A private company like Fashion Designs Ltd only needs to encounter the realised profits test only.
Both tests are just generally put into place to allow the company and its shareholders to see the amount the dividends it has.
(b) If on the basis of interim accounts the directors were to declare a dividend to preference shareholders in accordance with their class rights, but when final accounts for the year were completed the company discovered that it did not have enough profits to pay a dividend the legal position of the directors and the preference shareholders are to follow;
When Dividends Can & Must be Paid: As to when dividends can be paid, the Board of directors decides how much is to be paid to shareholders in any accounting period and accordingly declares the dividend. You can pay dividends at anytime, but it is usual to wait until the financial year's results are known before declaring a dividend. Interim dividends paid are set against the year's distributable profit.
In declaring dividends you must take account of the cash needed for continuing working capital requirements of the company and you can only pay a dividend out of distributable profit i.e. revenue profit and realised capital gains. Reserves of undistributed profit from earlier years may be carried forward, as may any deficit, in order to determine the amount of distributable profit available at any time.
The Preference Shareholder: The rights attached to preference shares will normally be defined in the Articles of Association including the right to receive dividends at a fixed rate payable on specific dates. It is important to compare the cost to your company of dividends payable to any preference shareholder with the cost of other sums advanced to the business, e.g. a bank loan. For example, with a fall in interest rates, it may be that the dividend originally agreed on the preference shares becomes unduly high. In that event some reorganisation, possibly involving redemption or repurchase of your preference shares, may be advisable.
If there is no profit available, either because none have been earned or because the directors decide to transfer all the profits to reserve, the preference shareholder cannot sue the company for his/her dividend. A dividend is not due unless it is declared. The articles may however provide that available profits must be applied to payment of preference shareholders if their dividends are not paid.
If the company/directors fails to pay, i.e. ‘passes’, its preference dividend, the right to it as a priority claim is usually carried forward. If for example no dividend is paid on 6 per cent cumulative preference shares in year 1 the holders of those shares (even if not the same persons as held them in year one) have a priority entitlement to 12 per cent in year 2 and so on. So as long as the arrears of dividend is accumulated and paid before other shareholders this is the position they are in. (Webb v Earle 1875).
The payment of dividends is usually dealt with by the articles. Article 102 gives directors the sole power to decide whether a dividend should be declared. Directors have power to declare an interim dividend without having to consent members.
Preference shares may be expressly designated as cumulative to indicate the right to carry forward entitlement to arrears. Preference shares are deemed to be cumulative unless a contrary intention which is not the case here.
(c) Balance Sheet extract for Fashion Designs L
£
Fully Paid Capital 100,000
Profit for 2003 1,000,000
Net Assets (all buildings) 230,000
Share Premium Account 100,000
1,430,000
Trading losses (400,000)
(200,000)
600,000
Total Profit 830,000
The total profit ending the year December 2003 is £830,000, the share premium account is £100,000 which cannot be used to pay dividends to its shareholders. See below for reasoning.
There is a rule for payment, the third rule, which states that a company without any special powers in its articles, issue its shares at a premium by way of either cash or non-cash assets. The share premium known as the share premium account has to be listed in the balance sheet. It is treated as a capital account, therefore cannot be used to pay a dividend.
Profits available for payments of dividends - A company may not make a distribution except out of profits available for the purpose: s.263. This rule primarily controls the dividends but distribution is defined to cover any distribution of assets other than:
- the issue of shares as fully or partly paid bonus shares
- payments on redemption or purchase of the company’s shares
- a reduction of share capital by extinguishing or reducing liability in respect of unpaid share capital or by repaying paid-up share capital
- a distribution of assets to members in winding up
The profits available for distribution are the accumulated, realised profits, so far as not previously utilized by distribution or capitalisation less accumulated realised losses so far as not previously written off by a reduction or reorganisation of capital made. This rule applies to all companies because the new formula on distribution profits is best illustrated by reference to the loopholes in the previous law which it closes.
Both profits and losses must be accumulated i.e. the profit and loss account must be maintained as a continuous record of the company’s financial results since incorporation. It is no longer possible to pay a dividend out of current profits without setting off against those profits and losses of previous periods.