When most directors think of "distributions", they think dividends: a cash payment declared usually at year-end and paid to shareholders. Simple. But in reality, the legal definition is far broader. Failing to identify a distribution is more common than you'd think and can easily lead to trip hazards and mistakes for boards.
Getting a distribution wrong can expose directors to personal liability and shareholders to repayment obligations. For companies operating within a group structure, boards should be aware that the risks are just as prescient; the requirements for lawful distributions of cash or non-cash assets to its parent company apply in the same way as any other shareholder.
In this article, we break down the technical details and explain what the rules actually require, why they matter, and what to do if something has gone wrong.
What counts as a "distribution"?
The Companies Act 2006 defines a distribution in a rather circular way: "every description of distribution of a company's assets to its members, whether in cash or otherwise".
Put simply, any cash or non-cash transfer from a company to its shareholder has the potential to be a distribution. So, beyond the usual cash dividend payments, this could include things like:
Transferring or loaning company property to shareholders for less than market value.
Making interest-free loans to a shareholder that are not repayable on demand.
Transferring assets (such as property, shares in another company, or intellectual property) to a shareholder or a fellow group company at below market value.
Writing off or waiving an intra-group loan owed by a parent or sister company.
Assuming a liability owed by a parent or sister company to a third party without receiving equivalent consideration.
Surrendering tax losses up the group for less than arm's-length value.
Crucially, the rules on distributions apply with equal force within corporate groups. A subsidiary paying a dividend to its parent or transferring property (including intellectual property) up the group is potentially making a distribution in the same way as if it were paying an external shareholder.
The key message here is that identifying a distribution can be difficult, especially if some consideration is provided in relation to the payment or transfer. The courts have consistently held that whether a transaction amounts to a distribution is a question of the true purpose and substance of the transaction that has taken place, not its form.
What does the law require?
Once a distribution has been identified, it can only be made lawfully if the (a) the company has the power to make it and (b) the statutory and common law rules are complied with. The principle underlying the rules is the protection of the members and creditors of the company.
The company should first establish that it has the power to make a distribution by checking its articles of association (they usually do) and that there are no restrictions on distributions.
Once the company's power to distribute has been confirmed, the company needs to ensure it can make a lawful distribution by satisfying the statutory financial requirements. A lawful distribution requires two aspects:
- First, the company must have sufficient "profits available for distribution", which is defined as its accumulated, realised profits, less its accumulated, realised losses.
- Second, the distribution must be justified by reference to "relevant accounts", most commonly the company's last annual accounts, or specially prepared interim accounts where those are needed.
These rules apply to every UK company, whether public or private, listed or a wholly-owned subsidiary. Importantly, in a group context, the relevant accounts are always the individual company's own accounts, never the consolidated group accounts.
To illustrate how a distribution can be caught out with a practical example:
- Totally Made Up Company Limited is a wholly-owned subsidiary of Totally Made Up Holdings Limited.
- The subsidiary owns a property with a book value of £10,000 but a market value of £15,000.
- It transfers that property to Totally Made Up Holdings Limited for £8,000.
- Therefore, it's making a distribution to its holding company of £2,000, being the shortfall between book value and consideration received.
- The subsidiary company must have at least £2,000 of distributable reserves to make that transfer lawfully. If it does not, the transfer is unlawful, regardless of the group's overall financial health.
It's important for directors to also consider their statutory duties and the company's future solvency before approving any distribution. For more on director duties, check out our guide here.
Why does it matter?
The consequences of an unlawful distribution are serious and far-reaching:
Shareholders may have to repay the distribution. Any member who knew, or had reasonable grounds to believe, that a distribution was unlawful is liable to repay it. In a group context, this commonly means a parent company that received an unlawful dividend from its subsidiary will be liable to return the money (particularly where group companies share the same directors). Conversely, if a member receives an unlawful distribution without the knowledge that it was unlawful, then it cannot be recovered unless there is a winding up (or the shareholder agrees to repayment).
Directors face personal liability. Directors who authorise or permit an unlawful distribution may be jointly and severally liable to repay the amount to the company. The test is fault-based rather than strict, so it's relevant whether the director knew, or ought reasonably to have known, the facts that rendered the distribution unlawful. Ignorance of the law on distributions won't help; it's the director's knowledge of the relevant facts (not the law) that counts.
Group knock-on effects. Where dividends are paid up a chain of companies, an unlawful distribution at subsidiary level can taint subsequent onward distributions by the parent, creating a cascade of unlawfulness through the group.
Two further factors can amplify these risks:
If the company making the distribution later enters into administration or insolvency, an administrator/liquidator can challenge the transaction and pursue directors and shareholders. These types of claims have become routine for insolvency practitioners.
The usual six-year limitation period does not necessarily apply to claims against directors for unlawful distributions, meaning exposure can persist for considerably longer than many assume.
Navigating the hurdles, especially in groups
For standalone companies, once the distribution has been identified, compliance is normally relatively straightforward: check distributable reserves against the last annual accounts, prepare interim accounts where needed, and ensure directors consider solvency. For groups, however, the challenges are more nuanced. Here are some tips to guide you:
Start at the bottom of the chain. Each company in a group must satisfy the distributable reserves test on its own individual accounts. It's not sufficient to point to healthy consolidated group reserves if the subsidiary's own balance sheet cannot support a distribution.
Use interim accounts where annual accounts are insufficient. If a subsidiary's last annual accounts do not show sufficient reserves (maybe because a profitable asset sale has occurred since the year-end), interim accounts should be prepared to capture that realised profit. For private companies, these need not be overly formal; good management accounts comprising a summarised balance sheet are usually sufficient.
Trace the distribution up the chain. Where assets are transferred between group companies at below market value, the sensible approach is to assess the lawfulness of the distribution at each step up the ownership chain. If any intermediate company has negative distributable reserves, there is effectively a "dividend block" and the transfer cannot proceed at less than market value.
Remember to consider impairment. When a parent receives a dividend from its subsidiary, the receipt may trigger an impairment of the carrying value of its investment in that subsidiary. If this impairment loss is not reflected in the parent's accounts before it makes its own onward distribution, that onward distribution may itself be unlawful.
For a deeper dive on group reorganisations and associated tax pitfalls, check out When company law attacks: group relief traps, an article authored by our fantastic colleagues Matthew Rowbotham and Sam Pennington. The article is behind a paywall, but you can register and read the article for free.
Think you may have got it wrong? How to fix it
It's not possible to retrospectively make an unlawful distribution lawful, because the lawfulness is assessed at the time the distribution is made. However, companies can take steps to mitigate the consequences, provided the company isn't insolvent at the time.
Typical ways to address an unlawful distribution include:
If the distribution was unlawful because there are insufficient distributable reserves, consider whether a capital reduction can create the necessary reserves which can then be appropriated to the payment of the prior unlawful dividend.
The shareholders can pass a resolution approving and formally allocating the company's newly created distributable profits (from the capital reduction) to cover the original dividend payment. In effect, this confirms that the profits now available should be treated as having been set aside for that purpose.
The company can waive its claims against shareholders in receipt of the distribution, which releases them from any repayment obligation.
Additionally, the shareholders can release the directors who authorised the distribution from liability.
In a group context, it's usually simpler to rectify where no money has left the group. But complexities grow if dividends have been paid up a chain of intermediate companies, because each link in the chain needs examining.
Importantly, time is of the essence. The longer an unlawful distribution remains unaddressed (particularly if the company's financial position deteriorates) the harder it becomes to rectify.
Get in touch
As we've set out, the rules on distributions are deceptively complex, and the consequences of getting them wrong can be severe.
Whether you're planning a reorganisation, declaring a dividend, or have spotted a potential historic breach, our Corporate team can help you navigate these areas. Get in touch if you'd like to discuss your specific situation.
