We have recently reviewed a number of filings in which dividends were not being treated correctly. Having helped our customers resolve their issues and prevented them from filing incorrect tax returns, we thought it would be useful to write a short post on the topic in the hope of helping some of our other fellow Xero users.
Dividends can only be paid out of company profits. No Profits. No Dividends.
A dividend can only be declared and paid when a company has sufficient accumulated profits (known as “retained earnings”). Retained earnings are the sum of your prior and current years’ profits (and losses, if applicable)m, and a dividend is paid out of these retained earnings. It is okay to be loss-making in the current year, as long as the total amount of accumulated profits (retained earnings) on your balance sheet is larger than the dividend you are paying.
It is in fact unlawful for a company to pay dividends when it has insufficient retained earnings available to cover the proposed payments.
There are several reasons for this but the easiest one to focus on is that the tax treatment of dividends is different, and generally advantageous, to that of salaries. Certainly if HMRC discover that a dividend payment was declared illegally, one action they can take is to treat that payment as salary and enforce any unfavourable tax implications.
Dividends are not an expense, they are a distribution of profits to shareholders
Unlike expenses, dividends are not part of the calculation of a company’s profit: they are not a cost of doing business. They are simply a mechanism by which companies distribute the profits they have made to their shareholders.
If you mistakenly put dividends through the Profit and Loss as an expense then you will artificially reduce your company’s taxable profit and therefore the corporation tax that it is due to pay. At best this could be considered a failure to take reasonable care and, at worst, a deliberate attempt to evade tax.
Dividend accounts in Xero should therefore be set up in the Balance Sheet and not in the Profit and Loss.
Because dividends have no role in the calculation of a company’s profits, there should be no accounts that relate to dividends in the Profit and Loss section in your Xero chart of accounts.
Instead, it is common in Xero to have two balance sheet accounts set up specifically to manage the declaration and subsequent payment of dividends: Dividends Payable (in Current Liabilities) and Dividends (in Equity).
To declare the dividend:
Credit: Dividends Payable
To pay the dividend:
Debit: Dividends Payable
In practice, many small businesses will simply declare and pay the dividend on the same date and not make any transactions on the Dividends Payable account.
Hopefully these tips will help you improve your accounting for dividends and ensure that you submit accurate statutory accounts and corporation tax returns.
Lastly, Instafile can help you to further improve the accuracy of your Companies House and HMRC submissions so please do not hesitate to get in touch with us if you’d like to know more.