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Can unlawful dividends be re-classified as salary?

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24/01/2019


In the recent case of Global Corporation Limited v Hale [2018] EWCA Civ 2618, the Court of Appeal considered whether payments to the director and shareholder of a company must be repaid on the basis that they constituted unlawful dividends pursuant to section 830 of the Companies Act 2006. The court confirmed that the legality of a payment to directors must be tested at the time when it is made. Any unlawful distribution cannot be ‘cured’ by subsequently treating it as remuneration.

Background

The respondent in this case was a director and shareholder of an engineering company, Powerstation UK Limited (the Company), which specialised in tuning motor engines. The respondent worked full time in the business and received regular monthly payments of around £1,800. On the advice of accountants, the monthly payments were treated as salary up to the personal allowance limit and dividends thereafter. At the end of the Company’s accounting period, the Company’s accountant would confirm whether or not the Company had sufficient distributable reserves out of which to lawfully pay a dividend. If there were not, the payments would be re-characterised for accounting purposes as salary payments and PAYE paid.

The Company was adversely affected by the financial crisis and went into liquidation on 25 November 2015. The liquidator sought repayment of the sums paid to the directors during the period when the Company had no distributable reserves on the basis that the dividends were unlawful distributions under section 830 of the Companies Act 2006. The claim was assigned to Global Corporate Limited.

High Court decision

At first instance, HHJ Mathews found that the decision to classify the payments as dividends was made “only in principle, with the formal decision left to be made at the year end”. On this basis, the Judge found that the payments were not dividends for the purposes of section 830 of the Companies Act 2006.

Given that the payments were found not to be dividends, the question arose as to whether the payments were made on any proper basis and, if not, whether the receipt of those payments constituted a breach of the respondent’s fiduciary duties. The judge found that the Company was obliged to pay the respondent a reasonable sum for his services, as the Company would be unjustly enriched if it received valuable services from him for free. On this basis, the judge found that the director was entitled to retain the payments and that the payments did not give rise to a breach of fiduciary duty. The decision was appealed.

Court of Appeal decision

The Court of Appeal stated that the relevant question was whether the payments constituted dividends at the time they were made. It was found that the payments clearly were dividends, given that they were expressly declared by the directors to be interim dividends and were taxed accordingly.

It was immaterial that the payment may subsequently have been re-characterised as remuneration. The Court of Appeal found that “the most [a re-characterisation] can do is to allow the monies to be notionally repaid and then re-applied in a way which does not contravene the provisions of s.830 and is otherwise a lawful application of the assets of the Company.” Lord Justice Patten went on to say “…it is immaterial that a subsequent realisation that the distribution should not have been made would prompt their being treated as remuneration. That cannot cure the illegality of the original payment.”

The Court of Appeal also doubted the judge’s finding that companies were bound by an obligation to pay reasonable compensation to directors and noted the decision in Guinness Plc v Saunders [1990] 2 AC 663, in which the House of Lords held that the law would not imply a contract for remuneration when such a contract could only be agreed under the articles of association by an appropriate resolution of the board. It was also noted that, even if a claim for unjust enrichment were to succeed, this would need to be proved for in the liquidation, rather than simply allowing the Respondent to retain the payments.

WM Comment

The case brings clarification to this area of the law and makes clear that director-shareholders cannot simply draw funds from the company on an ad hoc basis and avoid subsequent liability by referring to the value of work they provided the company. This clarification will no doubt be welcomed by liquidators.

As far as director-shareholders are concerned, there are obvious tax advantages in drawing compensation by way of dividend rather than as a salary, although this case highlights the risks of doing so. Any dividend paid at a time when the company has insufficient distributable profits is unlawful. This principle applies regardless of whether the company is currently trading profitably. The most prudent approach for director-shareholders of companies with unascertained distributable reserves would be to take a salary rather than a dividend.

Director-shareholders cannot simply hope to re-classify such dividends if necessary and will likely be required to repay the sums in the event of a challenge. Once such dividends are repaid to the Company, it appears unlikely that a company would be required to pay the director a reasonable sum for his services under the doctrine of unjust enrichment.

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