## **Learning Outcomes**

After reading this article, you will be able to explain how legal, tax, and liquidity constraints shape payout decisions in practice. You will understand the key rules governing dividends, the practical consequences of tax law for distributions, and why liquidity is central to the decision of whether—and how much—to pay shareholders. This knowledge will enable you to identify likely exam scenarios and confidently apply the appropriate principles.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand how real-world constraints affect payout decisions. In particular, focus your revision on:

- The impact of legal frameworks on the allowable sources and limits for dividends
- Tax influences on the form and timing of distributions to shareholders
- Practical liquidity tests and their effect on the ability to pay dividends
- The interplay between payout policy and financing decisions
- Practical restrictions on payment, including loan covenants and working capital adequacy

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What must a company have in order to lawfully pay a dividend?
2. True or False? A company can always declare a dividend as long as it is profitable.
3. What are the main tax consequences of paying large, irregular “special” dividends?
4. Why might a company with high profits still be unable to pay a dividend in a particular year?
5. Give one example of a non-statutory (contractual) restriction that can limit dividend payments.

## **Introduction**

Payout policy, especially dividend decisions, is affected not only by profitability but also by strict legal rules, tax regulations, and the day-to-day financial position of the business. Understanding these practical constraints is essential for ACCA Financial Management (FM) candidates. Exam questions will often present a scenario where a financially strong or profitable company faces hurdles when rewarding shareholders.

This article highlights the main legal, tax, and liquidity factors that determine whether—and how much—a business can pay out to its owners.

> **Key Term: distributable profits**
> Profits that are legally available for distribution to shareholders according to company law and accounting rules.
>
> **Key Term: liquidity test**
> An assessment of whether a company will remain able to pay its debts as they fall due after making a dividend payment.

## **Legal Constraints on Payout Decisions**

### Legal Requirements for Paying Dividends

Companies cannot pay dividends simply because they are profitable. Most jurisdictions require two main legal conditions:

1. There must be sufficient **distributable profits**, often defined as accumulated, realised profits that are not already distributed or required to cover accumulated losses.
2. Dividends must not reduce the company’s assets to less than the total of its share capital and undistributable reserves.

If these conditions are not satisfied, directors may become personally liable for unlawful dividends.

### Sources of Dividends

Distributable profits are primarily generated from trading activities but may be influenced by the treatment of revaluation surpluses, unrealised gains, and the outcome of past losses. Each company must check its statement of financial position and reserves before proposing distributions.

### Restrictions from Company Constitution or Contracts

In addition to statutory requirements, a company’s articles of association or financing agreements may impose stricter rules. Lenders, for instance, commonly prohibit shareholder distributions if key ratios are breached or require lender consent before any payouts.

### **Worked Example 1.1**

A company has \$1 million retained earnings and \$400,000 in accumulated losses from prior years. The current year’s profit is \$100,000. The board wants to pay a \$150,000 dividend.

> **Answer:**
> The total distributable profits are \$1 million (retained) + \$100,000 (current year) – \$400,000 (losses) = \$700,000. The company can lawfully pay the \$150,000 dividend, provided all other statutory and liquidity tests are met.

## Tax Implications Influencing Payout

Tax rules influence whether a company returns profits via dividends, share buybacks, or other methods. In some jurisdictions, high dividends may trigger additional tax costs for recipients or the company itself, especially if there is a difference in rates applied to retained versus distributed profits.

Special dividends or share buybacks may have different tax effects compared to routine cash dividends and could affect shareholder preferences or prompt regulatory scrutiny.

### **Worked Example 1.2**

A company is considering paying a large “special” dividend after a one-off sale. Most of its shareholders are higher rate taxpayers.

> **Answer:**
> High-rate taxpayers may face additional income tax on their dividend receipts compared to leaving profits in the company for capital growth and later realisation (possibly at a lower capital gains rate or with tax allowances). The directors need to consider the overall tax efficiency of their payout method.

## Liquidity Constraints on Payout

Even if legal and tax requirements are satisfied, a company must have enough liquid funds to pay dividends or repurchase shares. Profits shown in the financial statements may not be matched by available cash because of working capital needs, investment cycles, or delayed receipts.

Prior to recommending a dividend, directors must carefully assess the impact on the business's ongoing ability to meet obligations. If a dividend payment would threaten the payment of creditors or breach loan covenants, it should not be made.

> **Key Term: loan covenant**
> A contractual term in a loan or credit agreement restricting a company’s actions—such as paying dividends—when certain conditions are not met (e.g., exceeding a set gearing ratio).

### When Loans or Contracts Restrict Payouts

Loan agreements may explicitly ban dividend payments or set financial ratio thresholds (e.g., a maximum debt-to-equity ratio or minimum interest cover). Violating these can trigger penalties, require early loan repayment, or damage the company’s credit standing.

### **Worked Example 1.3**

A profitable business wants to pay a \$500,000 dividend. Its lender has a covenant requiring interest cover (EBIT/interest) of at least 3.0. The planned payment would leave interest cover at 2.8, marginally below the threshold.

> **Answer:**
> The dividend payment would breach the loan agreement, potentially making the loan immediately repayable and harming the company’s relationship with the bank. The directors should retain the earnings or negotiate a waiver, not pay the dividend as intended.

### **Exam Warning**

> Never assume that a company can pay dividends just because it is profitable. Both law and practical considerations (liquidity, loan covenants) must be checked. Declaring unlawful dividends can result in personal liability for directors.

## **Summary**

Real-world payout decisions must comply with a framework of legal, tax, and liquidity limits. Directors must confirm there are sufficient realised and undistributed profits, that the payment will not prejudice creditors, and that no contractual restrictions are breached. Tax consequences can shape the timing and form of payout. Even well-performing companies cannot pay dividends if liquidity is insufficient or contractual restrictions apply.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Legal requirements for declaring dividends, including distributable profit calculation
- The effect of tax rules on different payout methods and shareholder outcomes
- Liquidity assessment and how working capital position affects ability to pay dividends
- The impact of loan covenants and company-specific rules on dividend decisions
- The link between payout, financing, and shareholder expectations in practice

## **Key Terms and Concepts**

- distributable profits
- liquidity test
- loan covenant

Payout decisions in practice - Legal, tax, and liquidity constraints