Corporation tax - Tax treatment of company distributions to shareholders

Learning Outcomes

After reading this article, you will be able to explain how company distributions to shareholders are treated for corporation tax purposes. You will understand the tax implications of dividends, share buybacks, and loans to shareholders, including the relevant legal requirements and anti-avoidance rules. You will be able to identify the correct tax treatment in SQE1-style scenarios and advise on the consequences of different distribution methods.

SQE1 Syllabus

For SQE1, you are required to understand the corporation tax treatment of company distributions to shareholders. Focus your revision on:

• The corporation tax consequences of paying dividends to shareholders
• The legal and tax requirements for share buybacks and their classification as income or capital
• The tax rules for loans to shareholders, including the section 455 charge for close companies
• The interaction between company law and tax law in determining lawful and tax-efficient distributions
• The practical implications of different distribution methods for both companies and shareholders

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is deductible for corporation tax purposes?
   1. Dividends paid to shareholders
   2. Salaries paid to employees
   3. Share buyback payments
   4. Section 455 tax charge
2. When can the proceeds of a share buyback be treated as a capital gain for the shareholder rather than as income?
   1. Always
   2. Only if the company is a close company
   3. Only if specific statutory conditions are met
   4. Never
3. What is the main purpose of the section 455 charge in relation to loans to shareholders?
   1. To provide a tax deduction for the company
   2. To prevent avoidance of income tax on distributions
   3. To encourage companies to pay more dividends
   4. To reduce the company’s corporation tax rate

Introduction

Company distributions to shareholders—such as dividends, share buybacks, and loans—are subject to specific corporation tax rules. For SQE1, you must be able to identify the correct tax treatment for each type of distribution and understand the legal requirements that must be met for a distribution to be lawful and tax-efficient. This article explains the key principles, statutory rules, and practical consequences of the main types of company distributions.

Dividends: Corporation Tax and Legal Requirements

Dividends are the most common way for companies to return profits to shareholders. The tax and legal treatment of dividends is central to SQE1.

Key Term: dividend
A distribution of post-tax profits by a company to its shareholders, usually in cash, but sometimes in shares or other assets.

Dividends are paid out of profits after corporation tax. For corporation tax purposes, dividends are not deductible expenses. This means that paying a dividend does not reduce the company’s taxable profits.

Key Term: distributable profits
Profits available for distribution to shareholders, calculated according to company law and accounting standards, after corporation tax has been paid.

Under the Companies Act 2006, a company may only pay dividends out of distributable profits. Directors must ensure that the company has sufficient distributable profits before declaring a dividend. Paying unlawful dividends can result in personal liability for directors.

Key Term: unlawful dividend
A dividend paid when the company does not have sufficient distributable profits, in breach of company law.

Dividends paid to individual shareholders are subject to income tax in the hands of the recipient. UK-resident corporate shareholders are generally exempt from corporation tax on dividends received from other UK companies, to prevent double taxation.

Worked Example 1.1

A company has post-tax profits of £100,000. It pays a dividend of £30,000 to its shareholders. Is the dividend deductible for corporation tax purposes?

Answer: No. The dividend is paid out of post-tax profits and does not reduce the company’s taxable profits. It is not deductible for corporation tax.

Share Buybacks: Tax Classification and Conditions

A share buyback occurs when a company purchases its own shares from shareholders. The tax treatment of the proceeds depends on whether the payment is classified as income (a distribution) or capital (a disposal for capital gains tax).

Key Term: share buyback
A transaction where a company purchases its own shares from shareholders, reducing the number of shares in issue.

If the statutory conditions are met, the proceeds may be treated as a capital gain for the shareholder. The main conditions include:

• The company must be unquoted and trading
• The buyback must benefit the company’s trade
• The shareholder’s interest must be substantially reduced (usually by at least 25%)
• The shareholder must have held the shares for at least five years

If the conditions are not met, the payment is treated as an income distribution and taxed as a dividend.

Worked Example 1.2

A shareholder sells half of their shares back to the company. Their holding falls from 40% to 20%. The company is an unquoted trading company and the buyback is for the benefit of the trade. Will the proceeds be taxed as a capital gain or as income?

Answer: The proceeds will be taxed as a capital gain, provided all other statutory conditions are met. The shareholder’s interest has been substantially reduced and the company is unquoted and trading.

Loans to Shareholders: Section 455 Charge

Loans to shareholders (or their associates) by close companies are subject to special anti-avoidance rules. The main rule is the section 455 charge.

Key Term: close company
A company controlled by five or fewer shareholders (participators), or by any number of directors who are also shareholders.

Key Term: section 455 charge
A corporation tax charge on loans made by a close company to a shareholder or their associate, equal to 32.5% of the loan amount, payable if the loan is not repaid within nine months of the end of the accounting period.

The section 455 charge is designed to prevent shareholders from extracting value from the company by way of loans instead of dividends. If the loan is repaid, the tax is refunded. Anti-avoidance rules prevent “bed and breakfasting” (repaying and re-borrowing shortly after).

Worked Example 1.3

A close company lends £40,000 to a shareholder. The loan is still outstanding nine months after the end of the accounting period. What is the section 455 charge?

Answer: The company must pay a section 455 charge of £13,000 (32.5% of £40,000). If the loan is repaid later, the tax is refunded.

Comparing Distribution Methods

Companies may choose between dividends, share buybacks, or loans to shareholders. Each method has different tax and legal consequences.

Worked Example 1.4

A company has £50,000 of surplus cash. It can pay a dividend, buy back shares, or lend the money to its sole shareholder. What are the main tax consequences of each option?

Answer:

• Dividend: Not deductible for corporation tax; shareholder pays income tax on the dividend.
• Share buyback: If conditions are met, shareholder pays capital gains tax; otherwise, taxed as a dividend.
• Loan: Section 455 charge applies if not repaid; no immediate income tax for the shareholder, but benefit-in-kind rules may apply.

Key Point Checklist

This article has covered the following key knowledge points:

• Dividends are paid from post-tax profits and are not deductible for corporation tax.
• Dividends must be paid out of distributable profits; unlawful dividends can result in director liability.
• Share buybacks may be taxed as capital or income, depending on statutory conditions.
• Loans to shareholders by close companies are subject to the section 455 charge if not repaid promptly.
• The choice of distribution method affects both company and shareholder tax liabilities.

Key Terms and Concepts

• dividend
• distributable profits
• unlawful dividend
• share buyback
• close company
• section 455 charge