Paying dividends and the solvency test
In this article we take a look at the consequences of decisions made around private companies paying dividends and the solvency test.
When companies make a profit it is common practice to credit the profit share (or dividend) to their shareholders account each year.
The theory is that shareholders funds are listed as a liability in the balance sheet, and that the amount can then be demanded by the shareholder. Unfortunately, theory very often doesn’t match reality.
Commonly no cash is actually paid out to the shareholders, often because the company does not actually have the cash required to pay the dividend. So the dividend amount sits in the company’s shareholders’ current account(s) waiting for that happy day when it can be paid to the shareholders. For some that day never comes.
The test for paying a dividend under the legislation is clear, in that the Directors can only pay a dividend if the company will still be solvent immediately after the payment is made. Keep in mind that if the dividend is only credited to the shareholders’ current account(s), no payment has actually been made. Meaning that when there is a delay between declaring a dividend and actually paying it, the solvency test needs to be met on both occasions.
Section 254T(1) of the Corporations Act provides three tests to determine if a dividend can be paid:
- 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.
Essentially, the company must be assured that they can meet their debts as and when they fall due and that they have a positive net asset balance (in other words, their assets exceed their liabilities – including any contingent liabilities).
Case law has held that directors (who are often shareholders) cannot use their position to give themselves preference over their creditors in the event of insolvency. If a shareholder does receive money while the company is insolvent (or trading insolvent), they could find that they need to repay this back to a liquidator on demand.
The key message is that care does need to be taken when credits are made to current accounts and funds are withdrawn. The solvency test will apply twice in the case of dividends being paid later than they are declared.