New dividends test proposed for companies - Shareholders

Key points

On 10 April 2014, the Exposure Draft of the Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 was released for comment.
The Bill proposes replacing the existing net assets test for the payment of dividends with a pure solvency test.
The Bill expressly provides that a company may pay a dividend (or part) out of its capital provided it amounts to an equal reduction of capital. This may result in demergers effected by in specie dividend becoming more attractive and easier to implement.
The deadline for submissions on the Bill is 16 May 2014.

Background

Section 254T initially provided that companies could only pay dividends out of profits. In 2010, this section was replaced with the 'net assets' test that permits a company to pay a dividend provided:

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; and
the payment does not materially impact on the company's ability to pay its creditors.

In many ways, the net assets test is more flexible than the earlier profits test. For example, there is a view that under the net assets test a company is permitted to pay dividends out of its share capital, without requiring compliance with the return of capital provisions co ntained in Chapter 2J of the Corporations Act.

However, there have been a number of criticisms of the net assets test which included:

the net assets of the company are determined by reference to accounting standards. It was argued that this places an unreasonable burden on small proprietary companies that are not required to prepare accounts in accordance with accounting stan dards;
the net assets test has little relationship to solvency because it does not take into account the timing or magnitude of a company's cash flows;
it only provided for the declaration of dividends. This was problematic because most companies determine dividends rather than declare them. The legal distinction appeared to be lost on the drafters of the net assets test. At law, when a company declares a dividend it incurs a liability at the date of declaration and is bound to pay the dividend. However, when a company determines a dividend, it does not incur a liability until the due date for payment and the decision to make the payment is revocable at any time prior to that date. This is why most companies (particularly, listed companies) determine dividends rather than declare them; and
there remained doubt in some quarters about whether a company could pay a dividend (or part) out of its capital without complying with the return of capital provisions in Chapter 2J of the Corporations Act. Treasury was of the view that the legislation was clear on this point¹. It believed that paying a dividend out of a company's share capital under section 254T is a circumstance where the reduction of capital is 'otherwise authorised' ² by law and is therefore permitted without shareholder approval under Chapter 2J of the Corporations Act.

Proposed changes

To address the issues outlined above, the Exposure Draft proposes to replace the net assets test under the current section 254T with a pure solvency test. That is, if the directors of the company reasonably believe that the company will remain solvent after the payment of a dividend, the company may pay the dividend. The test for solvency is determined by the ability of a company to pay debts as and when they become due and payable ³. The proposed new section 254T also distinguishes between the declaration and determination of a dividend. It provides that the relevant date for determining a company's solvency when declaring a dividend is the declaration date. Whereas, the relevant date for determining a company's solvency where a dividend is determined, is the payment date. The Bill also proposes a new section 254TA which makes it clear that a company may pay a dividend (or part) out of its capital provided it is an 'equal reduction' - being a reduction which relates only to ordinary shares only and it applies to the holders of ordinary shares proportionately and on the same terms.

Effect on demergers

A number of demergers have been effected by in specie distribution of shares (ie. a direct distribution of shares in the company which is being demerged to existing shareholders). ⁴ Provided a company's constitution contains provisions which authorise the distribution of shares in another company to its shareholders, it may be possible to implement these types of demergers without Court or shareholder approval. However, instances of demergers effected in this manner have been few.

Confirmation in the Exposure Draft that a company may pay dividends out of its share capital without shareholder approval under Chapter 2J of the Corporations Act may mean that it becomes more attractive for companies to undertake a demerger by in specie dividend. If it can be done without Court or shareholder approval, it will certainly be a lot easier and quicker to implement. However, a company wishing to implement a demerger by in specie dividend will need to ensure that:

it has enabling provisions in its constitution that authorise this;
there are no other approvals requirements triggered under the Corporations Act or the Listing Rules by the proposed demerger; and
any return of capital under the demerger is an equal reduction (as described above). One important issue in this context is how foreign shareholders are to be treated under the demerger. Usually, due to foreign securities laws, foreign shareholders in many jurisdictions are given a cash payment in lieu of their entitlement to shares in the company being demerged . The question is whether this differential treatment means the reduction of capital is not an equal reduction.

This issue was tested before the Court in Idameneo ⁵ . In that matter it was argued that this type of differential treatment between foreign and other shareholders meant the reduction of capital was a selective reduction, and not an equal reduction. The Court rejected this argument and found that it was an equal reduction notwithstanding the differential treatment of foreign shareholders. Although this decision supports that view that foreign shareholders may be treated differently under an equal reduction of capital, its correctness is questioned by many.

Footnotes

¹ See Discussion Paper released by Treasury titled ' Proposed Amendments to the Corporations Act' dated 28 November 2011.
² s256B of the Corporations Act 2001 .
³ s95A of the Corporations Act 2001 .
⁴ For example, see the in specie distribution of Virgin Blue shares by Toll Group in 2008 and Virgin Group's in specie distribution of shares in its international operations in 2012.

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