In brief - Many companies will be reviewing their dividend policies in response to the adverse economic impacts of COVID-19. This article will explore key issues that companies should consider before deciding to pay dividends.
Changed business conditions in light of the COVID-19 pandemic will cause companies to review their dividend policies. It may be prudent for a company to defer or cancel its dividends to maintain liquidity, preserve shareholder value or secure employee jobs.
Company requirements to pay a dividend
However, companies should first consider the requirements for a company to pay a dividend. The directors of a company must generally be satisfied of the following conditions:
- sufficient net assets: the company has sufficient net assets
- fairness to shareholders: the dividend is fair and reasonable to the company's shareholders as a whole
- non-prejudicial to creditors: the dividend does not materially prejudice the company's ability to pay its creditors
- sufficient profits: the company has sufficient profits, and
- satisfaction of constitutional requirements: any requirements imposed by the company's constitution are met
The first three conditions are in section 254T(1) of the Corporations Act 2001.
Net assets test
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 (net assets test).
The net assets test restricts the amount of the dividend to the amount of any surplus of the company's assets over its liabilities. Section 254T(2) of the Corporations Act stipulates that assets and liabilities are determined in accordance with the accounting standards in force at the relevant time (even if the company is not generally required to comply with the accounting standards).
The test must be satisfied "immediately before the dividend is declared". This is generally interpreted to mean that the net assets test must be satisfied immediately before the company makes the decision to pay the dividend.
Fairness to shareholders test
A company must not pay a dividend unless the payment of the dividend is fair and reasonable to the company's shareholders as a whole (fairness to shareholders test). The test must be satisfied at the time of payment of the dividend itself rather than at the time that directors make the decision to pay the dividend (unlike the net assets test).
The fairness to shareholders test is really only applicable to a company that has different classes of shareholders. The test requires the company to balance the interests of the different classes of shareholders. For example, the test is unlikely to be satisfied if a company pays a large dividend funded by debt to only one class of shareholders, as those shareholders would receive a benefit, but all other classes would not and the financial position of the company would be impaired by the additional debt.
If the company has only one class of shareholders, then this test should easily be satisfied.
Prejudice to creditors test
A company must not pay a dividend unless the payment of the dividend does not materially prejudice the company's ability to pay its creditors (prejudice to creditors test). The prejudice to creditors test will be triggered if the company would become insolvent as a result of payment of the dividend, or if the payment of the dividend casts considerable doubt over the solvency of the company.
When deciding to pay a dividend, the directors will not only need evidence to satisfy the net assets test at the time of their decision, but they also need sufficient evidence that the payment will not materially prejudice the company's ability to pay its creditors at the time the dividend is paid. This means the directors must anticipate the future financial position of the company. Given the uncertainties resulting from the COVID-19 outbreak, directors should take extra care when assessing the future financial positions of companies.
Sufficiency of profits
The requirement that a company should have sufficient profits before paying dividends (profits test) originates in common law.
Although the legislative intention was to repeal the profits test and replace it with the net assets, fairness to shareholders and prejudice to creditors tests, it is unclear whether this intention has been achieved. This is because the three tests have been drafted in a negative way. That is, section 254T(1) of the Corporations Act states that a company is prohibited from paying a dividend unless the tests are satisfied. But it does not state that the payment of dividend is lawful if all the tests have been satisfied.
The better (and consensus) view is that there remains a common law principle that dividends may only be paid out of profits. As a result, the Corporations Act has, in effect, imposed additional tests over and above the profits test. During 2014, a bill was introduced to parliament to correct this position, but it lapsed without being enacted.
In practice, we see company directors asking finance teams to confirm that both the net assets test and the profits test are satisfied before deciding to pay dividends.
The term "profits" has never been comprehensively defined by the courts. However, it is generally accepted that profit is the amount of net profit attributable to members that is carried to the company's statement of financial position. This means that profits must generally be ascertained by reference to financial statements prepared in accordance with the accounting standards.
A dividend may be paid out of current year profits even though the company has unrecouped accumulated losses from prior years. Therefore, a dividend may be paid even though a company has negative retained earnings provided that it has derived current year profits, subject to satisfaction of the other tests referred to above.
Additional requirements under the company's constitution
A company's constitution should be reviewed to determine if there are any additional requirements before deciding to pay a dividend.
Considerations for company groups
For corporate groups, each of the above tests is applied to each company in the group on an individual basis. This means it is not possible to pay a dividend simply by having regard to a corporate group's consolidated financial statements and any net assets or profits calculated on a consolidated basis. In addition, the constitution of each group company should be reviewed to work out if there are any additional requirements before paying a dividend.
Distributions (dividends or return of capital) need to be made by subsidiaries to the parent company to enable it to satisfy the tests before it can pay a dividend to its shareholders. Profits generated by a trading subsidiary at the bottom of a corporate group will need to pass through each intermediate holding company to reach the parent company. Accumulated losses at any of these intermediate holding companies may result in "dividend traps", because those losses, depending on when they were incurred and accounted for, may absorb any dividends paid up, preventing those profits from passing to the parent.
The directors of each subsidiary should have appropriate evidence that the tests have been satisfied, even if the subsidiary is not required to keep financial records. Compliance with the net assets test can be demonstrated by reference to accounting records required to be kept in accordance with section 286 of the Corporations Act. However, if the business of the company is significant in size or complexity, then the directors will likely have to rely on accounting reports in addition to primary accounting records to satisfy the net assets test.
The net assets test may create difficulties where groups have entered into a deed of cross-guarantee. It may be necessary, for the purpose of calculating each group member's liabilities, to make provision for part or even the whole of the joint and several liability borne by group members under the deed. This could mean that some of the group members cannot satisfy the net assets test.
What happens if the tests are not satisfied?
The potential consequences of an improperly paid or declared dividend include:
- improper dividend may crystallise capital gains tax for shareholders: If a dividend is paid in contravention of the above tests, the dividend could be treated as an unauthorised return of capital. Such a dividend may not be frankable and may crystallise capital gains tax for shareholders
- provisional liquidator may be appointed over the company: Contravention of section 254T(1) of the Corporations Act may make it reasonable for a court to appoint a provisional liquidator over the company, if the breach is sufficiently serious
- injunction may be obtained to restrain payment: A creditor or shareholder may seek an injunction to restrain the payment of the dividend if the dividend breaches one or more of the tests in section 254T(1) of the Corporations Act. A shareholder may seek an injunction to restrain the payment if the dividend breaches a constitutional provision
- liability for directors or executive officers: Directors or executive officers may be liable for penalties, or may be personally liable to reimburse the company if the company becomes insolvent, and
- liability for shareholders who receive the improper dividend: Shareholders may be held as constructive trustees for the improper dividend, or money can be recovered from shareholders under liability for money paid under a mistake.
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.