Distributable Profits

Introduction

Those unfamiliar with the law on distributions in the UK might assume that the decision by a UK company to pay a dividend depends on the need to retain cash to develop the business and to ensure that the claims of creditors can be met as they fall due. These factors are important but are only part of the story. Dividends – or distributions to use the legal term – can be made only out of ‘profits available for distribution’ as shown in the ‘relevant accounts’ drawn up in accordance with the applicable UK law and accounting standards. A dividend cannot, therefore, be paid in the absence of accumulated profits regardless of the extent of surplus cash balances or unused borrowing facilities.

Another complication is that only ‘realised’ profits may be distributed. The application of the law in the context of present day accounting standards is comprehensively addressed in TECH 02/17 Guidance on realised and distributable profits under the Companies Act 2006 issued jointly by the Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered Accountants of Scotland (ICAS).

TECH 02/17

TECH 02/17 replaced TECH 02/10 Guidance on the determination of realised profits and losses in the context of distributions under the Companies Act 2006. TECH 02/10 required updating as a result of changes to IFRS Standards and UK Accounting Standards (notably the introduction of FRS 102) and the need to provide additional guidance on a number of areas that have arisen in practice. The purpose of TECH 02/17 is to identify, interpret and apply the principles relating to the determination of realised profits and losses for the purposes of making distributions under the Act.

Our related Need to know publication on TECH 02/17 is available here.

Disclosure of distributable profits

Currently there are no specific legal requirements on a company to disclose their capital allocation and dividend policies. However, there are growing calls from investors who are challenging company disclosure in this area; their expectation is that there should be greater transparency around dividend policy and capital allocation. Many investors see a lack of transparency in how companies allocate surplus capital between things such as investment, dividends and other important areas such as pension contributions or deficit reductions. Many see these decisions as vital to long-term success of the companies in which they invest.

This area is high up on the political agenda. In March 2018, as part of a wider consultation on insolvency and corporate governance, the Government sought views on, amongst other things, whether there was sufficient transparency and accountability to shareholders for dividend decisions and broader choices about how any surplus profits generated by a company should be allocated between investment in the company, payment of dividends, payments to reduce pension funds and other demands.

A Government response, in August 2018, highlighted investor sentiment that there is a lack of transparency around dividend policy and practice including the links between the principal risks of the company and its future viability and a company’s ability to pay dividends now and in the future. Several respondents also indicated that there had not been the desired uptake of the better practice on disclosure included within the November 2015 and October 2017 research reports of the Financial Reporting Lab. These reports support the messages from investors coming out of the Government-backed reports and provide better practice examples of disclosure. The Government response identified potential ways to strengthen disclosure including requiring companies to disclose the audited figure for available reserves and distributable profits in their annual report and accounts. In March 2019, in its ‘Future of audit’ report, the BEIS Select Committee commented that there was “…little compliance with and enforcement of the capital maintenance regime’, highlighting that there a number of high-profile instances where companies had paid unlawful dividends.

Investors have indicated that they would like to see disclosure of an audited figure for available reserves and distributable profits within the financial statements, including greater clarity over the split between unrealised and realised profits included within those reserves. The Government found that a “significant number of respondents” regarded this as an important transparency measure for shareholders giving them more confidence about the underlying basis for decisions on dividends and helping to clarify the dividend resources available within the group.

Some investors believe disclosure of distributable reserves is a legal requirement of the Act and that without it the accounts do not provide a true and fair view. The FRC understands that under the Act there is no requirement for companies to separately identify distributable profits in the accounts, although it does recognise that such disclosure may be useful in particular circumstances.

The Government is yet to legislate or mandate any form of dividend disclosure. Further pressure on companies to make fuller disclosure has come from the Investment Association, who in May 2019, issued a statement calling on all listed companies disclose their distribution policy within their annual reports and accounts, which would include such things as decisions over when and how to return capital to shareholders considering dividends, share buy-backs and any other capital distributions. The Investment Association has also indicated that it will make recommendations to the Government as to whether a shareholder vote on the distribution policy and/or yearly distributions should be mandatory.

Pressure from institutional investors and the new Section 172(1) reporting requirement should help to drive company reporting in this area (the FRC has indicated that it expects many companies to included disclosure of capital allocation and distribution policy within their s172 reporting). If sufficient progress is not made, the Government has indicated that it will legislate to require companies to disclose and explain their capital allocation decisions in their annual report and accounts. Recent proposals included within its March 2021 White Paper Restoring trust in audit and corporate governance will also, if finalised, require certain disclosures relating to profits available for distribution.

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