A new section 254T has been inserted in the Corporations Act 2001 ("Act") to make changes to the way dividends can be declared. The new section took effect from 28 June 2010.

The previous "profits test" which used to govern the way dividends can be declared and paid has now been replaced with a "solvency test". The solvency test requires the company to meet ALL of the following criteria before the declaration and payment of dividends:

  1. Assets must exceed liabilities immediately before the dividend is declared and the excess must be sufficient to pay the dividend;
  2. The payment of the dividend must be fair and reasonable to the company‟s shareholders as a whole; and
  3. The payment of the dividend does not materially prejudice the company‟s ability to pay its creditors.

The requirements of section 254T are to be applied alongside a director‟s duty under the Act to prevent insolvency.

As a result of the solvency test:

  • Valuation of assets and liabilities: must be done by reference to Accounting Standards as recorded in the company‟s balance sheet. As a result, directors cannot rely on reasonable market valuations to determine the value of the company‟s assets. The outcome may be that assets are valued lower on the balance sheet than market reality, which may lead to a company being unable to pay dividends, or able to pay much lower dividends than if market values had been the basis of the asset valuation.
  • Preparation of "special purpose" financial statements: Since dividends can‟t be declared and paid unless assets exceed liabilities by reference to Accounting Standards, even if the company is not usually required to apply Accounting Standards (such as small proprietary companies), in future financial statements applying Accounting Standards will need to be prepared to substantiate a decision to pay dividends. The likely result is that companies not normally required to apply Accounting Standards will have to incur additional expense to prepare special purpose financial statements.
  • "Point in time" test: The "solvency test" must be satisfied at the time the dividend is declared. This "point in time" test means that assets must exceed liabilities as shown on financial statements that show the position at the time the dividend is declared. So to pay a dividend for 1 July, companies that don‟t normally declare that dividend until after preparation of the end of year financial statements will need to ensure that not only on 1 July, but also on the date of declaration of the dividend (for example, 30 August), the solvency test‟ is satisfied. As a practical matter, it may be difficult to prepare financial statements in time to make a declaration, or alternatively special purpose financial statements may have to be prepared.
  • "Fair and Reasonable": Historically, the term fair and reasonable‟ requires determination of each shareholder‟s rights in relation to each of the other shareholders in different classes, and the adequacy of the dividend paid. These are not simple matters to determine, and it is likely that directors will need guidance from lawyers reviewing decided cases to assist them in making this determination. There is potential for shareholder disputes to arise even within companies with few shareholders, or actions against the Board, on the basis that dividends paid to shareholders with different class rights is not fair and reasonable‟, or that the dividend paid to all shareholders is not adequate.
  • "Materially Prejudice Creditors": Section 254T of the Act now requires an assessment of whether the payment of dividends will materially prejudice‟ creditors. This will require an increased level of investigation and use of resources for directors to determine whether, at the time that dividends are declared, creditors might be materially prejudiced‟ by the payment. Boards often manage the risk of getting this test wrong in the context of share capital reductions and share buy-backs by engaging expert accountant reports to guide them.

What needs to be done?

Companies should urgently review their constitutions and dividend payment policies as most company constitutions and dividend payment policies provide that dividends can only be paid out of profits.

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