Dividends ― When Are Solvency Tests Required?
Companies have an obligation to assess their solvency when resolving to distribute assets. Assets cannot be distributed if, at the time of the resolution, it is known or should be known that the company is insolvent or that the distribution would lead to the company becoming insolvent. But what happens if it is discovered after the resolution but before the distribution that the company is not solvent after all? Does the management have to refuse to implement the general meeting's resolution?
An increasing number of listed companies have begun paying out dividends in several instalments. This means that the management has to assess their company’s solvency more frequently.
Chapter 13, section 2 of the Limited Liability Companies Act provides for a solvency test. According to the test, assets cannot be distributed if, at the time of the resolution, it is known or should be known that the company is insolvent or that the distribution would lead to the company becoming insolvent.
This provision makes it clear that solvency must be assessed when resolving to distribute funds. However, opinions differ as to whether a solvency test also needs to be carried out when the resolution is being implemented. If a solvency test is failed at the time of payment, should the management refuse to implement the general meeting’s resolution?
Solvency Tests at the Time of Payment
Several months may pass between the general meeting’s resolution to distribute assets and the implementation of that resolution, i.e. the payment of assets. This could be the case, for example, if the annual general meeting decides to distribute dividends in several instalments: dividends resolved on in March may not be payable until September. The company’s financial condition may change significantly between the time when the resolution was made and the time when it is meant to be implemented. Many companies came face to face with this fact this past year when the COVID-19 pandemic turned their operating environment upside down.
The prevailing opinion that seems to have formed is that the management also has to assess their company's solvency at the time they are implementing the resolution to distribute assets—and they must refrain from implementing the general meeting’s resolution if the situation requires.
The assessment of solvency has also been examined in a joint research project of Tampere University and the University of Lapland that focused on the clarification of the protection of creditors and the easing of the related procedures. The final report of the study states that the time when solvency must be assessed should be provided for in more detail than it currently is. Whether or not the legislator takes up the report’s recommendations remains to be seen.
Taxable Income from Unpaid Assets?
If a company’s management refrains from distributing assets due to a solvency test, shareholders could potentially incur taxable income from assets that they never actually received.
In taxation, the distribution of assets is normally considered income of the tax year during which the assets are available to be withdrawn. Dividends are considered available immediately after the general meeting, unless the meeting resolves otherwise with respect to the withdrawal time.
Finnish tax law contains no express provisions concerning the cancellation of a distribution resolution. In tax practice, cancellation has generally been considered possible up to the time when the assets become available to the shareholders for withdrawal. The Finnish Tax Administration has also deemed that cancellation is possible if the general meeting’s resolution was made in violation of the Limited Liability Companies Act or other act. Distributing assets despite a failed solvency test is a violation of the Limited Liability Companies Act. As described above, the Limited Liability Companies Act leaves open to interpretation whether a solvency test must also be carried out when implementing the distribution of assets. However, a reduction in the company’s results and solvency following the resolution alone has not been enough to effectively cancel the distribution resolution from the perspective of taxation.
A General Meeting Can Cancel Its Own Distribution Resolution
If between the time of the resolution and the time of the implementation of the resolution it seems that it may be necessary to refrain from implementing the resolution based on a solvency test, it is worth considering whether the resolution should be cancelled by a general meeting before the assets can be withdrawn.
If it is not possible to convene a general meeting to cancel the resolution, it is a good idea to contact the Finnish Tax Administration in advance to discuss whether shareholders will be deemed to have accrued taxable income despite the fact that the distribution of assets could not be carried out due to a failed solvency test.
Flexibility through Board Authorisation
In uncertain times, companies can give themselves the necessary flexibility by authorising their boards to decide on the distribution of dividends or assets from the unrestricted equity reserve. In taxation, assets distributed based on such an authorisation are only deemed to be available for withdrawal by the recipients based on a board decision.
When considering such an authorisation, it must be kept in mind that shareholders with at least one-tenth of all of the shares in the company are entitled to demand minority dividend in accordance with chapter 13, section 7 of the Limited Liability Companies Act in the annual general meeting prior to the resolution on the use of profits. Naturally, minority dividends cannot be distributed either if doing so would endanger the solvency of the company.