Distributable Profits: The Companies Act 2006 Rules on Dividends

Distributable profits are the profits a company may lawfully pay out to its members. The figure is not the profit reported in the income statement, it is not retained earnings as shown in equity, and it is not cash. It is a statutory measure, defined for the purpose of deciding what may leave the company, and a dividend that exceeds it is unlawful however healthy the business appears.

The rule exists because a company's members have limited liability. Creditors can look only to the company's assets, so the capital subscribed by members is treated as a fund that must stay in the business. Distribution rules are the mechanism that keeps it there, and every technical detail below follows from that one purpose.

The basic definition

A company may make a distribution only out of profits available for the purpose, and those are its accumulated realised profits, so far as not previously used by distribution or capitalisation, less its accumulated realised losses, so far as not previously written off in a lawful reduction or reorganisation of capital.

Four words in that sentence carry the whole rule.

Accumulated. The test looks at the company's whole history, not at the current year. A company that made a large loss last year and a modest profit this year has nothing to distribute until the earlier loss has been made good. There is no such thing as distributing out of the profit of a single good year while cumulative losses stand.

Realised. Only profits realised at the balance sheet date count, and realisation is determined in accordance with principles generally accepted at the time the accounts are prepared. Unrealised gains — a revaluation surplus on property, a fair value uplift on an investment — are excluded.

Less accumulated realised losses. Losses are deducted symmetrically, and the netting is compulsory. A company cannot distribute the realised profits of one part of the business while ignoring the realised losses of another.

Not previously used. Profits already distributed, or capitalised in a bonus issue, are gone from the pool and cannot be counted a second time.

Why realised and unrealised are treated differently

The asymmetry between gains and losses is the part most often misunderstood, and the logic is about certainty, not prudence for its own sake.

An unrealised gain is an estimate. A property revalued upward may be worth the new figure, or the market may fall before it is sold. Paying cash out of the company on the strength of an estimate converts a paper gain into an irreversible transfer, and the creditors bear the consequence if the estimate was wrong.

An unrealised loss is different in one respect only: the company's exposure to it is real whether or not the asset has been sold. For that reason, while unrealised profits are excluded from the distributable pool, a public company is additionally required to take unrealised losses into account through the net assets test described below.

Two further points on realisation are worth knowing because they come up repeatedly.

A provision is generally a realised loss, which means that recognising an impairment reduces distributable profits immediately even though no cash has moved. A deficit arising on the revaluation of a fixed asset is treated as an unrealised loss, except to the extent it reverses a previous unrealised gain on the same asset.

Depreciation charged on an asset that has been revalued upward is a realised loss in full, but an amount equal to the excess of the new depreciation charge over the charge that would have been made on historical cost is treated as a realised profit. The revaluation surplus is therefore released to distributable reserves gradually, as the asset is used, and not all at once on revaluation.

The additional test for public companies

A public company faces a second hurdle. It may make a distribution only if, at the time, the amount of its net assets is not less than the aggregate of its called-up share capital and undistributable reserves, and only if the distribution does not reduce the net assets below that aggregate.

Undistributable reserves are the share premium account, the capital redemption reserve, the excess of accumulated unrealised profits over accumulated unrealised losses, and any reserve the company is prohibited from distributing by statute or by its own articles.

The practical effect is that a public company must absorb its net unrealised losses before distributing, while a private company need not. A private company with a large unrealised revaluation deficit may still have distributable realised profits; a public company in the same position may not.

Relevant accounts

A distribution has to be justified by reference to accounts, and the statute specifies which.

The normal case uses the last annual accounts laid before the members. Those accounts must have been properly prepared, and where the auditor's report is qualified the auditor must state in writing whether the qualification is material for determining the lawfulness of the distribution.

Interim accounts are required where the last annual accounts do not show sufficient distributable profits — the common case for a company paying an interim dividend out of profits earned since the year end. Initial accounts are required where the company proposes to distribute during its first accounting reference period.

The relevant accounts requirement is procedural, but it is not a formality. A dividend paid without accounts capable of justifying it is unlawful even if the profits in fact existed, because the directors had no proper basis for the decision at the time they took it.

Distributable profits and the profit in the accounts

The accounting figure and the distributable figure diverge for a set of reasons that recur, and being able to explain the gap is usually what a question is testing.

A revaluation surplus increases equity and reported net assets but adds nothing distributable until realised. Development costs capitalised as an intangible asset are generally treated as a realised loss for distribution purposes unless there are special circumstances, so capitalising them improves reported profit while reducing the distributable pool. A merger reserve arising on a share-for-share transaction sits in equity but is not a realised profit. Unrealised gains recognised on financial instruments measured at fair value are excluded.

Group structure adds a further separation that catches people out. Distributable profits are measured company by company, on the individual accounts of the company making the distribution. Consolidated reserves are irrelevant. A profitable group whose parent is a holding company with no trading income of its own has nothing to distribute until profits are passed up by dividend from the subsidiaries that earned them, and that is why intra-group dividend policy exists at all.

Unlawful distributions and who bears them

If a distribution is made in contravention of the rules and, at the time of the distribution, a member knows or has reasonable grounds for believing that it is so made, that member is liable to repay it to the company.

Two features of this remedy matter. It attaches to knowledge, not to fault in the ordinary sense, and in a close company where the members are also the directors that knowledge is easy to establish. And it is the statutory route; a member who did not know may still be liable as a constructive trustee under general law, and the directors who recommended and paid the dividend may be liable to make good the loss for breach of duty.

The leading illustration of how unforgiving this is came from a company whose sole shareholders took payments described as dividends while the company was loss-making, and were held liable to repay even though they had not appreciated that the payments were unlawful. Knowledge of the facts was enough; knowledge that the facts made the payment unlawful was not required.

A separate strand of authority treats a transaction that is not a dividend at all — a sale of an asset to a shareholder at a deliberate undervalue while the company has no distributable profits — as an unlawful return of capital. The label the parties use does not decide the question; the substance of a transfer of value to a member does.

Reduction of capital as the lawful route

Where a company has no distributable profits because of accumulated losses, the legitimate answer is not to pay a dividend anyway but to reduce capital.

A private company may reduce its share capital by special resolution supported by a solvency statement from the directors, which removes the need for a court order. The reduction can cancel accumulated losses against paid-up capital, and the effect is to restore a position from which future profits become distributable immediately rather than being absorbed by historical deficits.

A public company requires confirmation by the court, and creditors have a right to object. The distinction reflects the same policy as the two-tier distribution test: a public company's capital is treated as a more formal creditor safeguard than a private company's.

How it is examined

Questions come in two shapes and both reward the same discipline.

A calculation question gives a set of reserves and asks what may be paid. Work from accumulated realised profits, deduct accumulated realised losses, remove anything unrealised, and then apply the net assets test if the company is public. State which accounts you are relying on.

A discussion question asks why the reported profit and the distributable figure differ, or who bears the consequence when a dividend turns out to be unlawful. The answer is the creditor-protection rationale applied consistently: unrealised amounts are excluded because they may never arrive, losses are accumulated because a single good year does not repair a depleted fund, the measure is company-level because creditors contract with a company and not with a group, and repayment falls on members who knew the position.

The commonest error is treating retained earnings in the statement of financial position as the distributable figure. It is a starting point and nothing more, and a question that mentions a revaluation, capitalised development costs, or a group structure is signalling exactly where the adjustment lies.