Over the past few years, there has been an amendment and two proposed changes to section 254T of the Corporations Act 2001 (Cth). These proposed amendments focus on the solvency test. The rationale behind the solvency test is to ensure that companies have the ability to distribute dividends without prejudicing the company’s ongoing operations. The most recent proposed changes purport to achieve this objective with greater clarity than the current three-limbed solvency test by replacing it with a single solvency test. Interestingly, the most recent proposed changes would also allow dividends to be paid as an equal reduction of share capital.

In 2010, the Federal Government introduced the current three-limbed test under the Corporations Amendment (Corporate Reporting Reform) Act 2010 (Cth). Before then, a dividend could only be paid out of company profits. This was amended to provide that a company may only pay a dividend if it:

  • does not exceed net assets;
  • is fair and reasonable to the company’s shareholders as a whole; and
  • does not materially prejudice the company’s ability to pay its creditors.

Again, in 2012, the Commonwealth released an Exposure Draft of the Corporations Legislation Amendment (Remuneration and Other Measures) Bill 2010 in an attempt to amend section 254T. However, the amendments in the 2012 exposure draft were not adopted and did not become law.

On 10 April 2014, another exposure draft bill, the Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (the Draft), was published for comment and submissions.

The proposed new and improved single solvency test

If passed, these proposed changes would change the test for payment of dividends from a net assets test to a more effective, single test of solvency. Relevantly, some companies resolve to pay a dividend or determine a dividend without declaring it. On the other hand, some companies declare a dividend, at which point a debt is created and owing by the company and the dividend is usually paid some time later. The proposed changes address two different scenarios:

  • where a dividend is declared; and
  • where a dividend is paid without declaration.

Under the proposed revised solvency test, immediately before a dividend is declared, the directors of the company must reasonably believe that the company will remain  solvent after the declaration of a dividend. For non- declaration scenarios, a company must not pay a dividend unless, immediately before the dividend is paid, the directors of the company reasonably believe that the company will, immediately after the dividend is paid, be solvent. This provides more clarity than the current test. Like the 2012 proposed amendments, the 2014 Draft addresses the distinction between declaration dividends and determining to pay dividends without declaring them.

If these amendments are passed the three-limbed solvency test would be replaced by a cleaner, single test for solvency. Accordingly, directors would be better-equipped to understand when they can pay or declare dividends and when they cannot.

The proposed equal reduction of capital dividend

In regards to increasing the flexibility of the payment of dividends, the Draft expressly provides that a company may pay a dividend (or part) from its capital provided it amounts to an equal reduction of capital. This may result in in specie dividends becoming more attractive and easier to implement.

Notably, the reduction only applies to ordinary shares.

Practical issues

Despite these proposed legislative changes, it is worthwhile noting that a director will only have authority to pay a dividend in accordance with the company’s constitution. This is the first thing to check. If the proposed laws are passed, it will become clear how section 254T applies in relation to the capital maintenance provisions in Chapter 2J of the Corporations Act, because section 256B and others will also amended.

There have been previous suggestions that some corporate groups, which have deeds of cross guarantee in place may find that the new test is still required to be made for each entity in the group despite the group meeting the requirements of the new solvency test. Having a deed of cross guarantee in place practically means that the group as a whole will meet the debts of each company in the group.

A notable tax implication would be that dividends that constitute a payment from share capital could be considered unfrankable