Capital maintenance for holding companies: A comparative look at dividends and other distributions
18 / 09 / 2018
When it comes to deciding where to incorporate a company, it is not uncommon for cross border holding structures to have multiple options on the table. Although the available choices for operating companies are often narrowed due to the need for compliance with local regulatory regimes or tax treatment, there is often a wider choice available higher up in a holding structure. Typical factors include tax structuring and a jurisdiction’s market reputation in the relevant sector. When setting up a new holding vehicle, the ability to move funds and assets between group companies is an important factor that is usually overlooked.
The ability to return income and capital to investors is a cornerstone of the planning of any investment structure. Company and insolvency laws generally protect the creditors of financially unhealthy or insolvent companies by prohibiting or reversing the transfer of corporate assets to shareholders. Beyond this common thread, the rules on distributions widely between jurisdictions. This article looks at the UK rules and then considers briefly the approaches of popular common law jurisdictions for the incorporation of holding vehicles – many of them offshore. Whilst all of these require a basic solvency test to be met, the applicable test varies widely and once solvency has been established, the rules governing what is and is not distributable to shareholders also differ.
Before a UK company can lawfully pay a dividend, it must have “profits” available for the purpose (often referred to as distributable profits or distributable reserves), calculated by reference to formal accounting methods. A company’s undistributable reserves are: (i) its share premium account; (ii) its capital redemption reserve; (iii) the amount by which its unrealised uncapitalised profits exceed its unrealised losses not written off; and (iv) any other reserve that the company is prohibited from distributing either by statute or by its constitutional documents. The distribution must also be justified by reference to “relevant accounts”. Relevant accounts are always individual (not group) accounts and may be (i) the company’s most recent annual accounts; (ii) specially prepared interim accounts; or (iii) specially prepared initial accounts. The form of these accounts may vary, depending on whether the company produces its accounts under UK GAAP or IFRS (IAS).
The profits rule for dividends is tempered by recent reforms making it easier for private companies to return capital to shareholders. Private companies may now make out of court non-dividend distributions out of capital if a cash flow solvency test is met and shareholder approval is obtained. Further streamlining was later added by allowing private companies to make small buy-backs out of capital (up to a maximum of £15,000 per financial year) without complying with the formal solvency and shareholder approval requirements. These routes are not available to public companies, who must use the court approval route.
Offshore jurisdictions in particular are typically seen as interchangeable by practitioners sitting in London or New York. Whilst this is often the case from a tax planning perspective, their corporate and regulatory regimes vary widely in many other respects. In particular, their rules on distributions differ and this information can be vital at the planning stage.
The British Virgin Islands (BVI), Guernsey and the Isle of Man now apply a single unified solvency test for dividends and all other distributions (at least for newer companies). The solvency test combines a balance sheet (net assets) test and a liquidity (cash flow) test: it requires that the value of the company’s assets will exceed its liabilities and the Company will be able to pay its debts as they fall due. Provided that the solvency test has been satisfied, dividends may be paid and shares may be redeemed or repurchased out of any capital or profits of the company. These tests follow the simple “one size fits all” double-pronged balance sheet and cash flow test first introduced in the ABA’s Revised Model Business Corporation Act. They allow the directors to take a flexible look at balance sheet values based on their good faith assessment of the valuation principles most appropriate to the company’s circumstances.
Bermuda also combines a cash flow test with a balance sheet test, but Bermuda companies may not pay dividends or make other distributions out of the share capital account or the share premium account. Dividends and other distributions may be paid out of the “contributed surplus” account, to which must be allocated, among other things, shareholder capital which is unrelated to any share subscription and which is reduced to the extent that dividends or distributions exceed net income. The net assets part of the test requires that the “realisable value” of the company’s assets will be less than its liabilities. “Realisable value” is not defined and is a matter for the directors, who may need to seek a valuation if value is not determinable by way of a ready market.
Subject to a cash flow test, Cayman and Jersey companies may pay dividends out of profits and share premium, but not share capital. However, the share capital account and capital redemption reserve can (subject to solvency) be utilised for share redemptions and repurchases. Since there is no net assets test, there is no need to consider asset values. Jersey differs slightly from Cayman and its other competitors in applying a 12 month forward-looking requirement for its cash flow test.
On the other hand, the UK’s current or former approaches to capital maintenance rules are still broadly followed in countries across Europe, Asia and Africa with a common law tradition. For example, Ireland’s rules are virtually identical to those of the UK, with the only difference of note that Ireland has not adopted the UK’s more recent exemption allowing private companies to make small buy-backs out of capital. Malta, Cyprus and Gibraltar continue to apply the profits rule. The original core principles remain in relation to dividends even in the jurisdictions which have updated the rules for other types of distributions (e.g. Hong Kong and Singapore).
Whether or not local tax is levied at a corporate level, special care should be taken in planning for the overseas tax treatment applicable to distribution payments. This is especially so in the case of distributions from sources other than profits, which may in some countries be taxable in the hands of the shareholder as a return of capital rather than income. This was highlighted in the Court of Appeal decision in First Nationwide v The Commissioners for HMRC. The court held that it is the legal machinery under the laws of the jurisdiction of incorporation of the company paying the dividend, and not the source of the funds, that is determinative of the nature of the payments (i.e. as capital or income) in the recipient’s hands. Because the payment was made by way of dividend (and was made otherwise than in the course of a winding up), then it had to be treated as a dividend, and was therefore income, even though it was paid by a Cayman company out of its share premium account. Whilst this appears to settle the immediate position for UK shareholders, appropriate tax advice should be taken wherever the recipient of a distribution will be liable to tax.
Capital maintenance rules serve a worthy purpose rooted in a desire to protect creditors and lower ranking shareholders from bad management decisions or, at worst, asset stripping. Critics of more rigid distribution policies note that placing too much reliance on accounting principles can artificially prevent financially sound companies from returning value to shareholders. A more liberal regime gives boards and investors the flexibility to adopt policies most fitting for their company’s evolving operating and financial circumstances. Those who oppose the wholesale dismantling of the older rules argue that the ability to call directors and shareholders to account for their actions after the fact may be of little value in practical terms. Both sets of arguments have their merits and their critics. What is best for the investors in a cross border holding company is unlikely to be suitable for a large trading company with employees, pension liabilities, lenders and business creditors. In a world of many different options, the most suitable vehicle in any given set of circumstances needs to be an educated one based on all relevant factors, of which the distribution rules can form an important part.
For further information please contact Claire McConway.
  EWCA 278