In brief - Solvency test placed at centre of dividend law and doubt removed on capital maintenance overlap
The proposed new dividend regime has administrative, corporate governance and other consequences for companies, including their constitutions, policies and accounting procedures. Companies should review these to ensure compliance and to ensure that they can benefit from the new regime. In addition, they should consider the significant impact the proposed amendment to section 254T of the Corporations Act will have on dividend streaming in corporate groups, structuring for corporate transactions and on annual reporting requirements.
Problems with the current dividends regime in Australia
The current regime regulating when Australian companies can pay dividends has been criticised for creating excessive compliance costs, being technically deficient in its drafting and lacking clarity on the potential overlap of dividend payments and capital maintenance rules.
The difficulty with the accounting treatment of dividends, which impacts on their treatment under the Corporations Act 2001 (Cth) and income tax law, was illustrated in the High Court case of Commissioner of Taxation v Consolidated Media Holdings Ltd  HCA 55. This article examines the current and proposed amendments to the dividend regime under the Corporations Act.
Solvency test proposed for payment of dividends
A new test for payment of dividends is proposed, based on a "solvency test", where directors must reasonably believe both at the time they declare and when they pay a dividend, that the company will be solvent after the respective declaration and payment.
Benefits for companies from the proposed amendment
Companies will be allowed to reduce share capital through dividend payments, without shareholder approval. The proposed amendment will make certain corporate reorganisations easier and cheaper, although ASX Listing Rules and ASIC regulatory guidance should be carefully considered.
High Court case illustrates confusion over dividends and their nature
In Commissioner of Taxation v Consolidated Media Holdings, the High Court considered a share buy-back arrangement. The company acquiring its shares in the buy-back recorded a debit of $1 billion in a new general ledger account called "Share Buy-Back Reserve Account". It maintained a "Shareholders' Equity Account" with a credit balance, as one would expect. No entry was recorded in relation to the share buy-back in the shareholders' equity account.
The primary judge held that the company's share capital account comprised both its shareholders equity account and its share buy-back reserve account. The Full Court of the Federal Court allowed an appeal, holding that the company's share capital account did not include its share buy-back reserve account.
Share capital account defined in Income Tax Assessment Act
The High Court held that an account that is a record of a transaction into which a company has entered in relation to its share capital, or that is a record of a company's financial position in relation to its share capital, is "an account which the company keeps of its share capital", and thus a "share capital account" within the meaning of section 6D(1)(a) of the Income Tax Assessment Act 1936 (ITAA) as it then was. It also held that section 6D(2) as it then was required all share capital accounts to be treated as a combined "share capital account".
Share buy-back reserve account determined to be share capital account
As a result, the share-buy-back reserve account was a record of the transaction by which the company had entered into an executory contract to reduce its share capital by $1 billion. Therefore, it was an account which the company kept of its share capital and thus a share capital account.
Accordingly, the $1 billion consideration received under the share buy-back agreement was debited against amounts standing to the credit of the company's share capital account and the Commissioner was correct to have assessed the shareholder as having made a capital gain.
Complexity of dividends, their accounting treatment and capital maintenance rules
This case, although dealing with the nuances of the ITAA, illustrates the complexity around the relationship between the characterisation of dividends, traditionally associated with distributions of profits, accounting treatment of dividends and capital maintenance rules.
A company may, for strategic reasons, want to distribute shares in specie to its shareholders, as was recently the case for one of our clients. In one case, there were other advisors involved and a debate ensued as to whether the distribution was a dividend and if so, whether it was caught by the capital maintenance provisions.
Two fundamental questions to help understand section 254T amendment proposal
There is now an amendment proposed to section 254T (and a new 254TA) of the Corporations Act relating to company dividends. To understand it, the following questions must be addressed:
- What is a dividend?
- Is a dividend different from a reduction of capital under Part 2J of the Act, or can a distribution be a dividend while still being regulated by Part 2J?
These questions have already been recognised and over a number of years, there have been attempts to answer them. To this end, the Corporations Legislation Amendment (Deregulatory and Other Measures) Bill 2014 (Bill) is currently being considered. To understand its relevance, brief reference to the historical position is needed.
Corporations Act regulates dividends but does not define "dividend"
There is no definition in the Corporations Act of a "dividend", whether out of "profits" or otherwise. Rather, the Corporations Act regulates circumstances when companies cannot declare or pay dividends.
Traditionally, dividends were paid by companies to shareholders from time to time as a way of distributing profits (ignoring for our purposes, payments to creditors in insolvency). A substantial body of case law exists around the meaning of "profit" and its availability for dividend payments. There was some inconsistency in those decisions, which were based on the primacy of capital maintenance.
Based on a dividend regime contingent on "profits" being available for distribution, distributions to shareholders other than out of profits were reductions of capital regulated by the capital maintenance rules. As to whether or not profits existed involved an interesting fusion of legal and accounting principles, often with conflicting results. Lawyers and accountants think differently.
Profits test for dividends pre-2010
Prior to June 2010, section 254T of the Corporations Act provided that companies could only pay dividends out of profits calculated according to Accounting Standards. Therefore, a company with profit could declare a dividend even if it had deficiency in net assets. Conversely, a company with no profits and substantial assets could not pay a dividend.
Criticisms of the pre-2010 profits test
The pre-2010 profits test in section 254T picked up the uncertainties associated with the common law position, namely that:
- the Corporations Act did not explain the concept of "profit" and there was no clear legal definition or satisfactory interpretation of "profits" in case law, despite its long history
- as a result of the International Financial Reporting Standards (IFRS) being adopted in Australia, fair value adjustments resulted in increasing volatility of profits and hence uncertainty around capacity to declare dividends
- a company with sufficient cash to pay a dividend could not necessarily do so, since it may have lacked profits as a result of non-cash expenses
- the profits based regime arguably ran counter to the international trend towards lessening the capital maintenance doctrine
In practice, a company with substantial assets, but no accumulated profits per se, could not pay a dividend without complying with the capital maintenance provisions of the Act, as payment of the dividend would necessarily be a reduction of capital caught by those provisions. This was considered disproportionately costly and burdensome.
Amendments to section 254T sees introduction of a "net assets" test for dividends
The traditional profits test was replaced in June 2010 following changes to the Corporations Act (Corporations Amendment (Corporate Reporting Reform) Act 2010) (Reform Act). A new section 254T was introduced and remains in force.
Section 254T provides that a company must not pay a dividend 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; and
- 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.
The new section was supposed to eliminate availability of profits as a basis for capacity to pay dividends in favour of a net assets test. On its face, this notion seems attractive.
Net assets test means companies with accumulated profits but deficiency in net assets cannot pay dividend
The test is a "net assets" or "balance sheet" test and allows companies without accounting profits to pay dividends. Thus, a company that does not have accounting profits (for example, where profits have been impacted by non-cash expenses) is now capable of paying a dividend. This can be useful for streaming dividends from subsidiaries to holding companies, for example.
However - counterintuitively perhaps - companies with accumulated profits, but a deficiency in net assets, cannot pay a dividend. It has been noted that this disproportionately impacts infrastructure projects.
Criticisms of the net assets test
Problems with the current test include:
- the imposition of a compliance burden on companies that are not otherwise required to comply with accounting standards, as compliance costs are incurred in deciding whether, under the accounting standards, assets exceed liabilities for the purpose of section 254T
- the net assets test has little relationship to solvency, as the timing or scale of flow of funds is not taken into account
- the use of the word ''declared'' rather than "pay" in respect of the timing of the net assets test is inconsistent with section 254V and most company constitutions. Under section 254V, a company does not incur a debt merely by fixing the amount and time for payment of a dividend, as the debt arises only when the time fixed for payment arises. But if the company has a constitution which provides for the declaration of dividends, it is thought that the company incurs debt when the dividend is declared
- no clarity on the overlap between this section and Part 2J (Capital Maintenance)
Confusion over capital reduction
The capital maintenance provisions in section 256B of the Corporations Act require shareholder approval for a company to reduce its share capital in a way that is not otherwise authorised by law. There is nothing in the drafting of section 245T to suggest that it permits a reduction of capital "otherwise authorised by law". Hence the confusion.
Capital maintenance provisions impact on section 254T
The prevailing view, which to date has limited the utility of the net assets test, is that the capital maintenance provisions impact on section 254T. Shareholder approval is required where a company pays dividends otherwise than out of profits, as the dividend in these cases results in a capital reduction.
Hence, as determined on historical precedent, the meaning of profits remains relevant, despite difficulty in defining its meaning and an expressed intention to supplant its use.
Solvency test to assist with capital reduction
This makes use of a "capital dividend" in corporate restructuring a more costly and time consuming exercise. As a result, it has been suggested that amendment is required to ensure that companies can reduce share capital by paying a dividend otherwise than out of profits under the solvency test regime without requiring shareholder approval.
New section 254T will put solvency at the centre of dividend law
The Bill proposes to replace the existing three-limb test in section 254T with a solvency test, removing all doubt as to whether the current section 254T permits an authorised reduction of capital without satisfying the requirements of Part 2J of the Corporations Act, particularly the requirement to obtain shareholder approval.
The proposed section 254T provides as follows:
- A company must not declare a dividend unless, immediately before the dividend is declared, the Directors of the company reasonably believe that the company will, immediately after the dividend is declared, be solvent.
- 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 puts the issue of solvency at the centre of the dividend law where it belongs.
Simpler test and using existing reporting requirements will benefit companies
The benefits of the amendment are:
- employment of a simpler test which is more likely to achieve the objective underlying the original section 254T
- allowing companies to calculate assets and liabilities based on existing reporting requirements (thereby allowing certain entities to calculate assets and liabilities with reference to financial records, rather than accounting standards)
Removal of doubt on capital maintenance overlap
The Bill also removes the substantial doubt that has existed since June 2010 as to whether the current section 254T permits an authorised reduction of capital without satisfying the requirements of Part 2J of the Corporations Act, particularly the requirement to obtain shareholder approval.
Proposed section 254TA expressly simply provides that a:
- the dividend is declared or paid, as the case may be, in accordance with section 254T; and
- the reduction in share capital is an equal reduction.
An equal reduction is one that, in effect, applies only to ordinary shares and on terms that are the same for each holder of ordinary shares (disregarding some minor differences).
Shareholder approval only needed in unusual cases
According to the Treasury's discussion paper, if a solvency or balance sheet test is adopted, reductions of capital with shareholder approval under Part 2J.1 will be needed only in "unusual cases".
Section 254TA is intended to expand the circumstances in which a company can pay a dividend. If implemented, the change may assist in facilitating corporate restructures – for example, demergers or spin-offs via in specie distributions of shares as a dividend, without the need for shareholder approval.
ASX-listed companies may still require shareholder approval
Despite paving the way for swifter capital dividend distributions in Australia, ASX-listed companies may be constrained from utilising flexibility in the new regime if, for example, there is a distribution in specie of the shares of a subsidiary carrying on its main undertaking, as shareholder approval may still be required under ASX Listing Rule 11.2. This may also trigger prospectus disclosure requirements pursuant to ASIC Regulatory Guide 188 (Disclosure in Reconstructions).
Some companies may still not be able to pay dividends under section 254T
The amendment retains the net assets test. It has been said that it merely clarifies that the test is a "net assets and solvency" test. As such, the new regime will not help certain companies (such as infrastructure companies) which, while clearly solvent, may have negative net assets because, for example, they are unable to revalue them under the accounting standards.
There is nothing in the new test that allows directors to rely on valuations of assets and estimates of liabilities that they consider reasonable in the circumstances (which was recommended to the government in submissions in response to the exposure draft of the Bill). These companies may continue to be unable to pay dividends under section 254T.