Further review of dividend rules - time for greater clarity

In June 2010 amendments were made to the Corporations Act 2001 (the Act) by the Corporations Amendment (Corporate Reporting Reform) Act 2010 (the Reform Act) with the objective of improving Australia's corporate reporting framework.  Most particularly, the Reform Act adopted a new test for the legal payment of dividends by a company (Current Dividend Test).

The Current Dividend Test (a 'balance sheet' test) allows a company to pay a dividend if the company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient to pay for the dividend.  However, there have been calls by some stakeholders for changes to a number of the amendments made by the Reform Act.  In part, because of the confusion caused by the specific drafting of the legislative provision and the potential administrative burden of complying with the Current Dividend Test, particularly for SME businesses that may not otherwise have to comply with Accounting Standards.

On 28 November 2011, the Treasury released a discussion paper in relation to revising the terms of the dividend provisions and to address related amendments to the Corporations Act (Discussion Paper).

The Discussion Paper puts forward four alternative options for the test for payment of dividends, as well as further amendments to the Act.  You can read a more detailed overview of the provisions on our website.  In our opinion, 'Option 2' which suggests replacing the Current Dividend Test with a solvency based test is clearly the best - putting the key question of solvency at the heart of a Company's ability to pay dividends and somewhat simplifying the compliance costs for SME businesses.

Public comment on the proposals are open until 30 January 2011.  Please contact us if you'd like assistance on the application of the Current Dividend Test in the context of your business or to comment on the Discussion Paper.

Current Dividend Test

The Reform Act substituted a new section 254T to the Act, introducing the Current Dividend Test, 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.

Criticisms of this test arise from the lack of clarity as to how this provision interacts with the requirements in the Act for the maintenance of capital by a company.  Other criticisms include the lack of relationship between the balance sheet test and solvency, internal inconsistencies within the Act between the nature of a dividend being 'declared' versus being 'determined' and, perhaps most relevantly for SME businesses, the potentially unreasonable compliance burden of having to have reference to accounting standards in assessing compliance with the balance sheet test.

Discussion Paper

The Discussion Paper suggests four alternatives to the Current Dividend Test.  These are:

• Option 1 - retaining the Current Dividend Test - In our view this is not the preferable approach.  Apart from the fundamental issue that the balance sheet test does not address the key question of a company's solvency before paying a dividend, there is significant potential for smaller entities that are not required to comply with accounting standards to have to incur additional professional costs in assessing compliance with the balance sheet test.  In addition, there are various technical issues that arise from the drafting of the current section that mean that professional advice from lawyers and accountants should always be sought from companies before declaring or paying a dividend;
• Option 2 - is based on the current provisions operating in New Zealand.  It would require the company to remain solvent following any distribution.  This is assessed by the company being able to pay its debts as they fall due (solvency test) and have assets that exceed known and contingent liabilities after payment of the dividend (balance sheet test).  In New Zealand, that is assessed by reference to the most recent financial statements and the directors assessment of other relevant factors impacting the company's assets and liabilities.
• Option 3 - is to reinstate the old 'profits test'.  While this test was generally well understood by companies and their advisers, there were a number of drawbacks.  In particular, there was no definition of profit in the Act and the case law had given rise to some unsatisfactory interpretations.  Profitability can also be impacted by various 'fair value' assessments under accounting standards, thereby making profit somewhat volatile.
• Option 4 - is a combination of a profits test (requiring dividends to only be paid out of profits) with the balance sheet and solvency tests (requiring that the company must have net assets before payment of the dividend and that the dividend is fair and reasonable to all shareholders and doesn't materially prejudice the company's ability to pay its creditors).  While seeking to combine some of the advantages of Option 2 above, this option would still retain a number of the significant disadvantages of the old profits test.

In addition to the question of the most appropriate test for the payment of dividends, the Discussion Paper also raises technical issues relating to the use of the term 'declared' in the provision, capital maintenance restrictions, the application of the dividend test in the context of group structures and various tax issues.