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Context
The aim of any business organisation is to earn profit and distribute it among the owners. In case of a company, such distribution of profits is connoted as Dividend. The Companies Act, 2013 (“the Act”), inter alia provides for declaration of dividend out of profits. Profit here is the net profit of a company, as determined for preparing financial statements, as per the provisions of Section 129 of the Act and after complying with all the applicable accounting standards notified under Section 133 of the Act.
Chapter VIII under the Act lays down the law on declaration and payment of dividend. These provisions are substantially in line with the provisions of the Companies Act, 1956 (“1956 Act”),with a few deviations. While the provisions under the Act have been in effect for about a decade now, certain intricate issues remain, even after the provision undergoing a round of amendments.[1] In this article, the authors are trying to decode certain key issues under the provisions governing dividend.
Legal Provisions relating to Dividend
Section 2(35) of the Act states that the term ‘dividend’ includes any interim dividend. Section 123(1) of the Act inter-alia states that “no dividend shall be declared or paid by a company for any financial year except out of the profits of the company for that year or out of the profits of the company for any previous financial years”. By the insertion of proviso to Section 123(1)(a), it has been expressly clarified that in computing profits, any amount representing unrealised gains, notional gains or revaluation of assets and any change in carrying amount of an asset or of a liability on measurement of the asset or the liability at fair value shall be excluded. Further, the Second proviso to Section 123(1)(b) states that in case of inadequacy or absence of profits, the company can propose to declare dividend out of the free reserves of the company, after complying with the restrictions prescribed under Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014 (“Dividend Rules”).
However, an anomaly related to permissibility is created when a company wants to declare interim dividend by utilising reserves. It is pertinent to note that sub-section (3) of Section 123 of the Act specifically deals with ‘interim dividend’. Unlike Section 123(1) of the Act, the situation of inadequacy of profits is not considered under Section 123(3) of the Act and therefore, a view may be taken that the profits transferred to free reserves is not a permissible source for interim dividend and the same can be paid only out of profits as provided in Section 123(1) of the Act. In support of this conclusion, it may also be inferred that interim dividend is declared and paid only by Board approval, whereas shareholder approval is a pre-requisite for utilising reserves for distributing final dividend.[2]
For examining the meaning of “surplus in the profit and loss account” mentioned under Section 123(3) of the Act, reference may be made to the Report of the Company Law Committee, 2016 (“CLC 2016 Report”), which was submitted to the Ministry of Corporate Affairs (“MCA”) on February 1, 2016[3]. The CLC 2016 Report states the following:
“The surplus balance (i.e., carried forward balance of profit and loss account) is a part of “free reserves” but it does not represent an amount ‘transferred’ to reserves. It has been suggested that to avoid any legal challenges in application, the requirements of the Rule and the section should be harmonized appropriately”.
Rule 3 of Dividend Rules prescribes the conditions to be complied with for declaring dividend out of reserves. A pertinent question here is – whether a company can declare dividend out of 100% of the amount that has been transferred to General Reserve. In accordance with Rule 3(2) of the Dividend Rules, a company may declare dividend out of free reserves, subject to the condition that the total amount to be drawn from such accumulated profits shall not exceed one-tenth (1/10th) of the sum of its paid-up share capital and free reserves, as appearing in the latest audited financial statements. However, this can be done through a scheme of arrangement formulated in accordance with Section 230 of the Act, which will require sanction of the National Company Law Tribunal (“NCLT”).
A company may transfer the entire amount present in the General Reserves to the P&L Account and reclassify it as “accumulated profits” of previous financial years, after providing for depreciation in accordance with Schedule II of the Act. Once the amount is transferred to the profit and loss Account and reclassified as “accumulated profits” of previous financial years, the restrictions stipulated under Rule 3 of Dividend Rules becomes redundant. This approach, adopted by Hindustan Unilever Limited [4]and International Paper APPM Limited[5], was upheld by NCLT.
Complications arising out of Accounting Standard Ind AS 109
Those companies and particularly investment companies that, as per Ind AS 109, irrevocably elected for the Other Comprehensive Income (“OCI”) route are now in a dilemma as to whether the amount directly credited as retained earnings under the head “reserves and surplus” of the balance sheet, without the same being routed to “profit and loss” account, would be available for distribution as dividend or the same will be treated as part of general reserve and consequently restrictions placed under Rule 3 of Dividend Rules would apply.
Interim Dividend – Safeguards to be observed
To understand the permissible sources for declaration of interim dividend, the provision under Section 123(1) of the Act can be broken down as follows:
- surplus in the profit and loss account or
- out of profits of the financial year for which such interim dividend is sought to be declared or
- out of profits generated in the financial year, till the quarter preceding the date of declaration of the interim dividend
The terminology “out of profits of the financial year for which such interim dividend is sought to be declared” suggests that profits for the entire year for which interim dividend is being declared can be used. It may be inferred that dividend can be declared even out of anticipated profits for the entire financial year. This issue has been dealt by the Companies Law Committee in CLC 2016 Report and it has been observed as follows and it recommended amendment to sub-section (3) of Section 123 of the Act:
“Further, the use of the word “and” after the words “surplus in the profit and loss account”, and before the words “out of the profits of the financial year” in subsection (3) of Section 123 appears at disharmony with the provisions of sub-section (1)(a), which provides for the declaration of dividend out of the profits of the company for that financial year, or the profits of the company from any previous financial year(s) (subject to deduction of depreciation and other conditions), or both the amounts. The Committee also felt that, as a measure of good corporate governance, a company should not declare interim dividend out of the projected profits for the full year”.[6]
However, post amendment, the wording “out of profits of the financial year for which such interim dividend is sought to be declared” is kept as is and an additional clause “out of profits generated in the financial year till the quarter preceding the date of declaration of the interim dividend” has been provided. While the intent was to permit declaration of interim dividend only out of the profit that has already been earned and not out of anticipated profits for the entire year, the amendment brought in is not fully effective because of the continuation of the earlier clause in the provision.
From a governance perspective, the recommendation in the CLC Report appears to be appropriate and Board should take a diligent view and declare dividend out of the actual profit and not out of the profit that is envisaged. A similar view is also expressed by the Institute of Company Secretaries of India[7] in its guidance note on Dividend. Hence, an amendment removing this clause entirely may bring absolute clarity in terms of permissibility for declaration of interim dividend.
Further, since declaring interim dividend is the prerogative of the Board of Directors (“Board”) and does not require shareholder approval, it can also form a part of ‘duties and responsibilities’ of the Board. Section 166 of the Act codifies fiduciary duties of directors, which includes but is not limited to acting in good faith, best interests of the company, exercising duties with due and reasonable care. However, Chapter VIII does not provide for penalty in such a case, where the Board declares dividend from anticipated profits and if the company fails to achieve to earn such profits, then it may amount to directors not adhering to their fiduciary duties. It was held in Kishinchand Chellaram v. Commissioner of Income Tax [8]that “If the Directors of a company have deliberately paid or negligently been instrumental in paying dividend out of capital, they may have to compensate the company for loss occasioned by their wrongful or negligent conduct”. Further, it was held in Bairstow v. Queens Moat Houses Plc[9]that: “No relief from accountability was allowed where the directors’ conduct in making unlawful payment of dividend did not reflect honesty and reasonableness”.
Concluding Thoughts:
In Companies Act, 1956, there were two rules governing dividend distribution – Companies (Transfer of Profits to Reserves) Rules, 1975, and the Dividend Rules. However, the rationale behind retaining dividend restriction under Rule 3 of the Dividend Rules may be inferred by applying the doctrine of capital maintenance to ensure that a company’s assets are not distributed in a way that is prejudicial to the interests of unsecured creditors, or, indeed, one class of security holders at the expense of another.[10]
The Board needs to adopt a pragmatic policy regarding dividend distribution. SEBI also mandates the top 1000 listed entities to disclose their dividend distribution policy on the website of the company.[11] Most Indian corporates have their internal benchmark on distribution of Profit After Tax (“PAT”) to ensure consistency in dividend distribution and at the same time to make sure that sufficient cash is available for growth and expansion of the company. The conservative rule is to distribute 35-40% of PAT as dividend. However, this can vary from industry to industry and company to company, based on whether the company is a multinational company or otherwise. Often, cash requirement of the promoter is a dominant consideration in deciding dividend percentage. A prudent dividend distribution policy gives adequate weightage to the company in the corporate governance score card.
[1] Companies (Amendment) Act, 2017, 9th February 2018
[2] Para 1.2.2 of ICSI Guidance Note on Dividend
[3] Para 8.1 of the CLC 2016 Report
[4] Hindustan Unilever Limited, TCSP No. 151 of 2017, Order dated August 30, 2018 [NCLT Mumbai]
[5] International Paper APPM Limited, CP No. 416 of 2016, Order dated November 16, 2018 [NCLT Hyderabad]
[6] Para 8.2 of the CLC 2016 Report
[7] Para 1.1.4 of ICSI Guidance Note on Dividend
[8] Kishinchand Chellaram v. Commissioner of Income Tax (1962) (SC)
[9] Bairstow v. Queens Moat Houses Plc [2001] EWCA Civ 712 [2002] B.C.C. 91
[10] Para 9.704 of Palmer’s Company Law Vol 2 (2015)
[11] Regulation 43 of Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015
