The court of appeal case of Global Corporate v Hale has set a new precedent in the treatment of director salaries and what constitutes an illegal dividend. The case carries an important message for directors to consider as well as their accountants in how they treat monies drawn from limited companies across the financial year.
Case Summary: Global Corporate v Hale
Mr Hale was the director of a limited company which entered liquidation in 2015. In the course of the liquidation it was found that Mr Hale had been drawing a salary at the National Insurance threshold along with the sum of £1,383 as dividends, issuing dividend certificates each month in relation to this. This was done for a number of years with the company accountant deciding whether there were sufficient profits at the end of the financial year and declaring the additional payments as PAYE where they were not.
In the original case the judge found in favour of Mr Hale, in that the payments were actually salary regardless of their tax treatment.
In late 2018 at the Court of Appeal, the original decision was overturned. It was established that these payments could only be classified as dividends since that is what the company had treated them as, and furthermore as there were insufficient reserves within the company they were in fact illegal dividends and repayable.
The conventional approach to directors income
It is not uncommon for directors in owner managed companies, meaning the directors own the shares, to be remunerated on the basis of drawing a basic salary at the national insurances threshold or at the income tax threshold. The rest of their remuneration will be then drawn as dividends. This is the structure adopted in the vast majority of cases we deal with. It is also common for directors to provide a 50 percent shareholding to their spouse to even further the tax benefits on dividends.
This approach usually works best where there are sufficient reserves within the company, to mitigate the inherent risks. Where a company does not have sufficient reserves to support this approach, or where there is uncertainty in the businesses future trade, it may be worth adopting a more prudent approach (such as increasing the level apportioned to salary) to avoid being liable for illegal dividends or carrying a overdrawn directors loan account, both of which are repayable upon insolvency of the company. This approach is likely to slightly increase tax liability, but is generally a cost worth bearing to remove a much more punitive future risk of full repayment to a liquidator.
Considerations for setting directors remuneration
Following the Carillion collapse an increased level of scrutiny is being applied to auditors and in turn accounting services. The CMA has announced new measures being taken against these firms and that it will continue to apply further measures until they are satisfied with the integrity of accountants and auditors. This could eventually mean accountants are accountable for the advice provided to directors in relation to their remuneration.
The case of Global Corporate v Hale makes a number of points very clear much must be taken into account when deciding a director’s remuneration:
- Dividends must be based on the last set of accounts prepared before declaring the dividend.
- It is not possible to retract a dividend declaration, unless the articles of the company allow for this.
- A claim for remuneration on a quantum meruit basis cannot be set off against unlawful distributions.
It is at no point disputed that a director is entitled to be remunerated for the work they are carrying out for the company, but as a director they must receive proper authorisation for this. If the company does not have reserves to allow for dividends then it may be sensible to put all drawings through the PAYE system until the company is in a position to pay regular dividends.
This approach may be less tax efficient for the director, but it will ensure they are not liable to repay a directors loan or illegal dividends if the company becomes insolvent, which where reserves are not being carried, is a much higher risk for the company. The salary level must also reflect the work being carried out by directors, and must be properly authorised by the shareholders of the company. Not doing so could result in a claim for excessive remuneration.
The effect on directors’ redundancy
As well as the previously mentioned effects upon the insolvency of a company, the way in which a director draws their remuneration will also affect their redundancy entitlements from the redundancy payments service (RPS). The RPS have issued a publication that only PAYE salary can be considered as a part of a directors claim and remuneration by other means will not be considered in line with existing case law.
Accordingly where other staff will receive payments on their PAYE salary (up to the limit of £508 for 2018/19), directors will only be paid at minimum wage, leaving them without a buffer for their income upon the failure of the company like other employees would have. Nationally only around 54 percent of companies survive the first three years, dropping to around 50 percent if the company is based in London.
With such a high startup failure rate and the upcoming government crackdown on directors dissolving companies, without paying creditors, it is worth directors considering future proofing their remuneration strategy until sustained profitability and growth has been established.