Capital Profits In Distribution Of Dividends: Indian Legal Context

Nidhi, pursuing B.A.LLB from Chanakya National Law University, Patna

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All corporate enterprises are undertaken with the view of making profits for their company and in every share of an individual member of a company falls a share of its profit  at a fixed rate or otherwise which is called as Dividend.

The Companies Act, 2013 defines “Dividend” as Dividend includes interim dividend.[1]This is an inclusive definition and no exact meaning has been provided. Chapter VIII of the Act deals with the declaration and payment of dividend from Sections 123 to 127. The Companies (Declaration and Payment of Dividend) Rules, 2014 has also been framed for this purpose.

Section 123(1) talks about the sources out of which the dividend can be declared which are-

  • Out of the profits of the company for that year arrived at after providing for depreciation ;
  • Out of the profits of the company for any previous financial year or years arrived at after providing for depreciation and remaining undistributed; or
  • Out of money provided by the Central Government or a State Government for the payment of dividend by the company in pursuance of a guarantee given by the Government.

Halsbury’s prescribes two modes of earning profit, one is Revenue/Divisible profits and the other is Capital profits[2]. Revenue Profits are made in the ordinary course of business which are available for the shareholders in dividends whereas the capital profits are earned by selling the assets, shares and debentures of the company at more than its book value and are used for meeting the capital losses. With the reference to the Capital Profit, there is no guidance given in the Companies Act as to whether this kind of profit can be used for the distribution of dividend.

Section 123 puts a restriction on the declaration of dividend that it can only be paid after providing for the depreciation and from the profits of the company. If there is loss, then it should be set off first then a declaration of the dividends can be made. Thus, from the perusal of above section we can say that the assets of the company can’t be used for the distribution of dividend. The rationale behind this rule is that the assets of the company are for the benefits of the creditors and not for declaration of dividend for the shareholders. A limited company held by its MOA declares that its capital will be applied for the purposes of the business. So, the capital should remain intact and used for the purpose of business.

The leading case in this subject matter is Lubbock v. British Bank of South America[3] in which a banking company sold its goodwill and property in a foreign country and then repurchased the rights to carry the banking operations which result into this sale and repurchase a substantial gain.  The court held that this is as the capital profit and that the distribution of dividend can be made out of the capital profits if :-

  1. the Article of Association permits,
  2. the assets are sold and realized in the cash and
  3. after fair valuation of all assets and liabilities, the surplus remains.

In Foster v. New Trinidad Lake Asphalt Co. Ltd[4] and in Dimbula Valley (Ceylon) Tea co. Ltd. v. Laurie[5], the question arose that whether the issue of the distribution of dividend out of the unrealized revaluation of assets can be used for distribution of dividend which has been resolved by the English Act of 1980 which imposed the restriction that the company must examine the value of the all assets and it should be a realized profit.

The Companies Act, 2013 is based on the same line of principle as in Section 208 of Companies Act, 1956, which says that the dividend can be paid only out of the profits of the company and not out of the capital of the company[6]. But there are exceptions in Section 208 –

(1)Where any shares in a company are issued for the purpose of raising money to defray the expenses of the construction of any work or building, or the provision of any plant, which cannot be made profitable for a lengthy period, the company may-

(a) pay interest on so much of that share capital as is for the time being paid up, for the period and subject to the conditions and restrictions mentioned in sub- sections (2) to (7); and

(b) charge the sum so paid by way of interest, to capital as part of the cost of construction of the work or building or the provision of the plant.

(2) No such payment shall be made unless it is authorised by the articles or by a special resolution.

(3) No such payment, whether authorised by the articles or by special resolution, shall be made without the previous sanction of the Central Government. The grant of such sanction shall be conclusive evidence, for the purposes of this section, that the shares of the company, in respect of which such sanction is given, have been issued for a purpose specified in this section.

(4) Before sanctioning any such payment, the Central Government may, at the expense of the company, appoint a person to inquire into, and report to the Central Government on, the circumstances of the case; and may, before making the appointment, require the company to give security for the payment of the costs of the inquiry.

(5) The payment of interest shall be made only for such period as may be determined by the Central Government; and that period shall in no case extend beyond the close of the half year next after the half- year during which the work or building has been actually completed or the plant provided.

(6) The rate of interest shall in no case exceed four per cent. per annum or such other rate as the Central Government may, by notification in the Official Gazette, direct.

(7) The payment of the interest shall not operate as a reduction of the amount paid up on the shares in respect of which it is paid.

(8) Nothing in this section shall affect any company to which the Indian Railway Companies Act, 1895 , (10 of 1895 .) or the Indian Tramways Act, 1902 , (4 of 1902 .) applies.

In India, the issue of distribution of dividends out of capital gains was raised in Factors(P.) Ltd.v. Commissioner of Income Tax[7], the assessee in this case contended that Article 97 of Table ‘A’ of the First Schedule of the Companies Act, 1913 prescribes that no dividend to be paid otherwise than out of the profits of the year and since the capital gains is an accretion to the capital asset so it would be contrary to the provisions of the Companies Act. If the accretion to the capital is not restricted by the articles of association then it is distributable but the payment out of the capital even if authorized by the articles and memorandum is not permissible as it would lead to the reduction of the capital[8]. The assessee cited the Gower’s Principle of Modern Company Law[9] statement, “A realized profit on the sale of fixed assets may be treated as a profit available for dividend, at any rate if there is an overall surplus of fixed and circulating assets over liabilities.

Here, two cases run against the assessee’s contention. The first is Lubbock v. British Bank of South America which we have already discussed above in which it was held that the profit on capital is a profit and not a capital itself. So, it can be distributed as dividend. On the same principle it was decided in Verner v. General and Commercial Investment Trust[10] that the ‘capital’ is the money subscribed pursuant to the memorandum of association and accretion to it if realized and turned into money may be divided. The assessee’s argument was held untenable as every distribution of profit as shown in the profit and loss account would not eat into its capital. The law requires only to keep the capital intact which was satisfied in this case.

Therefore, we can conclude that it is now a settled principle in India by virtue of the above-mentioned judicial decisions that the concept of profit prescribes to keep the capital intact but any accretion to it is not barred by law to distribute it as a dividend.

 


 

[1] Section 2(35) of Companies Act, 2013.

[2] Halsbury Laws of England,6, para 774 at 399-400(3rd Edition)

[3] (1892) 2 Ch. 198.

[4] (1901) 1 Ch. 208.

[5] (1961) 31 Com Cases 655.

[6] C.Acharya, Dividend (March 20, 2016 , 7.00 p.m) available at  http://assets.cacharya.com/CA-Final-CAL-SM-CHAPTER-2-Jan-2014-4J5ZP0V3.pdf?1426031954.

[7] 1975 98 ITR Mad

[8] Halsbury Laws of England,6, para 774 at 399-400(3rd Edition).

[9] Gower and Davis, Principle of Modern Company Law,118 (3rd edition, 2008).

[10] (1894) 2 Ch 239 (CA)

 

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