Companies may only make payments to members out of distributable profits – profits available for that purpose. This has been a fundamental tenet of company law since the earliest days of limited liability companies in the UK, and has been applied via common law and through statute.
Dividends are the most common form of distribution, but the term also covers other uses of company assets. The term distributable profits is applicable to determining how much a company can use for share buy-backs or the purchase of treasury shares, for instance.
The Companies Act 2006 says that distributions can only be made from “profits available for the purpose”, these being “accumulated, realised profits... less accumulated realised losses”. And while that legal position has remained unchanged, accounting treatments have moved on, both prior to and after the Companies Act.
ICAEW last issued guidance on distributable profits and reserves in the early 1980s, says Charles Worth, business law manager, to reflect the changes within international accounting standards being introduced into the UK. This guidance was subsequently updated in the light of the Companies Act 2006 and released as Tech 02/10.
Given changes to UK GAAP, most significantly the introduction of FRS 102 [see p.76], ICAEW jointly issued a revised draft of its technical guidance with ICAS for consultation in March 2016 (Tech 05/16B), and a working group was set up to sift and assess responses to the new draft. The bulk of the changes to Tech 02/10 have been updates, in the form of fairly straightforward cross-references to FRS 102 in place of references to old UK GAAP. As Ken Rigelsford, audit director at Deloitte and chairman of the working group on the consultation, says: “The law hasn’t changed significantly, but obviously accounting standards have moved on, so cross-references needed to be updated, which made this an appropriate time to reissue the guidance.”
While the law may seem clear, concerns remain as to how companies and directors will handle this. There can be confusion as to what “realised” actually means, says Matthew Stallabrass, corporate business audit partner at national audit, tax and advisory firm Crowe Clark Whitehill, and the increased focus on fair value accounting within FRS muddies the waters.
“By putting an increasing number of ‘unrealised’ gains and losses through profit or loss, such as fair value movements on financial instruments or investment properties, FRS 102 runs the risk of confusing the position. While the profession is reasonably clear on the matter, I suspect there are many directors who will assume that anything that goes through the profit and loss account is realised and therefore can be distributed, particularly if that amount has been subject to tax,” he says.
So how do directors determine the level of distributable profits and what key features of FRS 102 make their task difficult? All too few private companies track this information, Stallabrass says, with most of them assuming the profit and loss reserve is the same as distributable profits. “Any change that widens the difference between reserves and distributable profits, which FRS 102 does, is likely to make the problem worse.” And the consequences for declaring a dividend not supported by existing distributable profits are significant.
“The directors could be personally liable for declaring an illegal dividend. Problems will only arise in the event of insolvency proceedings. The illegal dividend could potentially be recovered from the shareholders or possibly personally from the directors. This liability could arise regardless of whether the directors themselves have received a dividend,” says Stallabrass.
The consultation has brought up some areas where new accounting treatments will make reporting within some areas of company accounts more protracted – areas that will have implications for companies looking to make certain payments or transactions.
By far the most contentious issue to emerge among responses to ICAEW’s exposure draft was the issue of distributed profit implications of certain inter-company loans, says Danielle Stewart, partner at RSM and member of the FRC’s committee for UK GAAP issues. “What’s upsetting people is that this is suddenly having an impact on distributed reserves,” she says.
The increased focus on fair value accounting within FRS 102 has changed the landscape when it comes to the accounting treatment of many of these kinds of loans, which are typically interest-free.
Old-style UK GAAP treated inter-company loans in a straightforward way, essentially ignoring the fact they were interest free. No more: under FRS 102 the market value implications of a loan must be accounted for.
It is not necessarily an issue for larger quoted companies, says Robert Carroll, audit director with Deloitte: “Accounting for these transactions is essentially what you would do under IFRS.” Sometimes in a group situation such loans are repayable on demand, which makes the accounting much easier, he explains.
Caroline Cook, partner in PwC’s structuring services, says: “While FRS 102 is generally less complex than IFRS, the analysis of distributable reserves for a company preparing entity accounts under FRS 102 is still required. As with old UK GAAP, distributable profits are not necessarily equal to the profit and loss reserves of the company and there are numerous examples of unrealised profits, which would not ordinarily be available for distribution.”
Privately held companies reporting under FRS 102 constitute the group of entities most likely to be hit. Their directors will need to exercise caution when it comes to drawing up their plans to distribute funds or make transactions such as inter-company loans. “Companies within a group are separate legal entities, but the lines can sometimes be blurred in small companies where shareholders and directors are the same people,” says Rigelsford. “Nevertheless, it is there in law and the law is there for the protection of creditors.”
A lot of small companies are financed by loans from shareholders and directors, sometimes because they don’t yet have the creditworthiness to command funding from outside the business, he adds. “The law hasn’t changed, but the accounting development has focused attention on this area. That is the guidance; essentially there are some extra accounting entries that will need to be recorded.” The more problematic area is when a subsidiary lends money interest-free to its parent company or another group company. “What the consultation has highlighted is that you can’t enter into such a transaction at all in the absence of distributable profits. Unless that shortfall is covered by distributable profits, that transaction isn’t lawful,” adds Rigelsford.
Directors will also need to take care with plans to make distributions once their accounts have been finalised. “The big risk,” says Carroll, “is that subsequent losses erode those profits. The common law principle says that if you are aware of that, you cannot make payments out of previously identified distributable profits.”
Another area affected by the greater use of fair value is investment property. The key point under FRS 102 is the same as the now well-established principle under IFRS – that gains on investment property cannot be considered distributable profits as they are not readily realisable in the short-term.
One outstanding issue in all of this is a niche accounting area for life insurance companies. The Companies Act 2006 (Distributions of Insurance Companies) Regulations 2016 came into force at the end of last year. These new regulations were required because the existing regulatory regime moved from Solvency I to Solvency II and ICAEW/ICAS are considering them in finalising the updated guidance.
An unwanted side effect
Micro entities, the UK’s very smallest companies, can avoid the accounting issues by opting for FRS 105. The demise of the FRSSE, the UK’s former small company accounting regime, means a second wave of small companies were due to transition to new UK GAAP. The greater focus on fair value accounting and the complexities of recording and accounting for director and inter-company loans under FRS 102 may encourage directors towards the much simpler FRS 105 if their company qualifies to use that standard. “My guess would be that this will result in bigger take up of the micro-entities regime,” says Robert Carroll. That would potentially lead to a loss of information in accounts, he says. “It’s not just the loans issue, it’s less disclosure, so less information for shareholders.”
“While the profession is reasonably clear on the matter, there are many directors who will assume that anything that goes through the profit and loss account is realised and therefore can be distributed, particularly if that amount has been subject to tax”