The basic test
The statutory rules on distributions in the Companies Act 2006 (the Act) state any company proposing to make a distribution must have "profits available for the purpose".
A company's "profits available for the purpose" are its accumulated, realised profits (so far as not previously distributed or capitalised) less its accumulated, realised losses (so far as not previously written off in a duly made reduction or reorganisation of capital). The question of when profits are "realised" is an accounting one. Therefore, accounting rules and guidance are at least as important as the Act in determining whether or not a particular distribution can be made. A distribution is "every description of distribution of a company's assets to its members, whether in cash or otherwise", except when it is:
- An issue of fully or partly paid bonus shares;
- A reduction of share capital by extinguishing or reducing a member's liability on unpaid shares or by repaying paid-up share capital;
- The redemption or purchase of the company's own shares out of capital or out of unrealised profits in accordance with the Act; or
- The distribution of assets to members on a winding up of the company.
The net assets test
Public companies must comply with two additional requirements. A public company must not make a distribution if:
- The amount of its net assets is less than the aggregate of its called-up share capital and undistributable reserves; and
- As a result of the distribution, the amount of its net assets will be reduced below the level of its called-up share capital and undistributable reserves.
"Net assets", for this purpose means the aggregate of its assets less the aggregate of its liabilities.
A company's undistributable reserves include:
- Its share premium account;
- Any capital redemption reserve;
- The amount by which its accumulated unrealised profits, so far as not capitalised, exceed its accumulated, unrealised losses; and
- Any other reserve which the company is prohibited from distributing by any enactment or by its memorandum or articles.
The test is complicated. Its impact is broadly that unrealised losses, in so far as they exceed unrealised profits, must be made good out of net realised profits before a distribution can be made.
The sufficiency of distributable profits and the net assets test are to be calculated against the company's relevant accounts at the time of the particular distribution being made or declared.
The relevant accounts are a company's last annual accounts unless the annual accounts do not show:
- sufficient distributable reserves; or
- that the net assets test is met.
In this case, more recent interim accounts must be used to justify the proposed distributions. However, such interim accounts must be:
- properly prepared;
- signed off by the directors; and
- duly filed with the registrar of companies.
The last of these three requirements has caught a number of company directors by surprise.
Consequences of unlawful dividends
A breach of the tests above or failure to comply with the statutory requirements under the Act (and therefore the failure to file interim accounts with the registrar before making the distribution) will render the distribution unlawful. The courts have held that the statutory requirements are not mere technicalities which are capable of being dispensed with. They provide important protection for members and creditors.
If a distribution is made in excess of the available distributable profits, only that part of the distribution which is beyond the distributable profits is unlawful. A shareholder who receives the improperly declared dividend with knowledge that it is improper holds the dividend on constructive trust for the company and therefore is liable to repay it (or the portion of it that is unlawful).There is no obligation on a shareholder who has innocently received an improper dividend to make any repayment to the company.
Directors may also be personally liable for the payment of unlawful dividends if, in declaring the dividend, they have breached their statutory or common law duties. It is irrelevant as to whether the director is also a shareholder of the company.