Summary

Australian law concerning how a company can pay a dividend is highly complex.

To pay a divided, the directors must be satisfied:

• the company has sufficient net assets;
• the dividend is fair and reasonable to the company's shareholders as a whole; and
• the dividend does not materially prejudice the company's ability to pay its creditors.

The directors must also be satisfied the company has sufficient profits and ensure any additional requirements imposed by the company's constitution are met.

The directors will then need to decide when the dividend will be paid, and whether it will be 'declared' or 'determined to be paid'.

This applies on a company-by-company basis, so a corporate group cannot simply satisfy the tests using the group's consolidated financial statements.

If the above is not done correctly, the dividend could be treated as an unauthorised return of capital, which may not be frankable and may therefore expose directors to liability.

Three tests under the Corporations Act

Section 254T(1) of the Corporations Act provides that a company must not pay a dividend unless:

(a) 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

(b) the payment of the dividend is fair and reasonable to the company's shareholders as a whole; and

(c) the payment of the dividend does not materially prejudice the company's ability to pay its creditors.

The section 254T tests were intended to be a 'solvency test' allowing dividends to be paid even if profits did not exist. For example, they were meant to allow a company with sufficient cash to pay a dividend, even though its profits were eliminated by non-cash expenses.

1. Net assets test

Limb (a) of section 254T(1) is itself commonly referred to as the 'net assets test' or 'balance sheet test'.

The net assets test is a relatively simple measure of assets vs liabilities. For those purposes, the company's assets and liabilities are to be calculated in accordance with accounting standards.

The amount of any surplus of assets over liabilities is the maximum amount of any dividend that can be paid by the company.

The net assets test must be satisfied immediately before the company decides to pay the dividend and at the future date when the dividend will be paid. However, the time that decision is made may not align with the timeframe of the last audited financial statements. In this instance, the directors may need to have regard to other evidence that the net assets test is satisfied. This evidence could be a supplementary update to the year-end accounts by the company's auditors or it may be management accounts (provided those accounts properly apply the accounting standards).

2. Fair and reasonable to shareholders

Limb (b) of section 254T(1) applies a shareholder focused 'fairness' test to payment of a dividend.

This relates to balancing the interests of different classes of shareholders. For example, if a company paid a large dividend funded by debt to only one class of shareholders, those shareholders would receive a benefit, but all other classes would not and would bear the burden of the additional debt.

A company that pays a dividend in the same amount to all of its ordinary shareholders can usually satisfy this test easily, especially where it has no other classes of shares.

3. Material prejudice to creditors

Limb (c) of section 254T(1) applies a creditor focused 'prejudice' test to payment of a dividend.

A payment of a dividend by a company to its shareholders necessarily reduces the cash the company has available for the payment of creditors.

This test will only be triggered where the dividend to be paid is so large it 'materially' prejudices the company's ability to pay its creditors. This has been interpreted as meaning that the company would become insolvent as a result of payment of the dividend.

This test must be satisfied at the time of payment of the dividend (rather than when the decision to pay it is made). This means the directors must anticipate the future financial position of the company, which is typically achieved by considering management forecasts.

It is important to note this analysis is considerably more complicated if the company is party to a group deed of cross guarantee, as is often the case in large corporate groups.

General law profits test

Unfortunately, the 'solvency test' in section 254T(1) was drafted in such a way that it did not over-rule the general law on payment of dividends. As a result, there remains a general law principle that dividends may only be paid out of profits.

The general law principle must be applied in addition to the tests in section 254T(1), so Australia in effect has both a 'solvency test' and a 'profits test' for dividends.

The term "profits" has never been comprehensively defined by the courts. However, it is generally accepted that 'profit' for this purpose is the amount of net profit attributable to members that is carried to the company's statement of financial position (see para 4.1(b) of the accounting standard AASB 1018) . A company's statement of financial performance will describe the amount of the period’s net profit attributable to members. The statement of financial performance will also describe the amount of that net profit attributable to members that is being carried to the company's statement of financial position – this amount is the 'profit' of the company.

Again, this means that profits must be ascertained by reference to financial statements prepared in accordance with the accounting standards. In this regard, directors should refer to the last audited financial statements, Where the decision to pay the dividend is made after the time of those financial statements, they should also have regard to more recent management accounts (provided that those accounts properly apply the accounting standards).

Additional requirements under the company's constitution

Sometimes a company's constitution will impose additional requirements that must be satisfied before a dividend can be paid. This is relatively rare with listed companies, but should be checked.

Tests are applied on a company basis, not a group basis

Both the Corporations Act 'solvency test' and the general law 'profits test' for dividends are applied to each company on an individual basis.

This means it is not possible in Australia to pay a dividend simply by having regard to a corporate group's consolidated financial statements and any net assets or profits said to exist on a consolidated basis.

This leads to three problems:

• First, in a corporate group, profits generated by each subsidiary (starting at the bottom of the corporate chain) must pass through each subsidiary above, all the way up to the ultimate parent company. This may necessitate individual dividends being paid by each company in the group to the company above it. The 'solvency test' and the 'profits test' will need to be applied each time to each company declaring a dividend.
• Second, the need to pass profits up a corporate chain means there is a risk that, at any point in the chain, there will be a company that has insufficient profits or accumulated losses that 'cancel out' the profits delivered to it by companies below it. This means it may not be possible to pass the full amount of the group's profits all the way to the ultimate parent company. This is known as a 'dividend trap'.
• Third, often companies do not prepare stand-alone financial statements, for example where the company is a small proprietary company or is part of a group where only consolidated group financial statements are prepared. This poses difficulties in then determining whether the 'solvency test' and the 'profits test' are satisfied for that individual company.

Declaring a dividend vs determining to pay a dividend

A dividend is treated as a debt owing by the company at the time a dividend is 'declared'.

In comparison, if the directors 'determine to pay' a dividend at a future date (rather than declare that dividend), they are merely fixing the time for payment of a dividend, which does not create a debt until the time fixed for payment arises.

The other advantage of 'determining to pay' a dividend is that the decision to pay the dividend can be revoked at any time before the time for payment arises. This does not easily apply for a dividend that has been declared because it already has become a debt owing.

For those reasons, it is now far more common to 'determine to pay' a dividend rather than 'declare' a dividend. However, many older constitutions still have a requirement that the dividend be 'declared'.

What happens if you get it wrong?

If a dividend is paid in contravention of the 'solvency test' or the 'profits test', the dividend could be treated as an unauthorised return of capital, which may not be frankable and may expose directors to liability.

If the dividend is paid in contravention of section 254T(1), the dividend may be considered not to be a dividend and instead to be a reduction of share capital. Under the Corporations Act, a reduction of share capital usually requires shareholder approval. Therefore, by not obtaining shareholder approval for the payment of the dividend, the company contravenes section 256D of the Corporations Act. Those involved in the contravention, including the directors and executive management, may be liable under the civil penalty provisions.

Importantly, under Australian taxation law, a dividend can be 'frankable', but a return of capital is generally not 'frankable'. Therefore, if a dividend is considered not to be a dividend and instead to be a reduction of share capital because it was paid in contravention of the 'solvency test' or the 'profits test', it is generally not capable of being 'franked'. This may result in a shareholder being required to pay more tax as a result of receiving the contravening distribution.

Obtain your own advice

This article is intended a general guide only. It is not legal or accounting advice. If you wish to pay a dividend in Australia, you should obtain your own specific legal and accounting advice before doing so.