Until recently, companies could only pay dividends out of profits earned. From 28 June 2010, a company may now pay a dividend other than out of profits, provided certain requirements are met.

The government gave the following three reasons for the changes:

• The move to International Financial Reporting Standards (“IFRS”) has resulted in increased volatility in profitability as a result of fair value adjustments. These adjustments have reduced profits but not cash, and have resulted in companies with sufficient cash being unable to pay dividends;
• The lack of a clear and widely agreed upon definition of profit, with accounting standards and legal precedent varying greatly;
• With long running changes to company laws, the idea of equity providing a buffer for creditors is no longer being enforced. Past moves away from this idea include allowing share capital reduction and share buy backs. These changes continue this trend.

• 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.

In our opinion, the changes to the act will increase the burden on small business and non-reporting entities that currently are not required to complete statutory accounts in accordance with accounting standards.

These companies will need to perform additional work to ensure that they have met the three requirements now outlined in Section 254T, and this could involve significant additional costs to ensure compliance with accounting standards.

Directors will also need to review their company’s constitution - many older constitutions will specifically require that dividends only be paid out of the company’s profit, and so this requirement will need to be removed from the constitution moving forward.

There have also been some amendments to taxation legislation to ensure that dividends paid out of amounts other than profits are to be taken as dividends out of profits, thereby ensuring that they are capable of being franked. However, it remains to be seen whether the ATO will attempt to disallow franking benefits as being from unrealised or untaxed profits, as it can do under Section 177EA.

Liquidity Test:

This test effectively tests that a company’s assets exceed its liabilities, and this test must be performed in accordance with current accounting standards. When performing this test it is important to take into account all accounting standards including contingent liabilities and impairment charges.

These standards are not usually taken into account by small business whose statutory requirements are limited to keeping written financial records, so the completion of this test will require a higher level of financial reporting than most business would usually undertake.

Interestingly, when the changes were first proposed it was suggested that there would be a basic solvency test, which would be logical since the dividend should only be paid if it didn’t affect the company’s ability to pay its debts when they became due and payable. Instead a balance sheet test has been used, which is often irrelevant when looking at the solvency of a company.

Fair and Reasonable Test:

In most situations, a company only has a single class of shares and as such all shareholders are treated equally. However in situations where different classes of shares have different rights in the constitution of the company, the Fair and Reasonable test becomes more important.

Very little guidance is given in relation to this situation; however initial indications are that the fair and reasonable test may compromise the ability to pay these different dividends to different classes of shareholders.

Creditors Test:

Directors must ensure that the payment of a dividend to shareholders does not adversely affect creditors. The Act gives the example of when the payment of a dividend results in a company becoming insolvent. This test ties into a director’s duty to prevent insolvent trading in Section 588G of the Act.

Conclusion:

The changes have been implemented with little regard for the position of small business. We understand that the changes were needed for larger corporates; however the costs for smaller companies could become prohibitive.

We believe, along with other commentators, that a two tiered approach would have been more appropriate, with small business continuing under the single rule that dividends are paid out of profits and larger corporate operating under the three part test.

dVT Consulting are able to assist you in determining whether your company complies with all of the required tests, and you should seek independent professional advice before the declaration of a dividend. Remember that the changes to the Act also now specifically refer to Section 588G of the Corporations Act, in relation to a director’s duty to prevent insolvent trading, including the penalties that apply for non-compliance.

Written by Justin Ward, Senior Accountant with dVT Consulting Pty Limited