Can Dividends Be Paid Out of Capital
Dividend cannot be paid out of capital, even if the articles of association authorize such payment. Dividend may be paid out of the following three sources only:
- out of current profits
- out of profits for any previous financial year or years
- out of moneys provided by the Government for the payment of dividend
Directors who knowingly paid dividends out of capital shall be held personally liable to make good the amount to the company. When a misrepresentation was made to the shareholders by the directors that the dividends were being paid out of profits while they were actually paid out of capital the shareholders would not be accountable and the directors alone would be accountable to the company. But if the members knowingly received dividend which was paid out of capital the directors would have a right of indemnity against such members. The shareholders cannot keep the dividend with them and have to return the amount received to the company. In another case, due to an unintentional mistake on the part of the directors, dividend was paid out of capital, on realizing/mistake the directors recovered such dividend. No action can be taken against such directors.
Therefore, it is clear that directors and officers of the company making such payment would commit an offence under the Act and they will also be liable to make good the amount so paid as dividend to the company.
Payment Of Interest Out Of Capital
The normal rule of law is that dividend can be paid only out of profits and must not be paid out of capital. An exemption to the rule in effect, provides that where shares are issued to raise money to defray the cost of works or building or of plant or project which cannot be made profitable for the long period, the company may pay interest on the amount of the capital paid-up in respect of such shares and may charge the same to capital as part of the cost of works, buildings or project or plant provided the following conditions are satisfied:
- The payment should be authorized by the articles. In the alternative, a special resolution is passed and prior sanction of the Government is obtained. Prior sanction of the Government is necessary even when the articles authorize such payment. Before sanctioning any such payment, the Government is empowered to appoint a person to inquire into and report to the Government on the circumstances of the case. It may even require the company to give security for payment of the costs of the inquiry.
- The payment of interest shall be made only for such period as may be determined by the 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.
- The rate of interest shall, in no case, exceed for per cent per annum or such other rate as the Government may notify in the Official Gazette.
- The payment of interest shall not operate as a reduction of the amount paid up on the shares in respect of which it is paid.
Payment of Dividend Out of Capital Profits
The term ‘capital profits’ may be defined to mean those profits that arise otherwise than in the normal course of the business and earned out of capital transactions. The usual sources of capital profits are:
- profits on sale of fixed assets
- profits on revaluation of fixed assets
- premium on issue of shares/debentures/bonds/redemption of debentures
- profits on reissue of forfeited shares
- capital redemption reserve account
- profit prior to incorporation, that is, profits that accrue to a company till the date of incorporation.
In two important cases of Lubbock v. British Bank of South America and Foster v. The New Trinidad Co. Ltd. The courts have held that capital profits cannot be considered as available for distribution as dividend unless:
- the articles of association authorize such a distribution
- the surplus is realized and remains after a valuation of the whole of the assets and liabilities.
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