INTRODUCTION

An investment in equity shares reflects not just capital contribution, but also the investor’s intent to participate in management or earn returns through dividends. While some shareholders seek control, most invest to benefit from the company’s distributable profits.

The Companies Act, 2013 (“Companies Act”) governs the declaration of dividends, with final dividends approved by shareholders at the AGM based on the Board’s recommendation. However, the discretion to propose such dividends rests with the Board, subject to statutory compliance.

A common challenge for companies is determining whether final dividends must be declared only from current profits or if reserves may also be used. This article examines the legal distinction between profits and free reserves, and clarifies the conditions and limits applicable to the declaration of final dividends.

LEGAL FRAMEWORK UNDER THE COMPANIES ACT

Section 123(1) of the Companies Act lays down the sources from which a company may declare and pay a final dividend, which are as follows:

• Profits of the company for the year, after providing for depreciation; or
• Profits of any previous financial year(s), after depreciation, that remain undistributed; or
• Both current and past year profits; or
• Funds provided by the government pursuant to a guarantee.

UNDERSTANDING THE TERM ‘PROFIT’ FOR PAYMENT OF FINAL DIVIDEND

As the Companies Act permits declaration of final dividend out of profits, a key question arises—what constitutes “profits” and how should it be computed? Although the Act does not define the term, its interpretation has been shaped by judicial precedents and committee recommendations.

In Re. Spanish Prospecting Co. Ltd. [(1911) 1 Ch 92], profit was defined as the gain made during a year, determined by comparing the company’s assets at two dates. Similarly, in Bharat Insurance Co. Ltd. v. CIT [(1931) 1 Comp. Cases 192], profit was held to mean the net proceeds after deducting necessary expenses.

Under the Companies Act, “profit” refers to the surplus in the profit and loss account, as shown in the audited financial statements. Schedule III requires such surplus to be reflected under “Reserves and Surplus,” with debit balances shown as negatives.

Unlike interim dividend, which may be declared based on provisional financial statements, final dividend must be declared strictly from profits of the current or previous financial years as per audited financial statements. Further, as clarified in Secretarial Standard on Dividend (SS-3) issued by the ICSI, final dividend can only be paid after the adoption of financial statements at the Annual General Meeting (AGM).

In summary, only properly adjusted profits, determined in accordance with statutory provisions and audited accounts, shall constitute distributable profits for the purpose of final dividend under Section 123.

WHAT EXCLUSIONS ARE REQUIRED TO BE MADE BEFORE PAYMENT OF FINAL DIVIDEND?

Before declaring final dividend, the Companies Act, requires companies to compute distributable profits after making certain mandatory exclusions. Specifically, Section 123 of the Companies Act mandates that unrealised gains, notional gains, revaluation adjustments, and any change in the carrying amount of assets or liabilities due to fair valuation must be excluded.

Additionally, any unprovided depreciation and accumulated losses from previous financial years must be set off against current profits before determining the distributable surplus.

Importantly, this requirement of setting off past losses and unprovided depreciation applies mutatis mutandis to interim dividend as well, even though these conditions are specifically provided under the sub-section dealing with final dividend. This ensures that companies do not bypass the obligation of adjusting unaccounted losses and depreciation by declaring interim dividends.

WHAT IS THE MAXIMUM LIMIT FOR PAYMENT OF FINAL DIVIDEND?

As explained above, the Companies Act permits the use of current and previous years’ profits—or both—for the declaration of final dividends, provided all conditions are fulfilled. The use of the phrase “or both” in Section 123(1) of the Companies Act suggests there is no upper limit to the amount of dividend, as long as it is sourced from legally distributable profits.

Hence, a company may declare any amount of final dividend, subject to:

• Availability of adequate profits (current or accumulated),
• Prior adjustment of losses and depreciation, and
• Compliance with other applicable provisions of the Companies Act.

ARE PROFITS AND FREE RESERVES INTERCHANGEABLE FOR DECLARING FINAL DIVIDEND?

A common misconception among companies is treating profits and free reserves as interchangeable sources for declaring final dividends. As per the definition under the Companies Act, free reserves refer to those reserves which are free for distribution as dividend. Accordingly, both the profit lying in the surplus account and profits transferred to general reserves qualify as amounts available for dividend distribution.

In fact, across various provisions of the Companies Act—such as Sections 68, 180, and 186—the terms “profits” and “free reserves” are often used interchangeably. However, Section 123 carves out a specific treatment: it permits the use of free reserves for declaration of dividend only in special situations, i.e., in cases of inadequacy or absence of profits. The requirement that profits must first be transferred to free reserves—followed by compliance with Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014 (“Dividend Rules”) —clearly indicates that, for the purpose of Section 123, surplus profits and free reserves are not interchangeable. The fact that section 123 provides for special case in case of declaration of dividend out of profits transferred to reserves, it is abundantly made clear the a specific reserves has to be created and surplus in profit & loss account, will not be a free reserves for the purpose of these Dividend Rules.

In such exceptional cases, the Companies Act permits use of free reserves strictly subject to Rule 3, which imposes the following conditions:

• The rate of dividend shall not exceed the average of the rates at which dividends were declared in the three immediately preceding financial years;
• The amount drawn from reserves shall not exceed 10% of the sum of paid-up share capital and free reserves;
• The balance of reserves after such withdrawal shall not fall below 15% of the paid-up share capital.

This distinction is critical: profits refer to the surplus available in the profit and loss account, whereas free reserves are profits that have been formally transferred and earmarked. Surplus retained in the profit and loss account, unless transferred, does not qualify as free reserves and cannot be used under Rule 3.

The Company Law Committee (2016) also acknowledged this distinction, clarifying that Rule 3 applies only when dividend is proposed from actual reserves, and not from retained earnings. Therefore, companies must not assume that all accumulated surplus can be treated as free reserves for the purpose of dividend payment under Section 123.

In conclusion, while both surplus and free reserves may be used for dividend under the Act in general, for the specific purpose of Section 123, only profits (surplus) can be used freely, and free reserves may be drawn upon only in limited circumstances and strictly in compliance with Rule 3. Misinterpreting this distinction may result in non-compliance and regulatory exposure.

CONCLUSION

Under the Companies Act, final dividend is generally declared out of the company’s profits, after making all required statutory adjustments. Where adequate profits are available, there is no specific cap on the amount, provided it falls within the distributable surplus and meets all legal requirements.

In contrast, where profits are inadequate or absent, the Act permits use of free reserves—subject to conditions under Rule 3 of the Dividend Rules. Importantly, for the purpose of Section 123 of the Companies Act, profits and free reserves are not the same, and reserves can be used only in limited circumstances.

Companies must ensure strict compliance with accounting standards and legal provisions before declaring dividends. A clear understanding of the distinction between profits and free reserves will help mitigate legal risks and reinforce sound corporate governance.