Previously on Talking Business (cue swelling music and a montage of soft-focused images as we provide a summary of the plot so far): in ‘Return to sender‘ we considered the different ways in which a company can return value to its shareholders. One of those methods is the payment of a cash dividend and in ‘Help! My dividend is unlawful’ we explained the restrictions on paying a dividend and the consequences of breaching those restrictions.
The main issue is that dividends can only be paid from distributable profits. Each year the company’s retained profit (ie. post-tax profits less dividends paid) is taken from the profit and loss account and added to the Profit & Loss Reserve on the balance sheet to give the company’s accumulated retained profit over time. That reserve is distributable – and for many companies it will be the only distributable reserve it has.
If a company has made losses over a number of years, it may have built up a deficit in its Profit & Loss Reserve which would operate as a block, preventing it from paying dividends even once it has returned to profitability. It could take some time for the retained profits each year to wipe out that deficit so is there another way the block can be removed?
Capital reduction to the rescue!
When a company carries out a capital reduction the amount by which the capital is reduced is transferred to a Capital Redemption Reserve. This is a distributable reserve: it is added to the Profit & Loss Reserve (and any other distributable reserves) to give the company’s overall distributable reserves. So, reduce the capital by more than the deficit on the Profit & Loss Reserve and, hey presto, the dividend block is removed.
An example might help…
Here’s an extract of the balance sheet of a company that’s made losses over a number of years and has a deficit on its Profit & Loss Reserve:
The company cannot pay dividends due to the deficit on its Profit & Loss Reserve so it decides to convert some of its non-distributable reserves into distributable reserves by means of a capital reduction. The company resolves to eliminate its share premium account of £200,000 and to convert the nominal value of its 150,000 ordinary shares from £1 (total value £150,000) to 10p (total value £15,000), resulting in a further reduction of £135,000.
After the capital reduction, the balance sheet would look like this:
The amount of the capital reduction (£200,000 of share premium and £135,000 of ordinary share capital) has been transferred to the Capital Redemption Reserve. This is aggregated with the £300,000 deficit on the Profit & Loss Reserve to give overall distributable reserves of £35,000 which the company could now use to pay dividends.
For private companies, a capital reduction requires a special resolution supported by a solvency statement from the directors. It is therefore relatively quick and easy to effect. For public companies, the process is more complicated and requires court approval but it can still be worthwhile if it enables a profit-making company to pay dividends, improving shareholder value and attracting further investment.