In today’s article, we will take a look at the relatively topical issue of profit-sharing payments.
What does an accounting entity need to do to pay out profit shares and what are the limitations?
The Corporations Act (CA) stipulates that profit shares are determined on the basis of regular or extraordinary financial statements approved by the highest body of a business corporation (i.e., the General Meeting in a capital company). Profits can then be distributed among the shareholders until the end of the accounting period following the accounting period for which the financial statements were prepared. Other own resources can also be distributed among the shareholders, which can be, for example, the profits from previous years or other funds. The statutory body shall decide on the payment of the profit shares and other own resources. The profit shares shall then be payable within 3 months from the date on which the decision of the highest body of the company on the distribution was taken (unless the articles of association or the highest body specify otherwise). However, the law sets out a number of conditions that must be met when deciding on the distribution and payment of profits, and these tests shall apply to all limited liability companies, joint stock companies, and cooperatives.
Balance Sheet Test
The first test derives from Section 34, par. 2 of the CA. The amount to be distributed may not exceed the sum of the financial result of the last completed accounting period, the financial result of previous years, and other funds (that the company can use at its discretion – for example, a different financial result from previous years or capital funds). Additionally, the amount to be distributed must be reduced by allocations to reserve and other funds, if they are regulated by law or articles of incorporation (these are most often profit funds – statutory or reserve).
Equity Capital Test
Another condition is derived from Section 40, par. 1 of the CA. The company may not distribute profits or other own resources, if the equity capital arising from regular or extraordinary financial statements (or equity capital after the planned distribution of profits or other own resources) is lower than the value of the subscribed share capital increased by the funds that cannot be distributed according to the law or articles of incorporation. This test does not have to be met, even if the company reports positive financial results and positive distributable funds, most often in a situation where negative amounts are reported in the items of own shares or valuation differences from the revaluation of assets and liabilities.
Development Costs Test
The third condition derives from Section 40, par. 2 of the CA. If the balance sheet assets comprise development costs, the company may not distribute profits or other own resources unless the amount to be distributed is at least equal to the non-written-off portion of the development costs. The amount to be distributed shall then be reduced by the amount of the non-written-off development costs. In other words, all companies that report capitalised development costs in the balance sheet must reduce the amount to be allocated by the net value of the development costs.
Insolvency Test
The insolvency test is derived from Section 40, par. 3 of the CA, which states that profit shares (or profit share advances) cannot be paid out if the company would cause its own bankruptcy. If the profit shares cannot be paid out by the end of the accounting period due to non-fulfilment of this condition, the right to them shall expire. Bankruptcy is then defined in the Insolvency Act.
Entry in the Register of Beneficial Owners
A new condition for the payment of profit shares is derived from the Act on the Registration of Beneficial Owners effective from 1 June 2021. The company may not pay profit shares (or advance profit shares) to a natural person who is not registered as a beneficial owner, or to a legal entity that does not have a registered beneficial owner. If the condition of registration of beneficial owners is not met and a correction is not made by the end of the accounting period in which the payment was decided, the right to the profit shares shall expire.
Advance Payment of Profit Shares
According to Section 35 of the Corporations Act, it is possible to pay advances on profit shares only on the basis of interim financial statements. The interim financial statements are prepared during the account period at a time other than the end of the balance sheet date. A similar condition of a balance sheet test, insolvency test, and entry in the register of beneficial owners applies here as with the payment of profit shares. The sum of advances on profit shares cannot be higher than the sum of the financial result of the current accounting period, the financial result of previous years, and other funds consisting of profits, which the business corporation can use at its discretion, reduced by allocations to reserve and other funds in accordance with the law and articles of incorporation.
Advances on profit shares should already be accounted for on the basis of the decision to grant an advance on profit shares. This fact then reduces the value of the equity capital in the balance sheet under the item ‘Decided on the advance payment of profit shares’.
If the company, on the basis of regular or extraordinary financial statements, finds that the advance payments made are higher than what it could pay as profit shares, it shall be entitled to a refund of the advance payment. The advance on profit shares must then be returned within three months of the date on which the financial statements were or should have been approved. If you are planning to pay out profit shares in the near future and are carrying out the above tests, do not hesitate to contact us.
We will describe the taxation of profit shares in our next article.
