The Corporations Amendment ("Corporate Reporting Reform") Act 2010 ("Act") commenced on 28 June 2010. The package of reforms contained in the Act and its accompanying regulations change the company reporting and dividend framework in Australia by:
- Payment of dividends – replacing the profits test for payment of dividends with a three tiered test which focuses on the solvency of the company (discussed below)
- Parent entity financial reporting – abolishing the requirement for parent entities to prepare financial statements for the parent entity as well as for its consolidated group
- Companies limited by guarantee – reducing the regulatory burden on companies limited by guarantee by dividing the reporting requirements of companies limited by guarantee into three categories with a company's annual revenue and deductible gift recipient status determining which reporting framework applies
- Changing year end dates – allowing a company to more easily change its financial year end date
- Cancellation of share capital – clarifying the circumstances in which a company can cancel share capital which is lost or not representative of the company's assets.
This article focuses on the new rules surrounding the payment of dividends and how they change the way your company will decide whether to pay a dividend and the amount of that dividend.
Dividend payment rules
Under the three tiered test now contained in section 254T of the Corporations Act 2001, a company cannot pay dividends to its shareholders unless:
- 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
- The payment of the dividend does not materially prejudice the company's ability to pay its creditors.
In determining whether the first element of the three tiered test is met, the assets and liabilities of the company are to be calculated in accordance with the standards in force at the relevant time.
The first element
The first element of the new test raises two key issues to determining a dividend:
- Which accounting standards apply to the company in question
- The timing of the dividend payment.
Which accounting standards apply
The Explanatory Memorandum to the Act gives some guidance with regard to accounting standards by indicating that audited financial reports are not required to declare a dividend. Rather the fair value of assets and liabilities should be taken from the company's statutory accounts.
Timing of the dividend
The first element clearly requires that the balance sheet solvency test must be satisfied immediately before a dividend is declared. This requires an assessment of the balance sheet of the company just before a dividend is declared. This means that company's will need to prepare a balance sheet just before the dividend is declared in accordance with the accounting standards at that time. If the legislation is read literally, it is not enough that the company relies on previous balance sheets, even where these have been audited.
The second timing issue under the new test is when the dividend becomes a debt of the company. Under the previous regime, a company was only required to determine a dividend. This meant that the dividend did not become a debt of the company until the payment time of the dividend.
Under the new regime where a company's constitution provides for the declaration of dividends, the debt arises on the declaration of the dividend. This distinction is also relevant to director's duties to prevent insolvent trading on payment of dividends under section 588G of the Corporations Act 2001.
The second element
The second and third elements of the new test are somewhat less complex than the first element. The second element requires consideration of fairness to shareholders. Where a company has different classes of shareholders, directors will need to carefully consider the proposed dividend in light of the differing rights of shareholders to ensure that the dividend is not unfair or unreasonable towards a particular class of shareholder.
The third element
The third element of the test requires an assessment of the position of creditors. At this stage it is unclear under the Act what will amount to material prejudice to creditors. However, the Explanatory Memorandum to the Act makes it clear that directors in determining to declare a dividend should consider whether the payment of the dividend will impact upon the solvency of the company.
Further, the Explanatory Memorandum to the Act states that the Act aims to align the requirements for the payment of dividends with capital reductions and share buy backs under Part 2J of the Corporations Act 2001. Thus guidance as to what would amount to material prejudice can be taken from the rules associated with capital reductions in relation to creditors.
How the changes to dividend payments will affect you
The move from the profits test to the three tiered approach fundamentally changes the requirements for the payment of dividends. Under the new regime, a fuller assessment of a company's solvency is required before the directors declare a dividend. There are three key consequences of these changes:
- The regulatory compliance requirements for the payment of dividends have been increased as directors must ensure that each of the elements of the three tiered test are satisfied including assessment of current financial accounts of the company and any prejudice to creditors or shareholders
- Many companies will need to amend their constitutions. Many constitutions contain specific requirements about the way dividends should be paid, which may no longer comply with the Corporations Act 2001. For example, a constitution may require that dividends are determined following a profit being made by a company
- Companies will need to consider adopting fair value accounting to enable the payment of dividends in the future, particularly where the company has previously used a historical cost method of valuing assets.
Although there are likely to be increased compliance burdens under the new regime, a real advantage of the new system is that it eliminates the previous artificial restrictions on payments of dividends. However, the cost of this removal is likely to come at the expense of companies that have a deficiency in net assets, as those companies are unlikely to meet the first element of the new test.
This article was prepared by Grant Sefton at Moray & Agnew's Newcastle office.
If you would like further information regarding how your company should prepare for the declaration of dividends under the new system, or any of the other reporting requirement amendments to the Corporations Act 2001 please contact Grant Sefton.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.