Dividends and Corporations Act 2001: When can you declare a dividend?

The payment of dividends from private companies is an important tool in allowing shareholders to release value or distribute cash within a group. 

The circumstances under which an Australian company can pay a dividend are set out in the Corporations Act. 

Understanding of the current requirements of the Act, in particular the removal of the “out of profits” test from the legislation in 2010, are often misunderstood.

This article considers the legality of paying dividends under the Corporations Act 2001. However, it does not consider whether such a dividend may be franked or not for tax purposes. That requires separate assessment, for which the “out of profits” test may still be relevant.  

Key Requirements to pay dividends under the Corporations Act 2001

Section 254T⁽¹⁾ of the Corporations Act 2001 provides that a company must not pay a dividend unless:  

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

The calculation of net assets in part (a) above must be performed in accordance with Australian Accounting Standards, which are fully compliant with International Financial Reporting Standards (“IFRS”).  This may present challenges for smaller entities who do not have financial reporting obligations, and therefore would not usually maintain their books and records in accordance with Australian Accounting Standards.  They may need to consider whether adjustments for issues such as leases, deferred tax, or employee entitlements, could potentially affect their assets or liabilities.

Considerations for groups and the “dividend trap”

The tests in s254T must be performed on an individual company basis and not a consolidated basis. As a result, an Australian company cannot pay a dividend simply by assessing whether the entire corporate group's consolidated financial statements show net assets and solvency.  

Each subsidiary must make its own assessment as dividends are paid all the way up to the parent company and the ultimate shareholders.  

Therefore it may be necessary for every company in a consolidated group to prepare a balance sheet under Australian Accounting Standards to determine whether it can legally pay dividends, and then to pay a dividend before the company above it can pay its dividend. These requirements can potentially give rise to a “dividend trap,” where a company exists within a complex group structure which has insufficient net assets to pay a dividend up to the next company in the chain.

Removal of the “Out of Profits” Test  

The current three-pronged solvency tests in s254T as outlined above were introduced in 2010. Prior to 2010, s254T simply stated:  

A dividend may only be paid out of profits of the company.

The removal of the “out of profits” test from the Corporations Act is important due of the impact on which assets can be distributed from entities which have not themselves generated a profit.  This could previously be problematic for non-operating holding companies and could lead to issues in complex group structures with “dividend traps”, where entities within a group were unable to pay dividends upwards despite the overall group being profitable.  

Generally accumulated “profits” were considered to equate to retained earnings, although this was open to interpretation, particularly where transfers between reserves had occurred, or where the basis of preparation of financial statements had changed over time (for example, changes to accounting standards, or the initial adoption of IFRS in Australia).

Despite the introduction of the revised tests in 2010 and language referring to “out of profits” being removed from the Act, there are divergent views about the extent to which the “profits test” has been removed, with some legal practitioners arguing that a common law requirement to consider profits still exists. There is no reference in legislation to dividends requiring sufficient profits, and there have been rulings in Federal Court, in 2015 and 20161, in which the judges indicated a view that the “out of profits” test no longer applies.

RSM’s approach is usually to apply s254T may be read as it is written, and that the decision in drafting the legislation to remove the reference to “out of profits” shows a clear intent on the part of the legislators to remove this test. On this basis we would not consider a company which pays a dividend greater than its retained earnings to automatically be in breach of the Corporations Act, provided that the three tests in s254T are met.

However, the Company would need to separately assess whether it could apply franking credits to any dividends paid in these circumstances.

Timing of recognition of a dividend in the financial statements

The point at which a dividend should be recognised in an entity’s financial statements is considered in AASB Interpretation 17 Distributions of Non-cash Assets to Owners. While the interpretation was written specifically in respect of non-cash dividends, the same principles apply to dividends paid in cash, with paragraph 10 stating:

The liability to pay a dividend shall be recognised when the dividend is appropriately authorised and is no longer at the discretion of the entity, which is the date:

• a) when declaration of the dividend, eg by management or the board of directors, is approved by the relevant authority, eg the shareholders, if the jurisdiction requires such approval, or
• b) when the dividend is declared, eg by management or the board of directors, if the jurisdiction does not require further approval.

In Australia, the Directors have the authority to approve and declare dividends under the Corporations Act sections 254U and 254V which state:

• (1) The directors may determine that a dividend is payable and fix:
• a) the amount; and
• b) the time for payment; and
• c) the method of payment.

The methods of payment may include the payment of cash, the issue of shares, the grant of options and the transfer of assets.
(2) Interest is not payable on a dividend.

A company does not incur a debt merely by fixing the amount or time for payment of a dividend. The debt arises only when the time fixed for payment arrives and the decision to pay the dividend may be revoked at any time before then. (2) However, if the company has a constitution and it provides for the declaration of dividends, the company incurs a debt when the dividend is declared.

This means that no liability should be recognised in respect of any dividends declared after the balance sheet date, even if they distribute profits earned during an earlier period.  

Instead, where a dividend is declared after the balance sheet date, but before the signing of the financial statements, it should be disclosed as a non-adjusting post balance sheet event in accordance with AASB 110 Events After the Reporting Period and the disclosure requirements of AASB 101 Presentation of Financial Statements Paragraph 137.
 

FOR MORE INFORMATION

If you would like to learn more about the topics discussed in this article, please contact your local RSM office.

[1] The relevant case was Grant-Taylor v Babcock & Brown Ltd (In Liquidation) [2016], which concerned dividends which were paid out in excess of an entity’s profits prior to the change of the Corporations Act in 2010, thereby breaching the Corporations Act as it stood at that time. The judge noted that “it is not in dispute that under the current law the declaration and payment of the relevant dividends by Babcock & Brown Ltd would have been lawful.”