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- September 2010
- Dividends under revised Section 254T– Interpretational dramas and the backdoor mandating of accounting standards
Dividends under revised Section 254T– Interpretational dramas and the backdoor mandating of accounting standards
- By Rob Mackay
- Published 15/09/2010
- September 2010
- Unrated
They were supposed to be part of reforms that lessened the compliance burden on companies, but not only has the revised section 254T caused many interpretational issues for companies and their advisors, they have effectively mandated the recognition and measurement requirements of accounting standards for all companies.
Intention of the new dividends test
The old dividends test required that the entity have profits available from which to pay a dividend at the time of payment. There were seen to be some deficiencies in this requirement because the term ‘profits’ was undefined within the Corporations Act, legal precedents were viewed as having become outdated, and the prevalence of fair value measurements principles since 2005 with the implementation of international financial reporting standards meant that traditional profit measures of a company had become volatile. In this regard, the explanatory memorandum to the Act that amends the dividend payment test noted that “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".
Circumstances in which a dividend can be paid
There are three legs that must be satisfied before an entity can pay a dividend under the revised section 254T. They are as follows:-
(i) 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
(ii) The payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and
(iii) The payment of the dividend does not materially prejudice the company’s ability to pay its creditors.
Issue 1 - A company must not pay a dividend unless the company’s assets exceed its liabilities
Question 1(a) - How do I measure the excess?
Subsection 254T(2) states that assets and liabilities are to be calculated for the purposes of this section in accordance with accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned).
Question 1(b) – When would a standard ‘not otherwise apply’?
An entity that prepares a financial report in accordance with Part 2M.3 of the Corporations Act 2001 must comply with accounting standards. In Australia, the reporting entity concept continues to prevail. This will be the case both before and after an entity implements the AASB’s revised differential reporting framework as it is currently structured. Mandatory accounting standards to be complied with are AASB 101, AASB 107, AASB 108, and AASB 1031. Other accounting standards will only be mandatorily applicable to the extent that the entity is a ‘reporting entity’ and therefore prepares a general purpose financial report. Therefore, a standard may not be applied by an entity if management has determined that it is a ‘non-reporting’ entity.
In addition, not all companies are required to prepare a financial report. Such entities will generally be small proprietary companies that are not controlled by foreign companies which have no statutory financial reporting obligations. Accounting standards are therefore not applicable to such companies.
The wording of s.254T(2) therefore effectively ignores both the reporting entity concept and the statutory financial reporting obligations by requiring all accounting standards to be adopted in the calculation of the excess.
Question 1(c) - My company does not prepare financial statements because it is a small proprietary company. What do I do?
There is an interesting comment that appears in the explanatory memorandum to the amending Act. It states as follows:-
“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.” (paragraph 3.12)
It is not surprising some people have interpreted this guidance literally as allowing a company that does not prepare financial statements to merely rely upon the accounting records of the company (as kept under s.286) of the Act for the purposes of determining the asset excess and that such a process will suffice for compliance with s.254T. There is no direct legislative requirement that such records record and explain its transactions and financial position and performance in accordance with accounting standards, only that those financial records would enable true and fair financial statements to be prepared and audited.
As mentioned above, under the reporting entity concept, a company need only comply with the recognition and measurement requirements of all accounting standards where that company is a ‘reporting entity’ as defined.
We must be mindful that the purpose of the explanatory memorandum is to provide explanation around the law and aid in its interpretation. Relying upon its contents is not an automatic means of complying with the law. In this regard, the wording and requirements of s.254T(2) must prevail in all circumstances. In this regard, paragraph 3.12 to the explanatory memorandum should not be viewed as a contradiction to s.254T(2), but should be viewed as an interpretation. The only logical interpretation is to suggest that Treasury, and ASIC as the enforcement agency of Treasury, expect accounting records to reflect the requirements of accounting standards. Where this is not the case, then the accounting records must be adjusted to align with recognition and measurement requirements of accounting standards for the purpose of calculating the asset surplus required by s.254T(1)(a).
This is likely to come as a shock to many companies and their advisers. In effect, the government has mandated recognition and measurement in accordance with accounting standards through the back door.
This is one of the most significant accounting reforms that has occurred, yet there does not appear to have been a great deal of disquiet since the amending legislation has been enacted. It is therefore possible that constituents are either taking their chances by ignoring it, or they are inappropriately relying upon the explanatory memorandum to provide them with an out-clause.
It would appear that the Australian Securities and Investments Commission are also keeping coy on this development and may be waiting for the hype surrounding the legislative amendments to settle down before they use this particular reform to their regulatory advantage, noting that ASIC have long held the view that the concept of a non-reporting entity choosing its own accounting policies for the purpose of recognition and measurement was a nonsense.
This development should also make it easier for the Australian Accounting Standards Board to achieve what it originally set out to do last year, and that is to eliminate the reporting entity concept so that all companies preparing financial statements for lodgement with ASIC must adopt full recognition and measurement under accounting standards.
Question 1(d) – My company is a non-reporting entity that does not adopt full recognition and measurement requirements of accounting standards. What do I do?
The same principles as in 1(c) apply. The entity’s net assets as displayed in the statutory financial statements will need to be converted so as to reflect full recognition and measurement and measurement of accounting standards. This may involve extra cost to the entity and from a practical point of view is likely to lead to entity’s adopting full recognition and measurement in their statutory financial statements to avoid the necessity of keeping two sets of books and records.
Issue 2 – Can the asset surplus be based on group accounts?
Section 254T(2) of the Act refers to the asset surplus as being calculated in accordance with the accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned). [emphasis added]
This latter part of the phrase (as emphasised) inferring that there may be more than one company’s accounts involved in the calculation is perplexing and could infer that the relevant asset surplus could be that of the group’s, and not necessarily that of the company that pays the dividend.
However, an interpretation that consolidation is required may be reading too much into this section and is likely to contradict the requirements of subsection 254T(1) which requires the asset surplus to reside within the company. In a legislative context, this is the legal entity and not the accounting entity. In addition, given the reference to ‘consolidated financial statements’ elsewhere in the Corporations Act, it is likely that such a reference would have been made in this section if that was the intention.
We are left wondering however what was intended by the reference to the other companies concerned.
Issue 3 – I don’t have an asset surplus unless I revalue my land and buildings. Can I revalue them so I can pay a dividend?
Entities that have sufficient cash to pay dividends but which do not have an adequate asset surplus may adopt a revaluation model for classes of property, plant and equipment in accordance with AASB 116 to create an asset surplus. The same applies for investment property under AASB 140.
Such revaluations must be undertaken in accordance with those standards, and where an entity is reverting to a revaluation model from a cost model of measurement, this will constitute an accounting policy change. Having regard to the requirements of AASB 108 dealing with changes in accounting policies, an entity would be unable to revert back to a cost measurement basis in future years.
Under a revaluation model, property, plant and equipment is required to be revalued on a regular basis so that the carrying value at each reporting period is not materially different to current fair values.
Issue 4 - When do I measure the excess?
The revised s.254T requires that the asset surplus exist immediately before the dividend is declared. On the basis that companies would rarely declare a dividend on balance date, management will need to have regard to the movement in the asset surplus between balance date and the date of the declaration. This may prove troublesome for some entities, particularly those that do not have ‘live reporting’ capabilities where there may be some doubt as to the continuing existence of the surplus as reflected in the historical financial statements.
Issue 5 - Dividends vs return of capital
One of the main purposes of the reform was to allow the continuance of dividend payments notwithstanding that an entity may not have reflected a profit for the period or may even have retained losses in their accounts at the time of payment.
The previous dividend test required that a dividend be paid out of profits. The profit could have been a current period reported profit, retained profits carried forward from prior periods, a profit generated otherwise and set aside by the directors for payment as a dividend, unrealised asset revaluations that could reasonably be considered to be of a permanent nature, or a combination thereof. One wonders that if a dividend could not be found from those sources, the company is unlikely to have an asset surplus from which to pay a dividend in any event.
Assuming that there may be entities to which this new dividend policy suits, the corporate world would need to ask themselves whether they might be satisfying the second leg of the dividend payment test when paying dividends when there a no available profits. That second leg requires that the payment of a dividend is fair and reasonable to the company’s shareholders as a whole.
In this regard, management needs to consider the amendments to the Income Tax Assessment Act 1936 which now deem that “a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits” and hence is taxable as a dividend in the hands of a shareholder. Is it fair and reasonable that a shareholder be taxed on a return of capital that they have contributed? Probably not.
Sitting aside that potential problem is the risk that a company paying dividends and eroding capital of the company is in breach of the capital maintenance provisions of the Act which are in place to protect shareholders and creditors of the company. The various sections of the Corporations Act dealing with share capital reduction generally require that such reduction be undertaken with the approval of shareholders. It is doubtful that Treasury intended that s.254T be an alternative and automatic authority for the return of capital, and companies could find that such payments will need to be authorised by shareholders in accordance with the Act.
This may be an area that ends up with the Courts if legislative amendments are not made to clarify this issue.
Issue 6 – Conflict of terms
The revised s.254T requires that the asset surplus be determined immediately prior to the ‘declaration’ of the dividend. Many companies will have their internal governance determined by the replaceable rule of s.254U that provides that the directors may ‘determine’ that a dividend is payable and fix the amount, time and method for payment. There is a distinction between the terms ‘determine’ and ‘declare’ when related to the payment of dividends. This is evident in s.254V which indicates that the ‘determination’ of a dividend will not be deemed to be the incurrence of a debt until the time fixed arises. The company will however be deemed to have incurred a debt upon the ‘declaration’ of a dividend.
It could be perceived that the declaration of a dividend has been mandated through this revision. In order to avoid any uncertainty about incurring debts at inappropriate times, companies are likely to continue to ‘determine’ dividends but prior to payment, an assessment will need to be undertaken to ensure that an asset surplus exists and only then will the dividend be ‘declared’.
Issue 7 – Constitutional amendments
In instances where companies want to maintain maximum flexibility in the payment of dividends, the constitution of the company should be reviewed to ascertain whether it restricts the payment of dividends to those paid out of profits. Amendments to the constitution need to be passed at a company’s AGM. Companies may however be inclined to wait and see whether there are further developments in the ‘return of capital’ debate before rushing ahead with any constitutional changes.
Playing it safe
It may be a case of back to the drawing board for Treasury, or they could either reinstate the previous rule or delete section 254T in its entirety so that only the insolvency prohibitions of section 588G regulate the payment of dividends. Otherwise, it is likely to be back to the Courts for interpretation of the various anomalies of section 254T.
In the meantime, companies may have to play it safe by consulting with their legal advisors before paying a dividend, and possibly ensuring that it is clear that profits are available from which to pay them, as was the case under the previously ‘simpler’ but superseded s.254T.
Contact
Intention of the new dividends test
The old dividends test required that the entity have profits available from which to pay a dividend at the time of payment. There were seen to be some deficiencies in this requirement because the term ‘profits’ was undefined within the Corporations Act, legal precedents were viewed as having become outdated, and the prevalence of fair value measurements principles since 2005 with the implementation of international financial reporting standards meant that traditional profit measures of a company had become volatile. In this regard, the explanatory memorandum to the Act that amends the dividend payment test noted that “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".
Circumstances in which a dividend can be paid
There are three legs that must be satisfied before an entity can pay a dividend under the revised section 254T. They are as follows:-
(i) 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
(ii) The payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and
(iii) The payment of the dividend does not materially prejudice the company’s ability to pay its creditors.
Issue 1 - A company must not pay a dividend unless the company’s assets exceed its liabilities
Question 1(a) - How do I measure the excess?
Subsection 254T(2) states that assets and liabilities are to be calculated for the purposes of this section in accordance with accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned).
Question 1(b) – When would a standard ‘not otherwise apply’?
An entity that prepares a financial report in accordance with Part 2M.3 of the Corporations Act 2001 must comply with accounting standards. In Australia, the reporting entity concept continues to prevail. This will be the case both before and after an entity implements the AASB’s revised differential reporting framework as it is currently structured. Mandatory accounting standards to be complied with are AASB 101, AASB 107, AASB 108, and AASB 1031. Other accounting standards will only be mandatorily applicable to the extent that the entity is a ‘reporting entity’ and therefore prepares a general purpose financial report. Therefore, a standard may not be applied by an entity if management has determined that it is a ‘non-reporting’ entity.
In addition, not all companies are required to prepare a financial report. Such entities will generally be small proprietary companies that are not controlled by foreign companies which have no statutory financial reporting obligations. Accounting standards are therefore not applicable to such companies.
The wording of s.254T(2) therefore effectively ignores both the reporting entity concept and the statutory financial reporting obligations by requiring all accounting standards to be adopted in the calculation of the excess.
Question 1(c) - My company does not prepare financial statements because it is a small proprietary company. What do I do?
There is an interesting comment that appears in the explanatory memorandum to the amending Act. It states as follows:-
“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.” (paragraph 3.12)
It is not surprising some people have interpreted this guidance literally as allowing a company that does not prepare financial statements to merely rely upon the accounting records of the company (as kept under s.286) of the Act for the purposes of determining the asset excess and that such a process will suffice for compliance with s.254T. There is no direct legislative requirement that such records record and explain its transactions and financial position and performance in accordance with accounting standards, only that those financial records would enable true and fair financial statements to be prepared and audited.
As mentioned above, under the reporting entity concept, a company need only comply with the recognition and measurement requirements of all accounting standards where that company is a ‘reporting entity’ as defined.
We must be mindful that the purpose of the explanatory memorandum is to provide explanation around the law and aid in its interpretation. Relying upon its contents is not an automatic means of complying with the law. In this regard, the wording and requirements of s.254T(2) must prevail in all circumstances. In this regard, paragraph 3.12 to the explanatory memorandum should not be viewed as a contradiction to s.254T(2), but should be viewed as an interpretation. The only logical interpretation is to suggest that Treasury, and ASIC as the enforcement agency of Treasury, expect accounting records to reflect the requirements of accounting standards. Where this is not the case, then the accounting records must be adjusted to align with recognition and measurement requirements of accounting standards for the purpose of calculating the asset surplus required by s.254T(1)(a).
This is likely to come as a shock to many companies and their advisers. In effect, the government has mandated recognition and measurement in accordance with accounting standards through the back door.
This is one of the most significant accounting reforms that has occurred, yet there does not appear to have been a great deal of disquiet since the amending legislation has been enacted. It is therefore possible that constituents are either taking their chances by ignoring it, or they are inappropriately relying upon the explanatory memorandum to provide them with an out-clause.
It would appear that the Australian Securities and Investments Commission are also keeping coy on this development and may be waiting for the hype surrounding the legislative amendments to settle down before they use this particular reform to their regulatory advantage, noting that ASIC have long held the view that the concept of a non-reporting entity choosing its own accounting policies for the purpose of recognition and measurement was a nonsense.
This development should also make it easier for the Australian Accounting Standards Board to achieve what it originally set out to do last year, and that is to eliminate the reporting entity concept so that all companies preparing financial statements for lodgement with ASIC must adopt full recognition and measurement under accounting standards.
Question 1(d) – My company is a non-reporting entity that does not adopt full recognition and measurement requirements of accounting standards. What do I do?
The same principles as in 1(c) apply. The entity’s net assets as displayed in the statutory financial statements will need to be converted so as to reflect full recognition and measurement and measurement of accounting standards. This may involve extra cost to the entity and from a practical point of view is likely to lead to entity’s adopting full recognition and measurement in their statutory financial statements to avoid the necessity of keeping two sets of books and records.
Issue 2 – Can the asset surplus be based on group accounts?
Section 254T(2) of the Act refers to the asset surplus as being calculated in accordance with the accounting standards in force at the relevant time (even if the standard does not otherwise apply to the financial year of some or all of the companies concerned). [emphasis added]
This latter part of the phrase (as emphasised) inferring that there may be more than one company’s accounts involved in the calculation is perplexing and could infer that the relevant asset surplus could be that of the group’s, and not necessarily that of the company that pays the dividend.
However, an interpretation that consolidation is required may be reading too much into this section and is likely to contradict the requirements of subsection 254T(1) which requires the asset surplus to reside within the company. In a legislative context, this is the legal entity and not the accounting entity. In addition, given the reference to ‘consolidated financial statements’ elsewhere in the Corporations Act, it is likely that such a reference would have been made in this section if that was the intention.
We are left wondering however what was intended by the reference to the other companies concerned.
Issue 3 – I don’t have an asset surplus unless I revalue my land and buildings. Can I revalue them so I can pay a dividend?
Entities that have sufficient cash to pay dividends but which do not have an adequate asset surplus may adopt a revaluation model for classes of property, plant and equipment in accordance with AASB 116 to create an asset surplus. The same applies for investment property under AASB 140.
Such revaluations must be undertaken in accordance with those standards, and where an entity is reverting to a revaluation model from a cost model of measurement, this will constitute an accounting policy change. Having regard to the requirements of AASB 108 dealing with changes in accounting policies, an entity would be unable to revert back to a cost measurement basis in future years.
Under a revaluation model, property, plant and equipment is required to be revalued on a regular basis so that the carrying value at each reporting period is not materially different to current fair values.
Issue 4 - When do I measure the excess?
The revised s.254T requires that the asset surplus exist immediately before the dividend is declared. On the basis that companies would rarely declare a dividend on balance date, management will need to have regard to the movement in the asset surplus between balance date and the date of the declaration. This may prove troublesome for some entities, particularly those that do not have ‘live reporting’ capabilities where there may be some doubt as to the continuing existence of the surplus as reflected in the historical financial statements.
Issue 5 - Dividends vs return of capital
One of the main purposes of the reform was to allow the continuance of dividend payments notwithstanding that an entity may not have reflected a profit for the period or may even have retained losses in their accounts at the time of payment.
The previous dividend test required that a dividend be paid out of profits. The profit could have been a current period reported profit, retained profits carried forward from prior periods, a profit generated otherwise and set aside by the directors for payment as a dividend, unrealised asset revaluations that could reasonably be considered to be of a permanent nature, or a combination thereof. One wonders that if a dividend could not be found from those sources, the company is unlikely to have an asset surplus from which to pay a dividend in any event.
Assuming that there may be entities to which this new dividend policy suits, the corporate world would need to ask themselves whether they might be satisfying the second leg of the dividend payment test when paying dividends when there a no available profits. That second leg requires that the payment of a dividend is fair and reasonable to the company’s shareholders as a whole.
In this regard, management needs to consider the amendments to the Income Tax Assessment Act 1936 which now deem that “a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits” and hence is taxable as a dividend in the hands of a shareholder. Is it fair and reasonable that a shareholder be taxed on a return of capital that they have contributed? Probably not.
Sitting aside that potential problem is the risk that a company paying dividends and eroding capital of the company is in breach of the capital maintenance provisions of the Act which are in place to protect shareholders and creditors of the company. The various sections of the Corporations Act dealing with share capital reduction generally require that such reduction be undertaken with the approval of shareholders. It is doubtful that Treasury intended that s.254T be an alternative and automatic authority for the return of capital, and companies could find that such payments will need to be authorised by shareholders in accordance with the Act.
This may be an area that ends up with the Courts if legislative amendments are not made to clarify this issue.
Issue 6 – Conflict of terms
The revised s.254T requires that the asset surplus be determined immediately prior to the ‘declaration’ of the dividend. Many companies will have their internal governance determined by the replaceable rule of s.254U that provides that the directors may ‘determine’ that a dividend is payable and fix the amount, time and method for payment. There is a distinction between the terms ‘determine’ and ‘declare’ when related to the payment of dividends. This is evident in s.254V which indicates that the ‘determination’ of a dividend will not be deemed to be the incurrence of a debt until the time fixed arises. The company will however be deemed to have incurred a debt upon the ‘declaration’ of a dividend.
It could be perceived that the declaration of a dividend has been mandated through this revision. In order to avoid any uncertainty about incurring debts at inappropriate times, companies are likely to continue to ‘determine’ dividends but prior to payment, an assessment will need to be undertaken to ensure that an asset surplus exists and only then will the dividend be ‘declared’.
Issue 7 – Constitutional amendments
In instances where companies want to maintain maximum flexibility in the payment of dividends, the constitution of the company should be reviewed to ascertain whether it restricts the payment of dividends to those paid out of profits. Amendments to the constitution need to be passed at a company’s AGM. Companies may however be inclined to wait and see whether there are further developments in the ‘return of capital’ debate before rushing ahead with any constitutional changes.
Playing it safe
It may be a case of back to the drawing board for Treasury, or they could either reinstate the previous rule or delete section 254T in its entirety so that only the insolvency prohibitions of section 588G regulate the payment of dividends. Otherwise, it is likely to be back to the Courts for interpretation of the various anomalies of section 254T.
In the meantime, companies may have to play it safe by consulting with their legal advisors before paying a dividend, and possibly ensuring that it is clear that profits are available from which to pay them, as was the case under the previously ‘simpler’ but superseded s.254T.
Contact
Rob Mackay
T +61 3 8635 1800
rmackay@moorestephens.com.au
www.moorestephens.com.au
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Article Series
This article is part 1 of a 3 part series. Other articles in this series are shown below:
-
Dividends under revised Section 254T– Interpretational dramas and the backdoor mandating of accounting standards