Clear warning to directors of a company in financial difficulty.
Until 2010, the Corporations Act 2001 allowed directors to pay a dividend to shareholders if sufficient profits or retained earnings existed (in the current year). Surprisingly, the Act did not specifically require directors to consider the company’s solvency at the time of payment or whether the payment itself would affect the company’s ability to pay creditors. Consequently, many companies declared and paid dividends when the company was insolvent, or became insolvent because of such payment. Relevantly, a company is insolvent when it is unable to pay its debts as and when due.
This issue was addressed by the somewhat recent amendments to section 254T of the Corporations Act, which warn directors to carefully consider their obligations before declaring and paying dividends.
Section 254T states that a company must not pay a dividend unless:
a) 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
b) the payment of the dividend is fair and reasonable to the company’s shareholders; and
c) the payment of the dividend does not materially prejudice the company’s ability to pay its creditors.
Importantly, these amendments align with the insolvent trading provisions that impose a duty on a director not to incur a debt when the company is insolvent (i.e. without the director expecting that the company can pay all its due debts). A breach of that duty is an offence in certain circumstances, and may result in the director being liable for those debts. The Corporations Act links the insolvent trading to the dividend conditions by expanding the definition of “debt” in the insolvent trading provisions to include “payment of a dividend”.
While the implications are clear for public company directors who are often under pressure to pay a dividend to maintain the share price, the issue is particularly acute for private company directors who, before the section 254T amendments, repaid debit loan accounts owed to themselves by paying a dividend, without considering whether the company was insolvent at the time. Commonly directors (who are also the shareholders) of SME companies draw company funds and debit their loan account—rather than treat those payments as a salary (including PAYG and superannuation obligations). At year end, a dividend would be “paid” by journal entry (subject to sufficient profits or retained earnings) extinguishing the loan account; and the dividend taxed in the hands of the directors. The fact that the company may have been insolvent at the time the dividend was paid was not an issue which the directors considered.
The insolvent trading provisions allow a liquidator to review a dividend paid, in the same way that they consider debts which are incurred. So, a debit loan account, which is extinguished by the “payment” of a dividend when the company was insolvent (or assets exceed liabilities), is potentially recoverable if a liquidator is appointed. In this regard it's worthy to note that in determining the extent of a company’s liabilities, section 14ZZM of the Taxation Administration Act 1953 requires all tax liabilities, even where disputed, to be brought to account on the balance sheet.
In such circumstances, a director declares a dividend in breach of section 254T of the Corporations Act is exposed to a penalty, and exposed to having the dividend (i.e. amount of the discharged debit loan account) clawed back in a liquidation.
In essence, where a company is experiencing cash flow difficulties, it may be preferable for directors to pay themselves a (reasonable) salary with PAYG and superannuation obligations, rather than going down the debit loan account/dividend path with its potentially serious adverse consequences if the cash flow difficulties prove endemic, and the company falls into liquidation.