With the tax season about to get underway, we thought it would be useful to look at the consequences of decisions made around paying dividends and the solvency test.

When companies make a profit it is common practice to credit the profit share (or dividend) to their shareholders current account each year.

The theory is that shareholders funds are listed as a liability in the balance sheet. The amount can then be demanded by the shareholder. Sadly, theory very often doesn’t match reality.

Commonly no cash is actually paid out to the shareholders. This is often because the company does not actually have the cash required to pay a dividend. So the dividend amount sits in the company’s shareholders’ current account(s) waiting for that happy day when it can be paid to the shareholders. For some that day never comes.

The test for paying a dividend under the legislation is clear. Directors can pay a dividend only if the company will still be solvent immediately after the payment is made. Bear in mind that if the dividend is only credited to the shareholders’ current account(s), no payment has actually been made. So where there is a delay between declaring a dividend and actually paying it, the solvency test must be met on both occasions.

The solvency test is not complicated. The company must be assured that they can meet their debts as and when they fall due and that they have a positive net asset balance (in other words, their assets exceed their liabilities – including any contingent liabilities). If you are not familiar with the term, contingent liabilities are liabilities that could be incurred in the future depending on the outcome of an event like a court case.

Case law has held that directors (who are often shareholders) cannot use their position to give themselves preference over their creditors in the event of insolvency. If a shareholder does receive money while the company is insolvent, they may very well find that they must pay this back to the liquidator on demand.

The good news is the situation can be avoided with a simple transaction. We suggest that where possible you pay dividends in cash and the shareholders can put the money back into the company as loan advances. In doing this, the “character” of the money has changed. So long as the company is still solvent immediately after the payment, the reintroduction of the funds can be treated as a loan advance. The key to this is that the company would no longer be subject to the solvency test every time funds were paid from the shareholders’ current account(s).

The key message is that care does need to be taken when credits are made to current accounts and funds are withdrawn. The solvency test will apply twice in the case of dividends being paid later than they are declared.