Tuesday, May 24, 2016

Interim Dividends - Is the Confusion Clearing?

[The following guest post is contributed by Siddharth Raja and Neeraj Vyas, who are Founding Partner and Associate respectively of Samvad Partners. Views are personal, and comments are welcome]

The concept of 'interim dividend' was only introduced into the Indian companies statute in 2000 -- that was legislative recognition of a move that had started to develop and gain acceptance within Indian corporates, especially in the 1990s.  A move that essentially postulated freedom to a Board of Directors (in contrast to the shareholders in general meeting) to declare a dividend in the interregnum between two 'regular' (so to speak, although the word is not used in the statute) dividend declarations which typically take place at annual general meetings of shareholders, year-on-year. 

The Companies (Amendment) Act of 2000, amending the Companies Act, 1956 (the "1956 Act"), made it clear that the Board of an Indian company may declare an 'interim dividend', which had to then be segregated into a separate bank account for the only purpose of making the payment of such 'interim dividend' -- importantly, the terms under which such an 'interim dividend' could be declared and paid was the same as applicable to dividends itself.  As a result, one of the key conditions governing both 'interim dividend' and 'dividend' under the 1956 Act was the need to declare and pay the same only out of profits.

The Companies Act, 2013 (the "2013 Act") had further refined the construct of 'interim dividend', but the wording of the provisions has left a lot to be desired -- something the Report of the Companies Law Committee of February 2016 notes as 'disharmony', while suggesting ameliorative measures that are certainly welcome.  But, some of the suggested changes or comments on clarifications to be made, especially in the Companies (Declaration and Payment of Dividend) Rules, 2014 (the "Dividend Rules"), are yet to see the light of day, currently, whether in draft or final form.

Dividends:    Section 123 of the 2013 Act (earlier -- although entirely the same as -- Section 205 of the 1956 Act) deals with the declaration of dividends.  Section 123(1) inter alia provides that dividend can only be declared or paid by a company for any financial year out of profits for that year, or out of the profits of any previous financial year(s), arrived at after providing for depreciation.  

Furthermore, no dividend can be declared or paid by a company out of its reserves other than free reserves (emphasis added), but, subject in those cases, to the fulfilment of certain conditions.  In other words, the Further Proviso to Section 123(1) provides that, in cases of losses (or, what the provision calls, 'absence of profits') or the inadequacy of profits in any financial year, the company in question may only declare a dividend out of the accumulated profits earned by it in previous year(s) and transferred by it to the reserves, subject to the procedure and conditions laid down in the rules prescribed by the Central Government in this regard (namely, Rule 3 of the Dividend Rules).

Interim Dividends: The concept of 'interim dividend', as contrasted with that of a 'dividend' dealt with above, is provided for in Section 123(3) of the 2013 Act -- the Board of a company may declare an 'interim dividend' during any financial year out of the surplus in the profit and loss account and out of profits of the financial year in which such interim dividend is sought to be declared.  

The only restriction statutorily provided on interim dividends (in the Proviso to this Section 123(3)) is a ceiling on the maximum rate of any such interim dividend in case the company in question has incurred a loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of such interim dividend -- the ceiling in that case, is a rate no higher than the average dividends declared by the company during the immediately preceding three financial years.

Scope of Application of the Dividend Rules; whether applicable to Section 123(3):

Based on a combined and harmonious reading of the provisions of the main statute itself and the Dividend Rules properly constructed, the view, we think, is inescapable that Rule 3 of the Dividend Rules does not apply to the concept of an 'interim dividend' as in Section 123(3) of the 2013 Act.

The Dividend Rules, by its very terms, have been promulgated in exercise of powers conferred on the Central Government under Section 123(1) of the 2013 Act -- its applicability is, therefore, confined to that Section 123(1) relating to 'dividends' and, cannot and, indeed, does not extend in its application to Section 123(3) of the 2013 Act dealing with 'interim dividends'. 

This position is further borne out by the express provisions of the Further Proviso to Section 123(1) of the 2013 Act that clearly references and provides for the Dividend Rules having effect in the case of declarations of 'dividends' (as opposed to, and not as regards, 'interim dividends'), proposed to be paid out of accumulated profits earned in previous years and transferred to reserves, but where there is inadequacy or absence of such profits in the financial year of such proposed dividend (note, not 'interim dividend') declaration.  

Moreover, Rule 3 of the Dividend Rules provides for the procedures and conditions to be followed when dividends are to be paid out of the free reserves (emphasis added), whereas Section 123(3) of the 2013 Act (unlike the Dividend Rules, as delegated legislation, which is subject to the principal statute) deals with the declaration of interim dividend (emphasis added) from out of the surplus in the profit and loss account, as well as the profits of the company for that particular financial year in which such interim dividend is sought to be declared.

Circumstances under which 'interim dividend' can be declared and paid:

Now, unfortunately, Section 123(3) of the 2013 Act is not happily worded as regards the use of the word 'and' in the phrase '....declare interim dividend during any financial year out of the surplus in the profit and loss account AND out of profits of the financial year in which such interim dividend is sought to be declared'.

The Parliamentary Standing Committee on Finance (2009-10; headed by Mr. Yashwant Sinha), in its 21st Report of August 2010 on the then Companies Bill, 2009 suggested the inclusion of what eventually became Section 123(3) of the 2013 Act -- with one important drafting clarification relevant for our current purposes, which, unfortunately, was garbled in the 2013 Act itself as brought into force: the two criteria for the declaration of an interim dividend, namely, (i) from out of the surplus in the profit and loss account, and (ii) from out of profits of the financial year in which such interim dividend is sought to be declared, the Standing Committee suggested should be separate, i.e., by the use of the words 'as well as', which is not the same as 'and' in these circumstances.

Indeed, the Report of the Companies Law Committee of February 2016 appointed to further review and examine and suggest changes to the 2013 Act notes that the use of this word 'and' is at "disharmony with the provisions of sub-section 1(a), which provides for the declaration of dividend out of the profits of the company for that financial year, OR [our emphasis] the profits of the company from any previous financial year(s) (subject to deduction of depreciation and other conditions), OR BOTH THE AMOUNTS [our emphasis]."

The Committee's recommendation in this regard has been accepted in full -- such that the 2016 Amendment Bill to the 2013 Act that is currently pending in Parliament, expressly provides an amendment in Sub-section 3 to Section 123 of the 2013 Act as follows (all emphasis supplied):

"The Board of Directors of a company may declare interim dividend during any financial year or at any time during the period from closure of financial year till the holding of the annual general meeting out of surplus in the profit and loss account or out of profits of the financial year for which such interim dividend is sought to be declared or out of profits generated in the financial year till the quarter preceding the date of declaration of the interim dividend."

The suggested elimination of the word "AND", and its substitution by "OR", is welcome, as is the construct to declare interim dividends out of profits in the ongoing financial year until the quarter preceding the date of declaration of such interim dividend.

The Committee further "...felt that once Rule 3 is aligned with the provisions of the Act, it would be clear that in case a company declares dividend out of surplus i.e. accumulated credit balances of Profit and Loss Account which has not been transferred to reserves, the provisions of the [2013] Act and Rule 3 would not be applicable (our emphasis).  The Committee recommended harmonization of Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014 and Section 123 of the [2013] Act to provide clarity on the issue".

Clarity continues to be elusive on this aspect; but hopefully we may see a change in the Dividend Rules soon.

In effect, therefore and until the 2013 Act and the related Rules are modified as above, the current Section 123(3) (read with its Proviso) is, in our view, to be interpreted as follows:

1)    In order to be able to declare an interim dividend it is not necessary that BOTH criteria for the declaration of such an interim dividend in Section 123(3) of the 2013 Act be present -- in other words, a company can validly declare an 'interim dividend' in terms of Section 123(3) if it has a surplus in its profit and loss account; it can also (or in the words of the Parliamentary Standing Committee on Finance, "as well as") declare validly such an 'interim dividend' out of the profits of the financial year in which such interim dividend is sought to be declared.

2)    The only stipulation then on the declaration of such an interim dividend is as regards the rate of such interim dividend -- that rate cannot be higher than the average dividends declared during the immediately previous three financial years, if the company has incurred a loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of such interim dividend.  The Proviso is so drafted as to cover the situation when interim dividends are declared during the financial year in question; the only caveat being that that rate of interim dividend cannot exceed a certain stipulated threshold if there are losses up to the previous quarter, thereby implying the ability of a company to declare such interim dividends during any quarter.

This leads to two probable situations: 

Firstly, situations wherein the company has surplus in its profit and loss account and also has profits in the said financial year.  In such cases, the Proviso does not apply and the board of directors can declare any interim dividend.  The only issue that remains to be touched upon here is the quantum of any such dividend -- the statute by the use of the words "out of" or "from" profits or free reserves (as the case may be) clearly prevents any excessive dividends of either type that are not matched by the amounts of such profits or free reserves.

Secondly, situations wherein the company has incurred losses during the current financial year up to the end of the quarter immediately preceding the date of declaration of the interim dividend (or even for the full year), but has had a surplus in the profit and loss account during the quarter in question.  In such cases, as per the Proviso, the rate at which dividend is declared cannot be higher than the average dividends declared by the company during the preceding three financial years.  But, that position does not invalidate the interim dividend declaration. 


- Siddharth Raja & Neeraj Vyas

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