Legal Framework of Dividend Distribution In India

This write-up outlines the procedure for distributing dividends as prescribed under Section 123 of the Companies Act, 2013, read with the Companies (Declaration and Payment of Dividend) Rules, 2014. Before examining the procedural aspects, it is important to understand the meaning and nature of dividends.

DIVIDEND

According to Section 2(35) of the Companies Act, 2013, “dividend includes interim dividend.” However, the Act does not provide a comprehensive definition of the term. It merely distinguishes between two types—final dividend and interim dividend. This lack of explicit definition leads to an essential question: what, in substance, constitutes a dividend?

To understand the concept and origin of the term “dividend,” reference is made to the following sources:

(i) the general meaning of the term in English,

(ii) Wharton’s Law Lexicon,

(iii) Secretarial Standard-3 (SS-3), and

(iv) the Income Tax Act, 1961.

ENGLISH DICTIONARY MEANING

The term “dividend” is derived from the Latin word dividendum, meaning “that which is to be divided.” In general usage, a dividend refers to the portion of a company’s profits that is allocated for distribution among its shareholders.

WHARTON’S LAW LEXICON

Dividend, a share, the past allotted in a division; the interest paid on the public funds; the share of profits of a company payable to each shareholder (see articles 89 to 96 of table A to companies act, 1929, and ss. 120-123 of the companies clauses consolidation act, 1845); a distributive share of a bankrupt’s estate or on the winding-up of the company, of its assets.

As to the liability upon a company in respect of a dividend when the warrant for it, having been duly posted, is lost in the post, see Thairlwal v. G.N. Ry., (1910) 2 KB 509l.

“Dividend” means the share of the subscriber in the amount of discount available under the chit agreement for ratable distribution among the subscriber at each installment of chit. [chit funds act (40 of 1982), s.2(h(]

Dividend is share of profits, whether at a fixed rate or otherwise, allocated to the holder of shares in a company, henry v. great northern rly. Co., (1857) 1 De G&J 606.

‘Dividend ‘ in its ordinary connotations means the sum Paid to or received by a shareholder proportionate to his share-holding in a company out of the total sum distributed, C.I.T. v. Nalim Behari Singha, AIR 1970 SC 388 (389): (1969) 2 SCC 310.

As per Secretarial Standard-3, a dividend refers to the distribution of any sum to the members out of the profits of the company, or out of the free reserves, to the extent permitted for this purpose.

SECRETARIAL STANDARD-3

“Dividend” means a distribution of any sums to Members out of profits and wherever permitted out of free reserves available for the purpose.

“Final Dividend” means the Dividend recommended by the Board of Directors and declared by the Members at an Annual General Meeting.

“Interim Dividend” means the Dividend declared by the Board of Directors.

Secretarial Standard-3 further classifies dividends into two categories: interim dividend and final dividend. Although both are forms of dividend, the distribution of interim dividends is subject to certain restrictions.

The key phrase in the definition—“distribution of any sums to members”—highlights the release of the company’s assets, usually in the form of cash. This distinguishes dividends from other shareholder benefits like bonus shares, which do not involve any actual outflow of funds. In contrast, a dividend constitutes a real transfer of value from the company to its shareholders.

Among all statutory provisions, the Income Tax Act, 1961 offers the most comprehensive definition of the term “dividend.” Under Section 2(22), the Act defines dividend in an inclusive manner, thereby enabling a broader interpretation that goes beyond the conventional understanding of a return on shareholding. This inclusive approach allows various transactions—such as certain loans or advances made to shareholders or concerns in which they hold substantial interest—to be treated as deemed dividends, subject to specified conditions.

Section 2(22) – Definition of Dividend under the Income Tax Act, 1961:

Section 2(22) of the Income Tax Act, 1961, provides an inclusive definition of the term “dividend” for tax purposes. It covers not only traditional profit distributions but also various other payments and transactions that may be deemed dividends. The key components include:

1. Distributions of Accumulated Profits: Any distribution made by a company to its shareholders out of accumulated profits, whether capitalized or not, which entails the release of the company’s assets.

2. Issue of Debentures, Deposit Certificates, or Bonus Shares to Preference Shareholders:
Such issues are considered dividends if made out of accumulated profits.

3. Payments on Liquidation or Capital Reduction: Payments made to shareholders during liquidation or capital reduction are treated as dividends to the extent they are attributable to accumulated profits.

4. Deemed Dividend under Sub-clause (e): Any loan or advance made after May 31, 1987, by a closely held company (i.e., a company in which the public is not substantially interested) to:

• • A shareholder who holds at least 10% of the voting power, or
  • A concern in which such shareholder has a substantial interest

Such loans or advances are deemed to be dividends to the extent of the company’s accumulated profits.

However, the provision excludes certain transactions from being treated as dividends, such as:

• Buyback of shares in accordance with Section 77A of the Companies Act, 1956,
• Distributions on demerger, and
• Loans given in the ordinary course of business, where the company’s principal business is money-lending.

Section 2(22) in The Income Tax Act, 1961

(22)”dividend” includes—

(a)any distribution by a company of accumulated profits, whether capitalised or not, if such distribution entails the release by the company to its shareholders of all or any part of the assets of the company ;

(b)any distribution to its shareholders by a company of debentures, debenture-stock, or deposit certificates in any form, whether with or without interest, and any distribution to its preference shareholders of shares by way of bonus, to the extent to which the company possesses accumulated profits, whether capitalised or not ;

(c)any distribution made to the shareholders of a company on its liquidation, to the extent to which the distribution is attributable to the accumulated profits of the company immediately before its liquidation, whether capitalised or not ;

(d)any distribution to its shareholders by a company on the reduction of its capital, to the extent to which the company possesses accumulated profits which arose after the end of the previous year ending next before the 1st day of April, 1933, whether such accumulated profits have been capitalised or not ;

(e)any payment by a company, not being a company in which the public are substantially interested, of any sum (whether as representing a part of the assets of the company or otherwise) made after the 31st day of May, 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in profits) holding not less than ten per cent of the voting power, or to any concern in which such shareholder is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the said concern) or any payment by any such company on behalf, or for the individual benefit, of any such shareholder, to the extent to which the company in either case possesses accumulated profits;

but “dividend” does not include—

(i) a distribution made in accordance with sub-clause (c) or sub-clause (d) in respect of any share issued for full cash consideration, where the holder of the share is not entitled in the event of liquidation to participate in the surplus assets ;

(ia) a distribution made in accordance with sub-clause (c) or sub-clause (d) in so far as such distribution is attributable to the capitalised profits of the company representing bonus shares allotted to its equity shareholders after the 31st day of March, 1964, and before the 1st day of April, 1965;

(ii)any advance or loan made to a shareholder or the said concern by a company in the ordinary course of its business, where the lending of money is a substantial part of the business of the company ;

(iii)any dividend paid by a company which is set off by the company against the whole or any part of any sum previously paid by it and treated as a dividend within the meaning of sub-clause (e), to the extent to which it is so set off;

(iv)any payment made by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 77A of the Companies Act, 1956 (1 of 1956);

(v)any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the demerged company (whether or not there is a reduction of capital in the demerged company).

Explanation 1.—The expression “accumulated profits”, wherever it occurs in this clause, shall not include capital gains arising before the 1st day of April, 1946, or after the 31st day of March, 1948, and before the 1st day of April, 1956.

 Explanation 2.—The expression “accumulated profits” in sub-clauses (a), (b), (d) and (e), shall include all profits of the company up to the date of distribution or payment referred to in those sub-clauses, and in sub-clause (c) shall include all profits of the company up to the date of liquidation, but shall not, where the liquidation is consequent on the compulsory acquisition of its undertaking by the Government or a corporation owned or controlled by the Government under any law for the time being in force, include any profits of the company prior to three successive previous years immediately preceding the previous year in which such acquisition took place.

Explanation 2A.—In the case of an amalgamated company, the accumulated profits, whether capitalised or not, or loss, as the case may be, shall be increased by the accumulated profits, whether capitalised or not, of the amalgamating company on the date of amalgamation.

 Explanation 3.—For the purposes of this clause,—(a)”concern” means a Hindu undivided family, or a firm or an association of persons or a body of individuals or a company ;(b)a person shall be deemed to have a substantial interest in a concern, other than a company, if he is, at any time during the previous year, beneficially entitled to not less than twenty per cent of the income of such concern ;”

Clause-by-Clause Analysis of the Definition of Dividend under Section 2(22) of the Income Tax Act, 1961:

(a) This sub-clause covers the distribution of accumulated profits, whether capitalized or not, which results in the release of company assets to shareholders. This is the standard or classical form of dividend, typically in cash or in kind.

(b) This sub-clause refers to deemed dividends, where a company:

• Issues debentures, debenture stock, or deposit certificates (whether interest-bearing or not), or
• Issues bonus shares to preference shareholders,
  to the extent such issuance is made from accumulated profits. These are not traditional cash dividends but are treated as dividend income for tax purposes due to their source in profits.

(c) This sub-clause deals with distributions during liquidation, to the extent that the distribution is attributable to accumulated profits immediately before liquidation. These are treated as dividends, not capital receipts, if derived from profits.

(d) This clause pertains to distributions on capital reduction. If a company reduces its capital and pays shareholders amounts sourced from accumulated profits (earned after March 31, 1933), such payments are treated as dividends.

 (e) This sub-clause is a key anti-avoidance provision and deals with loans or advances made by a closely held company to:

• A shareholder holding at least 10% voting power, or
• A concern (e.g., partnership firm, HUF, etc.) in which such shareholder has a substantial interest (20%+ income interest).

Such payments are treated as deemed dividends to the extent of the company’s accumulated profits, unless certain exceptions apply (e.g., if the company is a money-lending company and the loan is in the ordinary course of business).

Though the clause further elaborates on what does not constitute a dividend, that part has been excluded here as the focus of this discussion is limited to understanding the meaning and scope of “dividend.”

Since we have understood what a dividend is, the next important question is: from where can such a dividend be paid, or what are the legal sources for its payment?

Section 123.Declaration of dividend

(1) No dividend shall be declared or paid by a company for any financial year except—

(a) out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2), or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with the provisions of that sub-section and remaining undistributed, or out of both or; both

Provided that in computing profits any amount representing unrealised gains, notional gains or revaluation of assets and any change in carrying amount of an asset or of a liability on measurement of the asset or the liability at fair value shall be excluded; or

(b) out of money provided by the Central Government or a State Government for the payment of dividend by the company in pursuance of a guarantee given by that Government:

Provided that a company may, before the declaration of any dividend in any financial year, transfer such percentage of its profits for that financial year as it may consider appropriate to the reserves of the company:

Provided further that where, owing to inadequacy or absence of profits in any financial year, any company proposes to declare dividend out of the accumulated profits earned by it in previous years and transferred by the company to the free reserves, such declaration of dividend shall not be made except in accordance with such rules as may be prescribed in this behalf:

Provided also that no dividend shall be declared or paid by a company from its reserves other than free reserves .

Provided also that no company shall declare dividend unless carried over previous losses and depreciation not provided in previous year or years are set off against profit of the company for the current year.

(2) For the purposes of clause (a) of sub-section (1), depreciation shall be provided in accordance with the provisions of Schedule II.

(3) The Board of Directors of a company may declare interim dividend during any financial year or at any time during the period from closure of financial year till holding of the annual general meeting out of the surplus in the profit and loss account or out of profits of the financial year for which such interim dividend is sought to be declared or out of profits generated in the financial year till the quarter preceding the date of declaration of the interim dividend:

Provided that in case the company has incurred loss during the current financial year up to the end of the quarter immediately preceding the date of declaration of interim dividend, such interim dividend shall not be declared at a rate higher than the average dividends declared by the company during immediately preceding three financial years.

(4) The amount of the dividend, including interim dividend, shall be deposited in a scheduled bank in a separate account within five days from the date of declaration of such dividend.

(5) No dividend shall be paid by a company in respect of any share therein except to the registered shareholder of such share or to his order or to his banker and shall not be payable except in cash:

Provided that nothing in this sub-section shall be deemed to prohibit the capitalisation of profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any amount for the time being unpaid on any shares held by the members of the company:

Provided further that any dividend payable in cash may be paid by cheque or warrant or in any electronic mode to the shareholder entitled to the payment of the dividend.

(6) A company which fails to comply with the provisions of sections 73 and 74 shall not, so long as such failure continues, declare any dividend on its equity shares.

Analysis of the Section 123 of the Companies Act, 2013:

Section 123(1) of the Companies Act, 2013, deals with the sources out of which a company can declare and pay dividends. This sub-section is divided into Clause (a) and Clause (b), and is further supplemented by five provisos.

Clause (a): Primary Sources of Dividend

Clause (a) provides three permissible sources for dividend payment:

1. Out of the current year’s profits,

2. Out of the profits of any previous financial year(s), or

3. Out of a combination of both (1) and (2)

In all cases, profits must be calculated after providing for depreciation in accordance with Section 123(2).

Exclusions While Computing Profits

The proviso to Clause (a) specifically states that, while computing profits for the purpose of dividend declaration, the following items shall be excluded:

1. Unrealised gains,

2. Notional gains, and

3. Gains arising from revaluation of assets or changes in fair value of assets and liabilities

These items do not represent actual realised earnings. They are merely accounting adjustments and do not reflect cash or liquid profits available for distribution. Therefore, they must be disregarded to ensure dividends are paid only from real and distributable profits.

Though Clause (a) of Section 123(1) provides that dividend can be paid out of profits, the Companies Act, 2013 does not define the term “profit”. To understand the meaning and scope of “profit” in this context, it is essential to refer to judicial interpretations. The following two judgments are particularly relevant:

“Profit implies a comparison between the state of business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets of the business at the two dates. If the total assets of the business at the two dates are compared, the increase which they show at the later dates as compared with the earlier date (due allowance, of course, being made for capital introduced into or taken out of the business in the mean while) represents, in strict sense, the profits of the business during the period in question.”

Profit means the net proceeds of the company after deducting the necessary expenses without which those proceeds could not be earned [ Bharat insurance Co. Ldt. , Lahore v. Commissioner of income tax (1931) comp. cases 192 (Lah)].

Clause (b): Dividend Out of Funds Provided by the Government

As per Clause (b) of Section 123(1), a company may declare and pay dividend out of funds provided by the Central Government or a State Government, provided that such payment is made pursuant to a guarantee given by the respective Government.

Proviso No. 2: Voluntary Transfer of Profit to Reserves

The second proviso to Section 123(1) provides that a company may, before declaring any dividend out of its profits, transfer such portion of the profits to the reserves as it considers appropriate.

This transfer is entirely voluntary, and the Companies Act, 2013 does not prescribe any minimum amount that must be transferred.

However, as a matter of prudent financial management, it is generally advisable for companies to transfer a portion of their profits to reserves. This helps in building a financial cushion to address future contingencies, capital expenditure, or unforeseen liabilities, thereby strengthening the company’s long-term financial stability.

Proviso No. 3: Declaration of Dividend from Free Reserves

The third proviso to Section 123(1) allows a company to declare dividends out of free reserves in cases where there is inadequacy or absence of profits in the current financial year.

Understanding Free Reserves:

The term “free reserves” refers to those reserves which are created out of accumulated profits by transferring a portion of such profits to specific reserve heads (e.g., General Reserve) through appropriate book entries. These are shown as separate heads in the financial statements and are available for distribution as dividends.

Note: Merely having reserves is not sufficient. The reserves must be “free”, meaning they are not earmarked for any specific purpose and are not capital reserves.

Conditions for Declaration of Dividend from Free Reserves:

When a company opts to distribute dividends from free reserves, it must comply with the following conditions prescribed under Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014:

1. Dividend Rate Cap:

The rate of dividend declared shall not exceed the average of the rates at which dividend was declared in the three immediately preceding financial years.

• • Exception: This restriction does not apply if the company has not declared any dividend in the past three financial years.

2. Withdrawal Limit:

The total amount withdrawn from such free reserves shall not exceed one-tenth (10%) of the sum of the company’s paid-up share capital and free reserves, as per the latest audited financial statement.

3. Adjustment of Current Year Losses:

The amount so withdrawn from reserves must first be utilized to set off the losses (if any) incurred in the financial year in which the dividend is proposed to be declared.

4. Minimum Reserve Retention:

The balance of free reserves after such withdrawal shall not fall below 15% of the paid-up share capital, as per the latest audited financial statement.

Important Clarification:

• The relevant figures for paid-up capital and free reserves are to be taken strictly from the latest audited financial statements, and not from provisional or updated figures after the end of the financial year.
• Therefore, any increase in paid-up share capital or reserves after the financial year-end (e.g., through rights issue or bonus issue) will not be considered for the purpose of compliance with the above conditions.

Proviso No. 4: Restriction on Source of Dividend – Only from Free Reserves

The fourth proviso to Section 123(1) clearly restricts the payment of dividends from any reserve other than free reserves.

Implication:

By implication, a company can declare and pay dividends only from the following legal sources:

1. Current year’s profits, as shown in the Profit and Loss Account, after providing for depreciation;

2. Accumulated profits of previous years (also from the Profit and Loss Account), again after providing for depreciation;

3. Free reserves (i.e., reserves available for distribution and not earmarked for any specific purpose); or

4. Funds provided by the Central or State Government in pursuance of a guarantee for dividend payment.

Dividends cannot be declared from:

• Capital reserves,
• Revaluation reserves, or
• Any reserve that is not classified as a “free reserve.”

This restriction safeguards the company’s capital base and ensures that dividends are paid only out of real, distributable profits.

Proviso 5^th No Dividend Shall be distributed before set-off of previous losses and depreciation.