Special dividend | A one-off distribution, often following the sale of an asset or an exceptionally profitable period |
Most private companies in the UK pay dividends on an interim basis throughout the year, with a final dividend declared after the year-end accounts have been prepared.
Legal Requirements
Distributable Profits
A company must have sufficient distributable profits to cover any proposed dividend. Distributable profits are calculated as:
Accumulated realised profits - Accumulated realised losses
This includes retained earnings brought forward from prior years. A company that made a loss in the current year may still pay a dividend if it has sufficient retained earnings from previous years.
| Item | £ |
|---|---|
| Retained earnings brought forward | 120,000 |
| Profit for the current year | 45,000 |
| Accumulated distributable profits | 165,000 |
| Dividends already paid this year (interim) | (30,000) |
| Available for further distribution | 135,000 |
Unlawful Dividends
If a dividend is paid when the company has insufficient distributable profits, it is an unlawful dividend. The consequences include:
- Directors who authorised the payment may be liable to repay the amount to the company
- Shareholders who knew or ought to have known the dividend was unlawful may be required to return it
- HMRC may treat the payment as something other than a dividend for tax purposes
Board Resolution
Dividends must be formally declared by the board of directors. A board minute should record:
- The date of the resolution
- The total amount of the dividend
- The per-share amount
- The date of payment
- The shareholders entitled to receive the payment
Accounting for Dividends
Declaring and Paying an Interim Dividend
The board declares an interim dividend of £20,000:
On the payment date:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Dividends paid | 20,000 | |
| Bank | 20,000 |
The dividend paid is shown as a deduction from retained earnings in the statement of changes in equity, not as an expense in the income statement.
Final Dividend
Under FRS 102, a final dividend proposed after the year end but before the accounts are approved is not recognised as a liability at the balance sheet date. It is disclosed in the notes to the accounts as a post-balance-sheet event. The dividend is recognised when it is formally approved by the shareholders.
| Timing | Treatment |
|---|---|
| Before year end (interim paid) | Recognised and deducted from retained earnings |
| After year end but before accounts approved (final proposed) | Disclosed in notes only |
| After shareholder approval | Recognised as a liability and paid |
Dividend in the Statement of Changes in Equity
| £ | |
|---|---|
| Retained earnings at start of year | 120,000 |
| Profit for the year | 45,000 |
| Interim dividends paid | (20,000) |
| Final dividend of prior year paid | (15,000) |
| Retained earnings at end of year | 130,000 |
Dividends and Tax
Corporation Tax
Dividends are paid out of after-tax profits. They are not a deductible expense for corporation tax purposes. The company pays corporation tax on its profits, and dividends are then distributed from the remaining post-tax amount.
Dividend Tax for Shareholders
Shareholders receiving dividends pay dividend tax at rates that depend on their income tax band. There is an ordinary rate for dividends falling in the basic rate band, an upper rate in the higher rate band and an additional rate above that. Dividends are treated as the top slice of income, so salary and other income fill the bands first.
Every individual also has a dividend allowance: dividends within it are taxed at 0%. The rates and the allowance are set at the Budget and can change from one tax year to the next, so check the current figures on GOV.UK.
Tax Efficiency
For owner-managed companies, paying a combination of a small salary and dividends is often more tax-efficient than taking a large salary, because:
- Dividends do not attract National Insurance (neither employer’s nor employee’s)
- Dividend tax rates are lower than the equivalent income tax rates
- A salary up to the NIC primary threshold (or the personal allowance) can be paid tax-free
| Payment Method | Income Tax | Employee NIC | Employer NIC |
|---|---|---|---|
| Full salary | Yes (at marginal rate) | Yes (above the primary threshold) | Yes (above the secondary threshold) |
| Small salary up to the personal allowance + dividends | Salary: nil (within personal allowance); Dividends: dividend rates on the amount above the allowance | Salary: nil (below threshold); Dividends: nil | Salary: nil or low, depending on the secondary threshold; Dividends: nil |
The exact savings depend on individual circumstances, and HMRC may challenge arrangements that lack commercial substance.
Dividends Versus Drawings
In unincorporated businesses (sole traders and partnerships), owners take drawings rather than dividends. The key differences:
| Feature | Dividends | Drawings |
|---|---|---|
| Business type | Limited company | Sole trader / partnership |
| Legal restriction | Must have distributable profits | No legal restriction |
| Tax treatment | Taxed at dividend tax rates | Not separately taxed (owner taxed on profit) |
| NIC | No NIC payable | Class 4 NIC on business profit |
| Formal approval | Board resolution required | No formal process |
Dividend Policy
Directors must balance competing demands when setting dividend policy:
| Consideration | Implication |
|---|---|
| Shareholder expectations | Shareholders expect a reasonable return on their investment |
| Cash availability | Distributable profits may exist on paper, but the company needs cash to pay dividends |
| Future investment | Retaining profits funds growth without the need for external borrowing |
| Tax planning | Timing and quantum of dividends affect shareholders’ tax positions |
| Loan covenants | Bank facilities may restrict dividend payments or require minimum retained earnings |
| Working capital needs | Paying excessive dividends can leave the company unable to meet its obligations |
Dividends in the Cash Flow Statement
Dividends paid are reported under financing activities in the cash flow statement:
| Financing Activities | £ |
|---|---|
| Proceeds from new bank loan | 50,000 |
| Repayment of bank loan | (20,000) |
| Dividends paid | (35,000) |
| Net cash from financing activities | (5,000) |
Dividend Vouchers
For each dividend payment, the company should issue a dividend voucher (also called a tax voucher) to each shareholder. The voucher records:
- The company name and registered number
- The shareholder’s name
- The date of payment
- The number of shares held
- The dividend per share
- The total dividend amount
Shareholders need this information to complete their self-assessment tax returns.
Dividends and Company Law
The Companies Act 2006 imposes several requirements:
- Dividends can only be paid from distributable profits (accumulated realised profits less accumulated realised losses)
- Public companies have the additional requirement that the net assets must not fall below the aggregate of called-up share capital and undistributable reserves
- Directors must have reasonable grounds for believing the company will be able to pay its debts as they fall due after the dividend is paid
- If interim accounts are needed to justify a dividend, they must be filed with Companies House (for public companies)
Paying a dividend when a company is insolvent – or when doing so would render it insolvent – exposes directors to personal liability for misfeasance or wrongful trading.