Explain the different provision regarding divisible profits, capital profits

Explain the different provision regarding divisible profits, capital profits and payment of dividend out of capital?

Ans.

Divisible Profits

The following four considerations may govern the determination of divisible profits–

(1) Principles of Accountancy

(2) Provisions of Memorandum of Association and articles of association

(3) Legal decisions

(4) Legal aspect (as per the provisions of the Companies Act.)

(1) Principles of Accountancy- To calculate divisible profits, the difference between assets and liabilities plus capital at the commencement of a year is found out. If assets are more, there is surplus, otherwise there will be deficiency. Similarly, the surplus or deficiency at the end of a year is calculated after considering in connection there with the increase or return of capital, etc. If there is a surplus, it is a profit and if there is a deficiency. it is loss. This is now a well-recognized principle for the determination of profiles.

So far as the valuation of assets is concerned, fixed assets are valued at cost less depreciation and similarly, floating assets are valued at cost price or market price, whichever is lower. Besides this, necessary provision is made for losses of the current year and of the years to come.

(2) Provisions of Memorandum of Association and articles of association- These two documents are quite important. The distribution of profit, which would affect the interest of third parties or which would lead to the return of capital is against the principles and illegal. The directors recommend the distribution or profits as dividends after making necessary reserves and provisions as required under the provisions of memorandum of association and articles of association. This is usually the way that have to pursue.

Payment of dividends out of capital is a breach of trust and the company may require the directors to replace it. (K. Madhava vs. popular Bank, 1970). of course, they may recover indemnity from the share holders who have received the dividends (Moxkam vs. Grant, 1900) Thus, in the well known Flitcroft’s case (re: exchange banking co, 1882) certain bad debts were credited to the accounts and fictitious thus created were paid away as dividends. The directors were held liable.

The decisions made in the various case have impressed upon the issue that the provision of articles of association should be fully observed and anything done against these rules will be illegal. It is thus, clear that the provisions of Articles of Association must provide a base for the determination of divisible profits in case of a joint stock company.

(3) Legal decisions and Legal aspect- Besides knowing the opinion of courts expressed in different cases, the legal aspect of the issue as provided by the companies Act is quite important. The legal position has been made clear by the companies acts, 1960 and 1974. The provisions of law are now a ‘must’ for all limited companies in India and serve as guideline in the determination of divisible profits and distribution of dividends.

in the pages that follow, an effort has been made to explain the legal aspect of the subject along with the legal decisions so that both the aspects may be comparatively studied. We proceeds with the reproduction of section 205 here under.

Capital Profits

Capital profits are not ordinary profit. They arise out of a bonafide revaluation of fixed assets or from receipt of premium on issue of shares, etc.

Legal Decisions

(1) If the articles of a company so permit, a profit made on the sale of a part of its undertaking is available for dividend.

-Lubbock vs. The British Bank of South America (1892)

Brief Facts of the Case- The bank was setup to carry on business is Brazil and other countries. It sold its goodwill and property in brazil to another bank for $8,15,000 and earned a net profit to the extent of about $ 205000. The directors of the bank wanted to credit the profit and less account with this sum and to pay dividend to its shareholder.

Decision- Under the articles, the directors were justified in carrying over the sum of $ 2,05,000 to the profit and loss account and having appropriated to the Reserve Fund so much of the sum as they thought fit, they could distribute the balance as dividends. It was plainly profit on capital and not part of the capital itself and hence, the Directors could distribute it by way of dividends to the shareholders.

(2) Capital Profits cannot be distributed as dividend uncen all other assets have been revalued, depreciation has been provided for, such profit are actually realized and the articles of association permit.

-Foster vs. The New Trinidad Lake as Phalte Company Ltd. (1901)

Brief Facts of the Case- In this case, a debt of $ 1,00,000 (shown as an assets) was written off as irrevocable subsequently, it was paid in full, together with interest accrued, realizing $ 26,258 165. The amount received was treated as a profit. The directors proposed to distribute it as dividend. This was objected to by the Debenture holders.

Decision- It was held that a realized appreciation in the value of a book debt cannot be distributed as dividend unless surplus remain after a revaluation of all the assets.

Payment of Dividend out of Capital- Dividend must never be paid out of capital and if the memorandum or articles of association give power to the company to do so, such power is invalid.

-Verner vs. General Commercial Investment Trust Ltd. (1894)

Directors who knowingly pay dividends out of capital are personally able to make good the amount of such dividends of the company.

-Oxford Benefit Building Society (1886)

re Kingston cotton mill company (1896)

It has also been made clear in the legal decisions on the subject that if dividends are received by members, knowing that they are paid out of capital, the directors may have a right of indemnity against such members to the extent to which they have received dividend. If an interim dividend has been paid out of capital due to a bonafide mistake and the directors. want to recoup such dividend out of profits before any further dividends are paid, a member who has received such dividend cannot maintain any action against the directors.