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.
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.
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