There has been surprisingly little discussion surrounding one of the most fundamental changes to the Corporations Act in recent times. Under recent changes, dividends can be paid regardless of whether the company has profits.
Dividends now may be paid, irrespective of whether the company has current year or retained profits, if the company satisfies a three stage test.
Under the new three stage test, section 254T of the Act allows a company to pay a dividend if:
- 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.
One of the reasons the Government gave for amending the Corporations Act was that the definition of “profits” was not widely agreed upon and as such caused difficulties for companies when determining whether they could pay dividends out of profits. The question was often whether to use the legal precedent of the meaning of profit, or the accounting standard. The Government has maintained that the abolition of the profit test eliminates this issue for companies.
While at first glance section 254T appears to allow more flexibility for companies to pay dividends, it has a number of consequences that companies should be aware of.
Corporate groups are often structured so that a holding company holds shares in numerous operating subsidiaries, each of which runs a part of the group’s business. These subsidiaries are often debt financed by holding company loans and may, for asset protection reasons, have a deficiency of assets against liabilities whilst being solvent because of support from the holding company. Notwithstanding this deficiency, the subsidiary may be profitable and its cash flows may be needed by the holding company.
Under the old law, the holding company would have been able to draw on the profits from the subsidiary by way of dividends. Under the new law, however, the subsidiary would not be able to pay dividends to the holding company because the subsidiary’s liabilities exceed its assets.
Therefore, company groups should consider whether or not the new law will impact on how the group is able to extract profits of subsidiaries to the holding company. Furthermore, the new dividend payment rules may impact on how future corporate groups are structured (for example whether and to what extent it should be debt funded by the holding company) so that dividends are able to be paid to the holding company if necessary. Finally, company groups should consider other corporate structuring or asset protection strategies that would offer similar protections under the new law.
Other potential considerations include a review of the company’s constitution to see whether the provisions on dividends require dividends to be paid out of profits. If so, they should amend their constitution to avoid having to satisfy the profits test in addition to the new law. Similarly, when incorporating a new company consideration should be given to the dividend provisions when drafting the constitution.
The new law, specifically the test of whether “assets exceed liabilities”, may not always be easy for smaller companies to apply. Determining what is an asset or liability can sometimes be a difficult accounting question and given that small proprietary companies may not prepare accounts in accordance with accounting standards, it may impose an unnecessary, expensive burden on the company.
Failing to understand or appreciate how the new dividend rules impact on a company or corporate group may result in a payment of a dividend being an illegal return of capital, resulting in potential liability for company directors.