The rules about when companies can pay dividends are under review again – last year's amendments raised more questions than they answered and now it is time to fix the mess. On 28 November 2011, Treasury released a discussion paper: Proposed Amendments to the Corporations Act. The Paper seeks public comment by 30 January 2012 on the resolution of issues arising from changes to the Corporations Act made by the Corporations Amendment (Corporate Reporting Reform) Act 2010 (Reform Act), which replaced the profits test for payment of dividends with a balance sheet test.
The Paper sets out a number of proposals, but we think that the option to replace the dividend test with a solvency requirement is clearly the best. Numerous drafting difficulties with the Reform Act should also be corrected. In this alert, we review and comment on the proposals in the Paper.
Test for payment of dividends
Before June 2010, section 254T of the Corporations Act provided that a dividend could only be paid out of profits. This requirement was generally well understood by companies and the investment community, but there were some critics.
The concept of 'profit' was not explained in the Corporations Act and there were some unsatisfactory interpretations in the case law. Under current Australian accounting standards, the profitability of companies is impacted by requirements relating to the fair value of assets and liabilities (whether realised or unrealised), and this has made the profitability of companies volatile. The Paper also asserts that a profits test for the payment of dividends is 'inconsistent with the trend to lessen the capital maintenance doctrine in Australia'. Despite Treasury's assertion, we doubt there is a trend to fundamentally weaken the capital maintenance doctrine in Australia. (A discussion of the history of the law in this area is set out in Ford's Principles of Corporations Law at [18.090].)
The Reform Act substituted a new section 254T, which 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 (the balance sheet test); 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 Paper says that this reform was generally well received, but that there were calls by some 'stakeholders' for amendments. In fact the new law contained drafting mistakes and created considerable confusion, which led professional bodies to argue that there was an urgent need for further legislative reform.
Criticisms of the balance sheet test
The Paper notes stakeholders' criticisms that:
- the inter-relationship between the capital maintenance requirements in Ch 2J of the Corporations Act and the dividends test requires clarification;
- a test for payment of dividends that depends on accounting standards imposes an unreasonable compliance burden on companies not otherwise required to comply with the standards; such as small proprietary companies that do not have to prepare financial statements, or companies that are not reporting entities and therefore do not have to comply with the full suite of standards;
- the balance sheet test has little relationship to solvency, as it does not take into account timing or scale of flows of funds, and may suffer from some of the same difficulties as the profits test due to the opaque nature of many accounting standards calculations; and
- the requirement for assets to exceed liabilities immediately before the dividend is 'declared' is inconsistent with section 254V and most company constitutions, which provide for the board to 'determine' that a dividend is payable.
In the Paper, Treasury outlines four options for dealing with the dividends test, in response to such criticisms:
- retain section 254T in its current form;
- adopt a solvency test, based on the New Zealand approach;
- reinstate the profits test; or
- allow a company to choose between a profits requirement and a solvency requirement.
In the Treasury's view, Option 1 provides certainty, reliability and objectivity. But in fact there are great uncertainties about the operation of the current law: for example, how it applies to corporate groups and to the authorisation of dividends which do not immediately create obligations to pay the dividends, and the extent (if at all) to which it cuts down on the requirement for shareholder approval for a reduction of capital.
The Paper also says the present section 254T provides a 'high level of comfort' to directors in complying with their obligation to prevent insolvent trading. Under section 588G, a company is deemed to incur a debt when a dividend is paid or declared. But section 588G is in no way dependent on section 254T, so it is hard to see how section 254T gives comfort to directors in complying with their obligation under section 588G.
These 'advantages' of the current law are less than compelling.
The Treasury acknowledges some disadvantages of Option 1:
- companies that do not have to comply with accounting standards may incur compliance costs in deciding whether they satisfy the balance sheet test; and
- the test may suffer from deficiencies similar to those of the former profits test, because non-cash adjustments to fair values are required to be reflected in the balance sheet, and so the difficulties presented by 'fair value' accounting remain.
To these disadvantages we would add the fundamental lack of clarity of the drafting of the present section 254T, on such issues as:
- whether the balance sheet test is meant to be a statement of the whole law about valid dividends, overriding the operation of the corporate constitution;
- whether section 254T permits the directors of the company to reduce the company's capital by making a distribution to shareholders by way of dividends, without shareholder approval;
- precisely when the balance sheet test must be satisfied, in circumstances where companies now rarely 'declare' a dividend as opposed to determining that the dividend be paid;
- what kind of evidence the directors should require concerning the company's assets and liabilities, especially to cover the period between the balance date and the date of payment/declaration of the dividend;
- whether the directors may authorise the payment of a dividend which does not immediately create an obligation to pay the dividend if the balance sheet test is not at that stage satisfied, but they have reasonable grounds to believe that it will be satisfied before the dividend is actually paid;
- how the balance sheet test applies to entities that are part of a corporate group.
Regardless of whether some form of Option 1 emerges from the Treasury's review as the preferred option, it is undeniable that the drafting of the section requires surgery to overcome these problems.
Even more fundamentally, why does existing section 254T focus on the balance sheet test as the first criterion for judging whether a dividend can be paid? Surely a more important criterion is whether the company will remain solvent after the payment of the dividend. Solvency requires a cash flow analysis in addition to a balance sheet analysis. It is not satisfactory to leave solvency as a subsidiary criterion that becomes relevant only as part of an assessment of the directors' liability for insolvent trading or indirectly relevant when assessing whether a dividend would prejudice the company's ability to pay creditors.
This option is based on the New Zealand approach. The New Zealand test has the following features:
- the directors of a company may only authorise the payment of a dividend if the company remains solvent following the distribution (section 52 of the Companies Act 1993);
- this requirement is satisfied if the company is able to pay its debts as they become due in the normal course of business (a solvency test) and the value of the company's assets is greater than the value of its liabilities (including its contingent liabilities) after the distribution of the dividends to shareholders (a balance sheet test) (section 4 of the Financial Reporting Act 1993); and
- for the purpose of assessing compliance with the solvency test, reference is to be made to the company's most recent financial statements prepared in accordance with generally accepted accounting practice (sections 4, 10 and 11 of the Financial Reporting Act 1993), and consideration should also be given to all circumstances affecting the value of a company's assets and liabilities. Directors may rely on reasonable valuations of assets or estimates of liabilities in this respect.
The New Zealand approach puts the issue of solvency at the centre of the dividend law, where it belongs. Treasury says a disadvantage of the New Zealand model is the absence of an express link to the accounting standards, and that the absence of such a link could result in less objectivity and consistency. But tying the satisfaction of the dividend test to the company's most recent financial statements and its financial records overcomes the difficulty, posed by the current Australian law, for companies not required to comply with the accounting standards. For companies that are required to comply with the accounting standards, there is an indirect link to compliance with the accounting standards, because the most recent financial statements are required to comply. And importantly, reference to the most recent financial statements provides clarity and certainty to the decision-making process.
If Treasury's real concern behind its ' less objectivity and consistency' comment is that some companies would not be required, before determining that dividends are payable, to ensure that assets are recorded at no more than recoverable value and that liabilities are not understated, Treasury should say so and deal with the matter as a note in the legislation detailing what directors need to do to make reasonable valuations of assets or estimates of liabilities, rather than casting the millstone of the whole accounting standards around the neck of companies which would not otherwise have to comply with them.
The third option is to reinstate the profits test. The main advantage of the profits test is that the basic concept, that distributions to shareholders are to be made by dividend only out of profits, is well understood by companies and investors. But there are generally recognised drawbacks, which are outlined above.
The fourth option is for section 254T to be redrafted, to say that a company must not pay a dividend unless:
- it is paid out of profits; or
- all of the following are satisfied:
- its assets exceeded its liabilities, immediately before either the declaration of the dividend or the time for its payment;
- the excess is sufficient for payment of the dividend;
- payment is fair and reasonable to the company's shareholders as a whole having regard to section 254W (dividend rights); and
- payment of the dividend does not materially prejudice the company's ability to pay its creditors.
Under Option 4, a company that is not required to prepare a financial report that complies with the accounting standards would be required to calculate assets and liabilities in accordance with its written financial records, whereas other companies would be required to calculate assets and liabilities in accordance with the accounting standards.
It is not easy to see why the latter requirement would be retained. In the interests of clarity and certainty, would it not be preferable to require the company to calculate assets and liabilities in accordance with its most recent financial report (which, in turn, must comply with the accounting standards)?
There may be a case for Option 4 as an interim measure, to allow flexibility in the transition to a solvency test along New Zealand lines. But as proposed, Option 4 retains the disadvantages of the profits test and the current balance sheet test, and fails to direct attention to the most important issue, namely whether the company will remain solvent after the distribution is made.
As well as setting out these four options for discussion, the Treasury Paper addresses some other issues about dividend law:
- use of the word 'declared' in the current balance sheet test;
- the inter-relationship between the dividends test and capital maintenance provisions;
- the application of the balance sheet test to group companies; and
- taxation issues.
The word 'declared'
Under section 254V, a company does not incur a debt merely by fixing the amount and time for payment of a dividend. The debt arises only when the time fixed for payment arises, and the decision to pay the dividend may be revoked until that time arrives. But if the company has a constitution which provides for the declaration of dividends, the company incurs debt when the dividend is declared.
Some modern company constitutions allow the directors to choose between declaring a dividend and simply determining that a dividend be paid, thereby preserving their flexibility to revoke the decision. Other constitutions abandon declarations of dividends, and simply empower the directors to determine that a dividend be paid.
Section 254T, as introduced in 2010, requires a company's assets to exceed its liabilities immediately before the dividend is 'declared'. On its face, the drafting has ignored the distinction between declaring a dividend and determining that it be paid. It was even argued by some lawyers that companies would have to revert to declaring dividends, in order to satisfy the test.
The Treasury has come to the view that, except where the dividend test is a solvency test (Option 2), there may be merit in bringing the terminology used in section 254T into line with the terminology used in section 254V and most company constitutions. With respect, the merit in doing so is obvious.
Treasury's opinion is that if a solvency test is to be used (Option 2), the section should continue to use the word 'declared'. But it is not easy to see why the current drafting confusion should be perpetuated in this way. If a solvency test is adopted, the section should say (as does the New Zealand s 52) that the company must not pay a dividend unless the board is satisfied on reasonable grounds that the company will, immediately after the distribution, satisfy the solvency test. The time of declaration of the dividend is not the critically important time, and in any event some companies are not constitutionally able to declare a dividend. Any obligation of the company to pay the dividend (because it has been declared) under section 254V should be expressly subject to the solvency test.
The dividend test and reductions of capital
According to section 256B(1), a company may reduce its share capital 'in a way that is not otherwise authorised by law' if the requirements of the reduction of capital provisions in Part 2J.1 are satisfied. These requirements include shareholder approval.
According to the Paper, Treasury considers that section 254T is a provision by which a reduction of capital is 'otherwise authorised' by the law. But the drafting of section 254T does not support Treasury's opinion. Section 254T(1) does not authorise the payment of a dividend when its requirements are satisfied. It prohibits a company paying a dividend unless its requirements are satisfied. If the legislature intended to create a gigantic exception to the reduction of capital requirements, that would permit directors to make a distribution reducing share capital without shareholder approval, it ought to have said so in plain language.
Notwithstanding its opinion, Treasury acknowledges that the 'concern raised by some stakeholders suggests that there may be merit in either amending the legislation or inserting a [clarifying] note.' What is needed, of course, is a positive statement that if the requirements set out in section 254T(1) are satisfied, the company may pay the dividend notwithstanding that it reduces its share capital by doing so.
Such clarification will be needed unless the law reverts to the profits test (Option 3). If Option 3 is adopted, a company will be able to reduce share capital only by following the current shareholder approval procedure in Part 2J.1.
If a solvency or balance sheet test is adopted and the law is clarified to reflect Treasury's intention, then reductions of capital with shareholder approval under Part 2J.1 will be needed only in unusual cases. Directors will be able to return excess capital to members by dividend without shareholder approval, so long as the solvency or balance sheet requirement is satisfied. This will give directors a flexible capital management tool currently not available to them unless they go to shareholders.
Where a subsidiary has distributable profits that are to be 'streamed up' to the holding company, the current balance sheet test may be an obstacle to its doing so. The question whether the subsidiary's assets exceed its liabilities by an amount sufficient to permit the payment of the dividend must be determined having regard to any deed of cross-guarantee in place within the group.
In the Paper, Treasury says that consideration should be given to whether an amendment is needed to clarify the manner in which the balance sheet test applies to group companies.
A clarifying amendment would be of assistance if the balance sheet test is preserved, or if the law adopts a solvency test. It would be sensible to enable ASIC to modify, or grant exemption to, the law so that, for example, if there is a deed of cross-guarantee in place for group entities, the balance sheet or solvency test (as the case may be) should be assessed on a group basis, for the purpose of considering whether any subsidiary subject to the deed of cross-guarantee can make a distribution to its immediate holding company (even if not subject to the deed of cross-guarantee).
Taxation and Franking
The Income Tax Assessment Act 1936 (the Tax Act) was also amended in 2010 to accommodate the Reform Act changes to section 254T – that is, to ensure that a 'a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits' for tax purposes – refer subsection 44(1A) of the Tax Act. (This provision would not, however, treat any part of a distribution which is in fact a return of capital properly debited to an untainted share capital account as a dividend for taxation purposes, because such a return of capital does not fall within the definition of dividend for taxation purposes.)
Although the tax reforms ensure that routine distributions would be deemed to be dividends paid out of profits for tax purposes, the franking rules were not amended to reflect the revised distribution policy. Relevantly. the franking rules do not permit a distribution that is sourced directly or indirectly from a company's share capital account to be franked.
The Australian Taxation Office (ATO) released two draft fact sheets on 21 June 2011 (Draft ATO Fact Sheets) setting out its view on when such distributions could be franked: The new section 254T and the franking of dividends, and Dividends and the new sections 254T and 44(1A).
The ATO view is that a dividend will be 'sourced indirectly' from the company's share capital and consequently will be unfrankable where a company's net assets are less than its share capital and the company debits a dividend to an account such as accumulated losses. Further, this will be the case even though:
- the amendments to section 44 of the Tax Act deem such a dividend to be a dividend paid out of profits (and therefore assessable as a dividend rather than a return of capital in the hands of shareholders); and
- the Explanatory Memorandum to the Bill which introduced the amendments also specifically states that the distribution would be frankable subject to the application of the usual integrity rules.
The ATO has informed the Treasury that, in light of the feedback received concerning the draft fact sheets, a draft Taxation Ruling is being prepared for consideration by the Public Rulings Panel.
Although the legal analysis in the draft fact sheets is hard to fault, the outcome seems difficult to reconcile with the revised corporation law policy for shareholder distributions. Importantly, we consider that amendments to the taxation law will be needed, if any of the four options now under consideration is pursued other than a return to the profits test (Option 3), so that a consistent policy outcome is achieved for both tax and corporations law.