The test under which companies can pay a dividend might be changing again. In our view, the potential changes are welcome but companies will still need to consider the proposed new test carefully when deciding whether or not to declare or pay a dividend.
In December 2012, Treasury released exposure draft legislation proposing amendments to section 254T of the Corporations Act 2001 (Cth) (Corporations Act), being the dividends test, in order to address ongoing stakeholder concerns about this section.
Prior to June 2010, section 254T provided that a company could only pay a dividend out of profits. From June 2010 section 254T was amended to provide that a company must not pay a dividend unless three separate conditions are met:
- the company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend. Assets and liabilities are to be calculated in accordance with accounting standards in force at the relevant time;
- 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.
This new test gave rise to a number of concerns from stakeholders. First, this test creates confusion in some instances as to when it should apply. Second, by linking the test to the accounting standards this places an unreasonable burden on companies that are not required to comply with the accounting standards (e.g. small proprietary companies that do not have to prepare financial statements). Third, the 'assets greater than liabilities' test can have little relationship to solvency as it does not take into account the timing and magnitude of fund flows. And, finally, there has been a question mark as to whether the capital maintenance requirements of Part 2J of the Corporations Act apply to dividends.
So what are the proposed amendments?
The proposed test is that a company must not declare (or pay) a dividend unless immediately before the dividend is declared (or paid):
- the company's assets exceed its liabilities, and the excess is sufficient for the payment of the dividend; and
- the directors of the company reasonably believe that the company will, immediately after the dividend is declared (or paid), be solvent.
Has this addressed the principal concerns?
The reformulated dividends test removes confusion as to when the test should be applied, by distinguishing between where a dividend is declared and where a dividend is paid without a declaration. As the draft explanatory memorandum notes:
'[w]here a company declares a dividend, the dividends test will apply immediately before declaration. Where a company determines and later pays a dividend without declaring it first, the dividends test will apply immediately before payment'.
Also, the proposed amendments take into consideration non-reporting entities, which may simply use their financial records in assessing assets and liabilities, rather than needing to comply with stricter accounting standards. Further, the collapsing of the latter two limbs of the current test (which mirror part of the requirements under the maintenance of capital rules under Part 2J) into one solvency based limb better aligns the section with the directors' duty to prevent insolvent trading under section 588G (which is also a solvency based test).
However, the approach taken to the fourth issue noted above is curious (being the interaction with Part 2J of the Corporations Act). In its draft explanatory memorandum, Treasury has arguably attempted to resolve the issue about whether the reduction of capital rules can apply to the payment of a dividend. In short, yes they do. The draft explanatory memorandum states that:
'[t]he 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 appears to be in contrast to Treasury's 2011 position and it is not entirely clear how it is envisaged the provisions dealing with share capital reductions and share buy-backs are intended to interact with the proposed new dividends test. However, the ATO has stated in a tax ruling last year that it appears that the procedures to approve a share capital reduction in Part 2J.1 of the Corporations Act would also have to be met for a company to pay a dividend not prohibited by section 254T of the Corporations Act that was sourced from share capital. The ATO has also indicated in that ruling that it considers the better view is that "dividends can only be paid from profits and not from 'amounts other than profits'" (and that the Income Tax Assessment Act prevents the franking of a distribution paid by a company where that distribution is a reduction or return of capital). As with many key corporate actions, tax advice will of course be crucial when determining whether to pay or declare a dividend.
Submissions in response to the proposals close on 15 March 2013. We will keep you updated about further important developments.
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