Declaration of Dividend Out of Reserves

Section 123 of the Companies Act, 2013 (the Act) and the rules made thereunder deals with declaration of dividend.

Section 123(1) of the Act provides that,

123. Declaration of Dividend

• No dividend shall be declared or paid by a company for any financial year except —
  • 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.

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

• 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: (emphasis provided).

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(emphasis provided), 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.

1. According to Section 123 (1) dividend can be declared out of

• Out of the profits of the Company for the respective financial year after providing for Depreciation, or;
• Out of the profits of the Company for any previous financial year(s), after providing for Depreciation and remaining undistributed or
• Both of the above or
• money provided by the Central Government or a State Government in pursuance of a guarantee given by such Government for this purpose.

2. According to the second proviso to Section 123(1), if owing to inadequacy or absence of any profits in any financial year, if any company proposes to declare dividend out of accumulated profits earned by it and transferred to free reserves, such declaration shall not be made except in accordance with Rule 3 of the companies (Declaration and Payment of Dividend) Rules 2014.
3. In the said proviso, the words “accumulated profits earned by it in previous years and transferred to free reserves” are clear and unambiguous. With use of word “and” the legislature makes it mandatory to comply with both the following conditions:
   1. accumulated profits earned by it in previous years and
   2. transferred to free reserves.

4. Section 2(43) of the Act defines term free reserves as “free reserves” means such reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend:

Provided that—

• any amount representing unrealised gains, notional gains or revaluation of assets, whether shown as a reserve or otherwise, or
• any change in carrying amount of an asset or of a liability recognized in equity, including surplus in profit and loss account on measurement of the asset or the liability at fair value,

shall not be treated as free reserves.

8. Looking at Schedule III, there is a specific difference between Surplus and Reserves. Thus, it can be inferred that carried forwarded Profit of the company would constitute as ‘Surplus/Retained Earnings’ of the Company and not ‘Reserve’.
9. As mentioned above, retained earnings are a surplus in the profit & loss statement and are not transferred to reserve as mentioned as required under second proviso to Section 123 and hence does not constitute ‘Reserves’ in legal sense.
10. Restriction as mentioned in second proviso to Section 123 of the Act and Rule 3 would apply only when any Company decides to declare a dividend out of General Reserve and not to declaration of dividend out of retained earnings / accumulated profits.
11. Also, a Company cannot use Capital Reserve, Capital Redemption Reserve, Security Premium Reserve, and such Other Reserves, kept aside for specific purpose, for declaration of dividend as these are not free reserves.

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