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Division of Company Profits
Company divides its profit into two parts one part will be transferred to reserves and the other part would be distributed to shareholders as dividend. That part of profit which is made available for payment of dividend is called Divisible Profit. While determining divisible profit the following considerations are to be made;
- Past losses
- Capital losses
- Capital Profit
- Transfer to Reserve
- Profits prior to Incorporation
According to Section 205 of Companies Act, company should provide for depreciation on all assets. That means dividend should not be paid without providing for depreciation. In case where dividend is paid without providing for depreciation, such dividend is said to be paid out of capital. It is well known that dividend should be return on capital, and it should never been return of capital. Therefore to keep capital intact, provision for depreciation is essential. But there are some historical cases where payment of dividend was allowed without providing for depreciation. Those historical cases are listed below;
- Lee Vs New Chatel Asphalte Co. Ltd.,
- Wilmar Vs Mc. Namara Co. Ltd.,
- Balton Vs Natal land Colonization Co. Ltd.,
Now also company can pay dividend without providing for depreciation with permission from the Central Government under Section 205 (c).
The term past losses is to be understood as past revenue loss i.e. Debit balance in profit & loss account. As per the provision of Companies Act, after meeting past loss only divisible profit is to be determined i.e. the dividend that can be paid.
There is a historical case where court allowed payment of dividend without meeting the past loss. That Historical case was; Ammonia Soda Co Ltd., Vs Arthur Chamberlyn and others.
While determining divisible profit, capital losses need not be taken into the consideration. That means capital losses need not be met out of revenue profits.
Capital profits are there to meet capital losses in Verner Vs General and Commercial Investment Trust Company Ltd., The investment Company comes across Capital loss due to fall in market value of investment. It is capital loss. But the company without caring for such capital loss declares dividend. Here Court decides that dividend from revenue profit can be paid without meeting Capital loss.
The profits which arise occasionally or rarely on account of some extra ordinary transaction are called Capital Profits. On the other hand business profit is revenue profit. Dividend can be paid out of Revenue Profit. But capital profit is not freely available for payment of dividend.
The following are some examples to Capital Profits:
- Premium on Issue of shares.
- Premium on Issue of Debentures.
- Profits prior to Incorporation
- Profit on forfeiture and Re-issue of shares.
- Profit on acquisition of Business
- Profit on Sale of Asset
- Profit on over insurance
- Profit on Revaluation, etc.
Payment of dividend out of Capital Profits: In connection with payment of dividend out of capital profit there are two views. Namely; General View and Legal View.
General View: It is otherwise known as commercial view. As per this view dividend should not be paid out of capital profit. All capital profits should be transferred to capital reserve which will be utilized for meeting capital losses like discount on Issue of shares and debentures, loss on Sale of Asset, etc.
Legal View: It is the view expressed by companies act. It is otherwise known as statutory view. According to this view, share premium and profit prior to incorporation should not be used for payment of dividend. As per this view dividend may be paid out of other capital profits by fulfilling the following conditions;
- There should be no restriction in Memorandum, Articles, etc. with regard to payment of dividend out of capital profits.
- The capital profit from which payment of dividend is decided should have been obtained in the form of cash.
- There should be on capital loss in co-existence.
- All assets should have been dealt with.
Lubbock Vs British bank of South America: In this case the banking company has place of business in Brazil. On one occasion the banking company sells away its entire business in Brazil to some other banking company at a high consideration. There after it purchases the same business again at a lower consideration. Thus there is capital profit. The banking company declares dividend out of that capital profit. One of the members files a suit to payment of dividend out of capital profit. But court decides that dividend can be paid out of that capital profit because all conditions are properly fulfilled.
Foster Vs The New Trinidad Lake Asphalte Co. Ltd.,: In this case X Ltd purchased Y Ltd., Out of debtors of Y Ltd., One debt was doubtful, the amount of which was one hundred thousand dollars. X Ltd advised Y Ltd to write off that doubtful debt as bad. Y Ltd does so and thus purchase consideration was computed. Acquisition of business was completed. There after X Ltd recovers that amount fully with interest. It was capital profit X Ltd declares dividend out of that capital profit. One of the members files a suit to stop payment of dividend out of capital profit. Here court decides that dividend should not be paid out of that capital profit because all assets have not been dealt with.
Transfer to Reserve
Here particularly transfer to general reserve is to be analyzed. Transfer to general reserve impacts the quantity of divisible profits. As per the provision of companies act transfer to general reserve should not exceed 10% of current year net profit.
Profits Prior to Incorporation
According to companies act dividend should not be paid out of profits prior to incorporation.