Dividend policy

What it means

Dividend policy is the set of principles by which a company decides what share of profit to pay out to its owners as dividends and what to keep for investment or reserves. Investors watch it closely at listed companies, while at small limited companies it is often unwritten and depends on the owners' needs.

The key measure is the dividend payout ratio, the share of profit paid out. Growing companies usually keep profit as retained earnings to finance growth, while mature companies with stable cash flow pay out more.

The policy must take account of legal restrictions, funding needs, bank loan covenants and the tax consequences of payouts. Profit distribution is decided by the general meeting when approving the financial statements, and rules can also be set in the articles or a shareholders' agreement.

How it works in practice

Before each payout, the solvency test must be applied: the company may not distribute profit if doing so would make it insolvent. Directors who approve a payout despite the risk are liable for the damage, and shareholders may have to return amounts received without entitlement.

Dividends paid to individuals are subject to withholding tax, which the company deducts and pays over. The rate depends on the year whose profit is distributed and, for payments abroad, on the applicable double tax treaty, so current rules should be checked when planning payouts.

Banks often restrict dividends in loan agreements, for example through a debt-to-EBITDA ratio. Breaching such a covenant can make the loan immediately repayable, so loan agreements should be checked before deciding on a payout.

What to watch out for

Paying money to shareholders outside a proper profit distribution, for example through unfavourable loans or payments with nothing in return, may be treated as a hidden profit distribution. This has tax and company law consequences and is hard to defend in an audit.

Interim payments on account of profit during the year are possible only on the basis of interim financial statements and under the terms of the articles. If the annual profit turns out lower, the advances must be returned, or the company has a receivable from the shareholder.