Distributable profits - how much do we have?
For investors a stable dividend stream is critical in addition to maintaining capital values intact. Economic pressures are making it increasingly difficult for the majority of companies to maintain their value and to generate sufficient profits to meet dividend expectations. Of concern also is the basis of measurement of profits and the impact of changes in accounting standards, and the application thereof.
Considerable difficulty is experienced by many companies in interpreting and understanding company law requirements in relation to the determination of what are distributable profits. The Institute of Chartered Accountants in England and Wales (ICAEW) has issued guidance in the form of Technical Releases to its members - 'Guidance on the Determination of Realised Profits and Losses in the context of Distributions under the Companies Acts' - which has been updated each year for the past number of years to take into consideration new developments. The Technical Releases provide general guidance and do not purport to deal with all possible questions and issues in a given situation. While the Guidance is based on UK Company Law, in addition to accounting standards, it is helpful in Ireland also given the high level of consistency between Irish company law and UK company law.
While addressing the position under company law, directors must also bear in mind their fiduciary duties regarding company solvency. During these challenging times when perhaps there is less certainty regarding future prospects, this takes on even greater importance.
It is useful to reflect on some of the basic parameters of how to determine what are distributable profits and the matters commented on in the following paragraphs transcend the accounting standards and the frequent changes therein.
Firstly, what constitutes a distribution - while the most obvious form of distribution is the annual dividend paid in cash, the term applies to any distribution of a company's assets to its members. This might often be significant to transactions within a group of companies which may include:
- The waiver of a liability due from a parent to its subsidiary
- The transfer of tax losses for no consideration
- The transfer of a property for below its market value
It is therefore important that the directors are mindful of their distributable profits position whenever they are contemplating such a transaction. In many groups, the parent company acts as a holding company only with investment in its various subsidiaries. As such it is dependent on distributions up from its subsidiaries in order to make a pool of profits available for distribution to external shareholders.
Secondly, what constitutes realised profits - profits are treated as realised when they arise in the form of cash or another form of qualifying consideration, generally assets which are readily realisable in cash. Transactions within a group may often need careful consideration; for example when a transaction results in recognition of a receivable from another group company, attention needs to be given to such matters as whether the debtor company is capable of settling the amount within a reasonable period of time and whether there is an expectation that the amount receivable will be settled. The recently released Tech 02/10 updates the guidance on the consideration to be given to the overall commercial effect of a group or series of transactions or arrangements, particularly if they are artificial, linked (legally or otherwise) or circular.
Thirdly, the determination of whether there are sufficient distributable profits to make a distribution - if the latest set of statutory accounts does not show sufficient distributable profits, interim accounts will have to be prepared, which may be in the form of management accounts. For listed companies, these requirements are more strenuous with information to be filed with the Companies Registration Office.
Common areas of difficulty
The development of standards over recent years has in many cases added to the complexity of determining what are distributable profits.
Some examples of the more common areas which can cause difficulties in the application of accounting standards include:
Share based payment expenses - with the charge to profit or loss and the credit to reserves. The constraints on whether the credit to reserves can be treated as a distributable profit include:
- The goods or services reflected in the expense do not, as a matter of law, constitute consideration for the issue of shares, and
- The expense is included in profit or loss and is not capitalised as part of an asset
Defined benefit retirement scheme - if a net credit to reserves has been recognised in respect of a net asset on the scheme, this is realised only to the extent that it has been agreed by the scheme's trustees that a refund will be paid in qualifying consideration.
Fair value measurement - as a general principle, fair value gains are realised where they are readily convertible into cash and therefore such gains as revaluation gains on investment properties are not realised. Fair value losses are more likely to be considered realised than profits except in limited circumstances.
Other areas where accounting complexities may arise which impact on the calculation of distributable profits include hedge accounting and debt/equity classification.
Guidance published in 2010
The recently published Tech 02/10 guidance updates the previous guidance made available by the ICAEW to its members, with much of it carried forward from previous editions. Some of the perhaps more generally significant new areas on which guidance is provided include:
- The 'linkage' principle that requires a group or series of transactions to be viewed as a whole, particularly if they are linked or artificial or circular
- The circumstances in which profits arising from a reduction in acquired liabilities are realised profits
- The treatment of gains or losses arising on translation of a company's accounts from its functional currency to the presentation currency of the group
- The treatment of goodwill previously written off to reserves
Whilst many of the revisions to previous guidance made by Tech 02/10 represent principles that were generally accepted prior to that date, the guidance emphasises that the revisions introduced now should not be used to question the lawfulness of distributions made at an earlier date. However, the guidance calls for balances on reserves to be re-examined and the position to be reassessed before a distribution is made.
The Deloitte IGAAP Alert published in November 2010 summarises the guidance provided regarding these matters and the other matters on which new or amended guidance has been provided.
The question of what is the amount of distributable profits may be quite straightforward in many cases, but complex issues can and do arise. The ICAEW Guidance provides helpful support in the determination of these issues.
First published in Finance Dublin online