Business finance - Distribution of profits and gains

Learning Outcomes

This article explains the rules governing how companies distribute profits to shareholders, primarily through dividends, and the related concept of capital maintenance. For the SQE1 assessment, you will need to understand the calculation of distributable profits, the procedures for declaring and paying dividends, the legal restrictions on distributions designed to protect creditors, and the main procedures for lawfully reducing or returning capital, such as share buybacks. This knowledge will allow you to apply the relevant legal principles to SQE1-style single best answer questions concerning company distributions and capital maintenance.

SQE1 Syllabus

For SQE1, you are required to have a practical understanding of the rules concerning the distribution of company profits and the maintenance of capital. It is likely that you will need to identify lawful methods of returning value to shareholders, particularly dividends, and understand the procedures and restrictions involved, such as those relating to share buybacks and reductions of capital under the Companies Act 2006.

As you work through this article, remember to pay particular attention in your revision to:

• the definition and calculation of distributable profits
• the procedures for declaring and paying lawful dividends
• the consequences of making unlawful distributions
• the doctrine of capital maintenance and its purpose
• the rules and procedures governing share buybacks (out of profits and capital)
• the procedures for effecting a lawful reduction of share capital
• the prohibition on financial assistance for public companies.

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. A private limited company has accumulated realised profits of £50,000 and accumulated realised losses of £20,000. Can it lawfully pay a dividend of £40,000?
   1. Yes, because it has positive accumulated profits.
   2. No, because the proposed dividend exceeds its net accumulated profits.
   3. Yes, provided the directors recommend it and the shareholders approve by ordinary resolution.
   4. No, because dividends can only be paid out of current year profits.
2. Which of the following is generally required for a private company to declare a final dividend?
   1. A special resolution of the shareholders.
   2. A board resolution only.
   3. A board recommendation followed by an ordinary resolution of the shareholders.
   4. Unanimous consent of the directors.
3. Can a private limited company finance the purchase of its own shares entirely out of capital if it has no distributable profits?
   1. Yes, without restriction.
   2. Yes, but only if approved by a special resolution and following strict procedures including a solvency statement.
   3. No, a buyback must always be funded at least partly from distributable profits or a fresh issue of shares.
   4. No, private companies cannot buy back their own shares out of capital.

Introduction

A primary objective for many companies is to generate profit for their owners, the shareholders. Returning value to shareholders often takes the form of dividend payments. However, the law imposes strict controls on distributions to protect the company's creditors. Creditors rely on the company's capital base as the fund from which they expect to be paid. If companies could freely return capital to shareholders, this fund could be easily diminished, leaving creditors exposed, especially in insolvency.

This article focuses on the main method of distributing profits – dividends – outlining the legal tests for determining distributable profits and the procedures for payment. It then examines the fundamental principle of capital maintenance, which restricts the return of capital, exploring the key exceptions: the purchase by a company of its own shares (share buyback) and formal reductions of share capital.

Dividends

The payment of a dividend is the most common method by which a company distributes its profits to shareholders.

Key Term: Dividend
A payment made by a company to its shareholders, usually out of its profits, distributed typically in proportion to their shareholdings.

Distributable Profits

The basis of dividend law is the requirement that distributions can only be made out of profits available for the purpose, as defined by the Companies Act 2006 (CA 2006).

Key Term: Distributable Profits
A company’s accumulated, realised profits, so far as not previously utilised by distribution or capitalisation, less its accumulated, realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made (s 830(2) CA 2006).

This definition has several key components:

• Accumulated: Profits and losses are considered over the entire life of the company, not just the last accounting period. Past losses must be offset against past or current profits before a distribution is lawful.
• Realised: Profits must be realised in cash or near-cash form, consistent with generally accepted accounting principles. Profits arising merely from the upward revaluation of assets (eg, property) are generally unrealised and cannot be distributed.
• Losses: Both realised profits and realised losses must be accounted for.

This ensures that dividends are paid from genuine trading surpluses and not from the company's capital base.

Procedure for Declaring and Paying Dividends

The company's articles of association usually dictate the precise procedure. The Model Articles (MAs) for private companies limited by shares provide a common framework:

1. Final Dividends:
   • The directors recommend the amount of the final dividend (MA 30(1)(a)). They must satisfy themselves that the company has sufficient distributable profits.
   • The shareholders declare the dividend by ordinary resolution (MA 30(2)). Importantly, shareholders cannot declare a dividend higher than the amount recommended by the directors, although they can approve a lower amount or declare no dividend at all.
2. Interim Dividends:
   • The directors may decide to pay interim dividends during the financial year if they are satisfied that the company's financial position justifies it (MA 30(1)(b)). Shareholder approval is not required for interim dividends. Directors must still ensure sufficient distributable profits exist at the time of payment.

Once declared, a final dividend becomes a debt owed by the company to the shareholders entitled to receive it.

Worked Example 1.1

Oak Ltd made a profit of £20,000 in its first year (Year 1). It made a loss of £30,000 in Year 2. In Year 3, it made a profit of £50,000. What are its total distributable profits at the end of Year 3?

Answer: Accumulated realised profits = £20,000 (Year 1) + £50,000 (Year 3) = £70,000. Accumulated realised losses = £30,000 (Year 2). Distributable Profits = £70,000 - £30,000 = £40,000. Oak Ltd can lawfully distribute up to £40,000 as dividends.

Consequences of Unlawful Dividends

Paying a dividend otherwise than out of distributable profits (an 'unlawful' or 'ultra vires' dividend) has serious consequences:

• Shareholder Liability: Shareholders who receive a distribution knowing, or having reasonable grounds to believe, that it is unlawful, are liable to repay it (or the unlawful part of it) to the company (s 847 CA 2006).
• Director Liability: Directors who authorise an unlawful dividend may be liable for breach of their duties, including the duty to exercise reasonable care, skill, and diligence (s 174 CA 2006) and potentially the duty to act within powers (s 171 CA 2006). They may be required to personally repay the unlawful amount to the company.

Capital Maintenance

The rules on distributable profits are part of a wider legal doctrine known as capital maintenance.

Key Term: Capital Maintenance
The fundamental company law principle that a company's share capital must be maintained as a permanent fund available to creditors and cannot be returned to shareholders except through specific, legally sanctioned procedures.

This principle protects creditors who rely on the company's capital base when deciding whether to grant credit. If companies could return capital freely, the creditors' buffer could vanish. The main exceptions where capital can be lawfully returned are share buybacks and formal reductions of capital.

Share Buybacks (Purchase of Own Shares)

A company purchasing its own shares reduces its capital and assets. Therefore, it is generally prohibited (s 658 CA 2006) unless done in accordance with the strict procedures laid out in Part 18 of the CA 2006.

Key Term: Share Buyback
A transaction where a company repurchases shares from its own shareholders, subsequently cancelling them (usually), thus reducing its issued share capital.

Funding the Buyback

The source of funds is critical and strictly regulated:

1. Distributable Profits: This is the preferred and primary source. A buyback funded entirely from distributable profits does not deplete the company's capital (s 692(2)(a) CA 2006).
2. Proceeds of a Fresh Issue of Shares: A company can issue new shares specifically to fund a buyback (s 692(2)(a) CA 2006). The capital base is maintained as new capital replaces the capital returned.
3. Out of Capital (Private Companies Only): Private companies have a limited power to finance a buyback out of capital under ss 709-723 CA 2006. This is only permitted if distributable profits are insufficient (s 710). The procedure is significantly more complex and designed to protect creditors.

Procedure: Off-Market Purchase (Private Companies)

The following steps are required for a buyback funded from distributable profits or a fresh issue:

1. Articles Check: Ensure the articles do not prohibit or restrict buybacks (s 690(1)(b)). If they do, they must be amended by special resolution.
2. Funding Check: Verify sufficient distributable profits or proceeds from a fresh issue are available. Shares must be fully paid (s 691(1)).
3. Contract Approval: The buyback contract terms require shareholder approval by ordinary resolution before the contract is entered into (s 694).
   • Voting Restriction: The selling shareholder(s) cannot vote on the OR if the resolution would not have passed without their votes (s 695). This applies to votes cast in respect of the shares being bought back.
   • Contract Availability: A copy of the contract (or a written memorandum of terms if not in writing) must be available for inspection by shareholders for at least 15 days before the GM and at the meeting itself (or circulated with a written resolution) (s 696).
4. Payment: Generally, payment must be made on purchase (s 691(2)).
5. Post-Buyback:
   • File Form SH03 (Return of purchase of own shares) at Companies House within 28 days (s 707).
   • File Form SH06 (Notice of cancellation of shares) at Companies House within 28 days (s 708). The shares are treated as cancelled upon acquisition (s 706).
   • Update the register of members.
   • Keep a copy of the contract available for inspection for 10 years (s 702).

Procedure: Payment Out of Capital (Private Companies)

This procedure involves additional steps on top of those for a purchase out of profits:

1. Use Profits First: Capital can only be used to the extent distributable profits are insufficient (s 710). The amount paid from capital is the 'permissible capital payment' (PCP).
2. Directors' Solvency Statement: All directors must make a statutory declaration of solvency not more than one week before the shareholders pass the special resolution (s 714). This states that the company can pay its debts and will remain solvent for the next 12 months. Making this statement without reasonable grounds is a criminal offence.
3. Auditor's Report: The solvency statement must be accompanied by a report from the company's auditor confirming it is not unreasonable (s 714(6)).
4. Shareholder Special Resolution: In addition to the OR approving the contract, shareholders must pass a special resolution approving the payment out of capital (s 716). This SR must be passed within one week after the solvency statement is made. The selling shareholder(s) votes are disregarded if the SR would not pass without them (s 717).
5. Publicity for Creditors: Within one week of the SR, the company must publish a notice in the London Gazette and either a national newspaper or give written notice to all creditors (s 719). This alerts creditors to the proposed use of capital.
6. Filing at Companies House: The SR, solvency statement, and auditor's report must be filed at Companies House within 15 days of the SR being passed (ss 30, 719).
7. Creditor/Member Objection: Creditors or dissenting shareholders have a five-week period following the SR to apply to court to cancel it (s 721).
8. Payment Timing: Payment out of capital cannot be made earlier than five weeks or later than seven weeks after the SR is passed (s 723). This allows time for objections.

Worked Example 1.2

Delta Ltd wishes to buy back 5,000 £1 shares from shareholder X for £10 per share (£50,000 total). Delta Ltd has distributable profits of £60,000. What shareholder resolution(s) are required?

Answer: Since Delta Ltd has sufficient distributable profits (£60,000) to cover the entire buyback cost (£50,000), the buyback can be funded entirely out of profits. Therefore, only an ordinary resolution under s 694 CA 2006 is required to approve the terms of the buyback contract. A special resolution for payment out of capital is not needed.

Reduction of Share Capital

A company can reduce its share capital using the procedures in ss 641-653 CA 2006. This is another way capital might be returned to shareholders or used to eliminate losses shown in the accounts.

Key Term: Reduction of Share Capital
A formal procedure under the Companies Act 2006 allowing a company to reduce its issued share capital, often involving returning capital to shareholders or cancelling unpaid capital.

There are two main procedures:

1. Special Resolution supported by Solvency Statement (Private Companies Only): This simplified route (ss 641(1)(a), 642-644) avoids court involvement. The directors must make a solvency statement confirming the company's ability to pay its debts currently and for the next 12 months. Shareholders then pass a special resolution. The solvency statement and SR must be filed at Companies House.
2. Special Resolution confirmed by Court Order (All Companies): This route (ss 641(1)(b), 645-651) requires court confirmation after the shareholders pass a special resolution. The court must be satisfied that the interests of creditors are adequately protected. Creditors have the right to object.

Exam Warning

Do not confuse a share buyback with a reduction of capital. While both can result in capital being returned to shareholders, they are distinct procedures with different requirements. A buyback involves purchasing existing shares, often from a specific shareholder, whereas a reduction typically applies across a class of shares or cancels unpaid capital.

Summary

Table: Distributions and Capital Maintenance Procedures

Key Point Checklist

This article has covered the following key knowledge points:

• Dividends are distributions of profit, not capital, and must only be paid from distributable profits (accumulated realised profits less accumulated realised losses).
• Final dividends typically require director recommendation and shareholder OR; interim dividends can usually be paid by directors alone.
• Unlawful distributions trigger liability for recipients and potentially for directors.
• The capital maintenance doctrine protects creditors by restricting returns of capital to shareholders.
• Share buybacks are a permitted exception, funded primarily by distributable profits or a fresh share issue, requiring OR approval of the contract.
• Private companies can fund buybacks out of capital using the PCP procedure, which involves a solvency statement, auditor's report, and an SR.
• Reductions of capital are permitted via SR plus solvency statement (private companies) or SR plus court confirmation (all companies).

Key Terms and Concepts

• Dividend
• Distributable Profits
• Capital Maintenance
• Share Buyback
• Reduction of Share Capital