Declaring and paying dividends: the law is proposed to change again

Two years after rewriting the rules on company dividends, the Government has gone back to the drawing board.

Late last week, it released draft provisions to replace the existing rules with completely new ones.

The Government also appears to have backed away from endorsing the use of dividends for capital reductions.

Background

For two centuries, the law governing dividends was relatively simple: you could only pay a dividend out of profits.

Amendments to the Corporations Act in mid-2010 replaced that profits test with a balance sheet test. This requires the company's assets to exceed its liabilities and the excess to be sufficient for payment of the dividend immediately before the dividend is declared. Assets and liabilities must be calculated according to the AASB accounting standards.

This raised a number of concerns, including:

• many smaller companies may not have AASB-compliant financial reports, and so would have to incur extra expense before being able to decide whether they could declare a dividend;
• the balance sheet test doesn’t address the issue of solvency; and
• the test is applied as at the date the board "declares" the dividend, even though current practice is for the board to "determine" that a dividend is payable (to avoid the fact that a dividend becomes a debt on the day it is declared).

Government's response

Late last year, Treasury released a set of proposals to address these issues. Those proposals have now been firmed up in a draft Bill. It addresses the three major concerns noted above:

• companies which aren't required to produce AASB-compliant financial reports will be able to rely on their existing financial records when determining whether their assets exceed their liabilities;
• the draft Bill addresses the solvency issue by retaining the balance sheet test, and adding a new additional requirement – the directors must reasonably believe that the company will still be solvent after declaring or paying the dividend. The draft Bill will also remove the current "no material prejudice to creditors" and "fair and reasonable to shareholders" tests which were introduced in the 2010 amendments and based on the capital reduction safeguards; and
• the balance sheet and solvency tests will apply when dividends are declared and when they are paid, but not both (ie. if the test is applied when a dividend is declared, it will not have to be reapplied when the dividend is paid).

Can a dividend be used to reduce share capital?

Another issue with the 2010 amendments was that the drafting of new dividend rule suggested that dividends could not be used to reduce share capital.

In its proposal paper last year, Treasury appeared to support a view that dividends can be used to reduce share capital:

• it stated that it was "clear" that paying a dividend was a circumstance where a reduction in capital is "otherwise authorised" by the law; and
• there may be merit in amendments to "clarify" the point.

There now appears to have been a policy shift on this issue:

"The new dividends test does not displace the existing requirements in relation to conducting share capital reductions and share buy-backs under Part 2J of the Corporations Act. These provisions will continue to apply under the new dividends test."

This decision may be related to the removal of the "no material prejudice to creditors" and "fair and reasonable to shareholders" safeguards.

What's the timeframe?

The new draft legislation is open for public comment until 15 March 2013.