In mid 2010 the longstanding ‘profits test’ for declaring and paying dividends was replaced with a ‘net assets’ test. Treasury has released for consultation the draft Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 which includes a proposal to change the test again, with the introduction of a pure solvency test for the declaration or payment of dividends. 

Background

Section 254T of the Corporations Act 2001 (Cth), which provides for the circumstances in which a company may pay a dividend, has been the subject of a range of reforms and proposed reforms in recent years.

Section 245T initially provided for the payment of dividends only out of profits of a company. In mid-2010 this “profits test” was replaced with the current “net assets test”, to address concerns that changes in accounting standards impacting on the calculation of profits limited a company’s ability to pay dividends, together with concerns relating to the appropriate method for determining “profits”.

The current net assets test dividend rules provide that dividends must not be paid unless all of the following conditions are satisfied:

  • 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.
  • The dividend does not materially prejudice the company’s ability to pay its creditors.

Current concerns

The current net asset test requires that assets and liabilities be calculated in accordance with accounting standards. As a result, the current dividend rules impose an additional compliance burden and cost on smaller companies, which are not otherwise required to comply with accounting standards nor to prepare accounts. It follows that those companies do not benefit from the flexibility that the introduction of the net assets test was intended to provide.

Other concerns include that the net assets test alone has an insufficient relationship with solvency, and consequently restricts the ability of companies with negative net assets, but a strong cash flow, to pay dividends, despite those companies being in a position of solvency.

Finally, widespread concerns also exist in relation to whether, under the current rules, a dividend paid from sources other than profits, amounts to a capital reduction requiring shareholder approval under Part 2J.1 of the Corporations Act.

Summary of proposed reforms

The draft bill contemplates the abolition of the existing net assets test under section 254T and its replacement with a pure solvency test.

Under the proposed new legislation, a company must not declare a dividend, unless, immediately before the dividend is declared, the directors reasonably believe that the company will be solvent immediately after the dividend is declared. The same restrictions apply in relation to the payment of dividends, where dividends are paid without a declaration.

The proposed reforms also seek to address the ambiguity around the payment of dividends from sources other than profits (i.e. capital) by expressly allowing a company to reduce its share capital through the payment of dividends without shareholder approval, provided that the dividend satisfies the requirements of an “equal reduction” of capital, namely:

  • The capital reduction relates to ordinary shares only.
  • The capital reduction applies to each holder of ordinary shares in proportion to the number of ordinary shares they already hold.
  • The terms of the reduction must be the same for each holder of ordinary shares.

Where dividends are paid out of capital, the proposed reforms require that the company’s annual directors’ report must include details about the source of dividends paid and the company’s dividend policy.

These reporting requirements only apply to companies that are required to prepare financial reports and directors’ reports under the Corporations Act, and are designed to ensure that shareholders have the information they need about a company’s dividend policy to make informed investment decisions.

Conclusion

If passed, the proposed new dividend rules will be a welcome reform, as they go a long way to addressing many of the concerns raised in relation to the current net assets test.

The replacement of the net assets test with a pure solvency test will enable directors to more generally assess the solvency of a company before declaring or paying dividends, having regard to all relevant factors including the balance sheet position of the company, the company’s undistributed profits and its cash flow position.