Dividend structuring and timing are making headlines presently. (For example: The Globe and Mail: Ottawa to rein in income ‘sprinkling’ by wealthy Canadians and the Financial Post: What the new ‘income sprinkling’ rules mean for tax planning). I thought I’d write a post describing the purpose and some typical features of dividends.
What are dividends and when are they declared?
The ability to issue dividends to shareholders is a standard for-profit corporation feature. Shareholders invest in shares for several reasons, including the hope that the value of the shares will increase and permit them to sell at a profit, and the anticipation that the corporation will be profitable enough to pay dividends to the shareholder while they own the shares.
Exactly as it sounds, “dividend” implies the division of the profits or retained earnings of the business, normally pro rata for the number of shares held, to the shareholders of the corporation.
Contingent on how the shares of the company are structured, there may be three (3) scenarios (among others) for timing of the issue of dividends.
First, dividends may be issued to all of the shareholders if there is a single class of shares.
Second, the corporation may decide to declare dividends payable to only one share class, or “sprinkle” dividends to several share classes, if multiple share classes exist and if there are tax reasons for doing so.
Third, the articles of incorporation may also require a selective dividend issue if the corporation has several classes of shares, and has structured the share classes to allow for certain investors to receive dividends in preference to others.
How are dividends declared?
The officers of the company (and their advisors including their accountant and/or lawyer) will want to check three (3) things to make sure that the board of directors of the corporation are authorized to declare the dividends.
First, they want to check the shareholders’ agreement to see if there are any restrictions on the ability to declare dividends. Restrictions could include shareholder or board majority approval requirements. The shareholder agreement could also prohibit the declaration of dividends until some triggering event has occurred, such as a minimum level of profitability, or repayment of shareholder loans. For example, the directors’ authority to declare dividends could be expressed as follows:
Dividends: Subject to solvency requirements under the Act, and to the extent permitted by law and after establishing sufficient reserves for the normal operation of the Corporation’s business activities and debt servicing requirements, declaring or paying of any dividend or other distribution on or in respect of any Shares or other securities of the Corporation.
The second place to check is the articles of incorporation, which set out the various share classes, and define the rights and privileges of each class of shares, including which shares are eligible to receive dividends, and the types and features of the dividend rights.
An example of this feature is a “cumulative” dividend. A shareholder holding shares with this feature would be allocated a certain percentage of their investment in the form of a dividend each year - if the company is unable to pay in a specific year, then that amount would be owed in a future year in which dividends are paid.
The third place to check in terms of whether a business can declare and pay dividends is the corporate law. The Canada Business Corporations Act, 1985 (CBCA) or Ontario Business Corporations Act, R.S.O. 1990 (OBCA) specify that a business must be solvent (able to pay its debts) in order to issue a dividend. Here’s the sample language from the OBCA:
s.38(3) - The directors shall not declare and the corporation shall not pay a dividend if there are reasonable grounds for believing that,
(a) the corporation is or, after the payment, would be unable to pay its liabilities as they become due; or
(b) the realizable value of the corporation’s assets would thereby be less than the aggregate of,
(i) its liabilities, and
(ii) its stated capital of all classes. R.S.O. 1990, c. B.16, s. 38 (3).
Takeaways:
- Check the rules!
- If you’re unsure as to whether or not you are properly able to declare and pay dividends, consider discussing the approval requirements and/or timing of dividends with your advisors.
- Make sure you properly check the rules for paying out dividends before doing so.
- Make sure you properly authorize the declaration and payment of dividends using a properly approved corporate resolution.
For more information, check out these blog posts:
When Should a Company Declare Dividends?
What are Share Repurchases and Why are Businesses Using Them So Much?