Changes to dividend payment rules: How do they affect your company?

27 October 2010 Topics: Compliance and corporate governance

On 28 June 2010 the Corporations Amendment (Corporations Reporting Reform) Act 2010 came into effect, signalling a shift from the long-standing profits-based test to a new solvency-based test for paying dividends.

With dividend season upon us, the changes to the rules will be met with a degree of uncertainty in boardrooms across Australia.

The traditional position – dividends out of profits

Historically, dividends could only be paid out of the profits of a company.

This meant that a company with an accounting profit could declare a dividend, even if it had a deficiency in net assets.

The new solvency-based test

Under the new section 254T of the Corporations Act 2001, a company is prohibited from paying a dividend unless:

  • the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend;
  • the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and
  • the payment of the dividend does not materially prejudice the company’s ability to pay its creditors.

 

What it means for your company

Critically, the balance sheet test will allow companies without accounting profits to pay dividends. This will benefit companies in their start-up phase, or companies that have suffered a net loss because of abnormal non-cash expenses, such as asset impairments.

The inverse of this is that companies with accounting profits but a deficiency in net assets will no longer be able to pay dividends they would have been permitted to pay under the old laws.

Practical reflections

Accounting Standards

For the purposes of determining whether assets exceed liabilities (and whether the excess is sufficient to pay the dividend), companies must calculate their net asset position in accordance with the accounting standards in force at the relevant time, even if the standard does not otherwise apply to the company concerned.

Where companies (such as small proprietary companies) do not prepare audited financial statements, directors will need to be particularly careful to ensure that they consider all accounting standards, including those relating to impairment write-downs, recognition of revenue and liabilities and classification of debt and equity. This is because the application of these standards may produce a different result to that reflected in non-audited accounts.

Timing issues

The balance sheet test must be satisfied immediately before the dividend is declared.

Directors will therefore need to be careful in placing too much emphasis on financial statements which are not absolutely up-to-date.

Directors should consider using unaudited management accounts to get the most up-to-date understanding of the net asset position of their company, particularly where the surplus of assets over liabilities is not a large one, or the surplus fluctuates depending on market conditions.

Fair and reasonable test

Directors of companies with different share classes should be mindful that any dividend payments must satisfy the fair and reasonable test under the new dividend payment rules.

If a dividend is paid to some but not all shareholders the directors will have to be satisfied that this is “fair and reasonable to the company’s shareholders as a whole”.

There is no guidance in the legislation or the explanatory memorandum as to how this fair and reasonable test should be applied.

Section 254W(2) may provide some assistance. It provides that “subject to the terms in which shares in proprietary company are on issue, the directors may pay dividends as they see fit”.

However this does not say that the directors can ignore the requirements under section 254T.

In these circumstances, directors should review their constitution and consider seeking professional advice to ensure that they can justify making the differential dividend. Directors should also document their considerations so they can defend any challenges by non-recipient shareholders on the basis that the fair and reasonable test has not been satisfied.

What you need to do

We recommend that you review your company’s constitution in light of the changes to the dividend rules.

Many constitutions contain a requirement that dividends be paid only out of profits. Companies in these circumstances should amend their constitution – otherwise they will need to satisfy both the profits test and the balance sheet test.

 

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This publication is for information only and is not legal advice. You should obtain advice that is specific to your circumstances and not rely on this publication as legal advice. If there are any issues you would like us to advise you on arising from this publication, please let us know.