Explanatory MemorandumCirculated By the Authority of the Minister for Financial Services, Superannuation, Corporate Law and Human Services, the Hon Chris Bowen
Chapter 3 - Requirements for paying dividends
Context of amendments
3.1 Currently, section 254T of the Corporations Act provides that a dividend may only be paid out of company profits. This is commonly referred to as the 'profits test'.
3.2 Industry has raised the following concerns with the profits test:
- the Corporations Act does not provide guidance about, or a definition of, the term 'profits'. In addition, the legal precedents on this issue are outdated and complex and not in line with current accounting principles. This makes it difficult for directors to understand the legal requirements when paying dividends;
- the nature of accounting principles for the calculation of profits has changed over time. Australian accounting standards, particularly following the adoption of International Financial Reporting Standards (IFRS), are increasingly linked to the fair value (whether realised or unrealised) impacting on the profitability of the company. This makes the profitability of Australian companies increasingly volatile with a large number of non-cash expenses being included in the net result. In these circumstances a company may have sufficient cash to pay a dividend to shareholders but is unable to do so because the accounting profits of the company have been eliminated by non-cash expenses; and
- the requirement for companies to pay dividends only out of profits is inconsistent with the trend to lessen the capital maintenance doctrine in Australia.
3.3 In 2002, the Australian Accounting Research Foundation released a discussion paper recommending that Australia move away from the current profits test.
Summary of new law
3.4 The profits test will be repealed and replaced with a more flexible requirement that allows a company to pay dividends if:
- the company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend;
- it is fair and reasonable to the company's shareholders as a whole;
- it does not materially prejudice the company's ability to pay its creditors.
- Where the payment results in the company becoming insolvent, it will clearly prejudice the company's ability to pay its creditors.
[Schedule 1, Part 1, item 7, section 254T]
3.5 The existing directors' duty to prevent insolvent trading in section 588G of the Corporations Act will continue to apply.
3.6 The Bill provides that the assets and liabilities referred to in the first limb of the test are to be calculated in accordance with accounting standards.
3.7 See 'detailed explanation of new law' below for an overview of the taxation issues relating to this proposal.
Comparison of key features of new law and current law
|New law||Current law|
|A company may pay a dividend if:
|A company may pay a dividend only from profit.
In addition, section 588G sets out the directors' duty to prevent insolvent trading.
Detailed explanation of new law
3.8 The first limb of the new test establishes an important safeguard by requiring companies to have sufficient assets in excess of their liabilities in order to pay the dividend. This is similar to the balance sheet tests currently in operation in New Zealand and Canada.
3.9 The second and third limbs of the new test align with the requirements imposed on companies in relation to conducting share capital reductions and share buy-backs under Part 2J of the Corporations Act.
3.10 The new test is designed to ensure that creditors and shareholders who are not entitled to dividends are sufficiently protected.
3.11 In addition to the limbs outlined above, companies may also be subject to additional regulatory requirements. For example, prudentially regulated entities must comply with regulatory requirements governing the payment of a dividend or reduction in capital. The proposal outlined above will in no way impact upon these requirements.
Companies not required to prepare an audited financial report
3.12 If a company is not required to prepare an audited financial report (for example, because it is a small proprietary company), then the first component of the test which requires the company to be balance sheet solvent can be determined by reference to the accounting records which are required to be kept under section 286 of the Corporations Act.
General consequential amendments
3.13 Consequential amendments to other provisions that currently refer to profits are made to Part 1.5 of the Corporations Act and other statutes such as the Medibank Private Sale Act 2006 and the Financial Sector (Business Transfer and Group Restructure) Act 1999. [Schedule 1, Parts 1 and 4, items 5, 55, 58 and 59]
3.14 Importantly, the share capital concept will remain in the Corporations Act for other purposes, such as the provisions dealing with share buy-backs in Part 2J of the Act.
Consequential amendments to the income tax law
3.15 For income tax purposes, a dividend is defined to mean, broadly, any distribution made by a company to its shareholders, other than an amount that is debited against the company's share capital account (subsection 6(1) of the Income Tax Assessment Act 1936). Therefore, distributions made as a result of the amendments to section 254T of the Corporations Act will generally be dividends for income tax purposes.
3.16 Dividends paid to shareholders are included in assessable income provided that the dividends are paid by the company out of its profits (section 44 of the Income Tax Assessment Act 1936). As a result of these amendments, some corporate distributions that are dividends for Corporations Act purposes may not be paid by the company out of its profits.
3.17 Therefore, a consequential amendment to section 44 will deem these distributions to be paid by a company out of profits for the purposes of the income tax law. This will ensure that shareholders include these distributions in assessable income . [Schedule 1, Part 4, item 56]
3.18 Subject to the operation of the current imputation integrity rules, these distributions will be frankable under section 202-40 of the Income Tax Assessment Act 1997.