Colombo Retail Holdings: Dividend and Share Buy-Back Against a Failing Solvency Test
Colombo Retail Holdings (Pvt) Ltd has a founder-director holding 60% and an institutional investor holding 40%. The board wants to pay a dividend of LKR 60 million in July 2025 and buy back the investor's entire 40% stake for LKR 150 million in September 2025. Draft accounts at 30 June 2025 show cash LKR 60 million, trade receivables LKR 140 million, inventory LKR 210 million and property, plant and equipment LKR 380 million; trade payables LKR 190 million, a bank term loan LKR 240 million repayable in December 2025, and provisions LKR 30 million. Retained earnings are LKR 210 million and there are no contingent liabilities. The bank has not waived its covenant, and there is no committed overdraft after the dividend. The directors propose to sign the solvency test certificate because net assets after both payments (LKR 120 million) remain positive. The investor is a resident company and the founder is a resident individual. Turnover is LKR 1.4 billion and the 2024/25 income tax return was filed 45 days late.
1. Apply the statutory solvency test to the proposed dividend and buy-back. May the directors sign the certificate?
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The test has two limbs, and both must be satisfied.
Limb 1 – able to pay debts as they become due. Current liabilities before any payment are 190 + 240 + 30 = LKR 430 million, of which 240 million falls due in December 2025. Cash is 60 million and receivables 140 million, giving 200 million of liquid resources. Paying 210 million out leaves almost no cash while 430 million of liabilities remain within six months. Limb 1 fails.
Limb 2 – assets not less than liabilities, including contingent liabilities. Net assets are 790 − 460 = LKR 330 million; after 210 million of distributions, 120 million remains. Limb 2 passes on the numbers, but only on book values – inventory of 210 million and PPE of 380 million are not cash and may be overstated.
Conclusion. Because limb 1 fails, the directors may not sign the certificate. Their reasoning is the classic error: they tested only balance-sheet surplus and ignored liquidity. The dividend must be reduced or deferred, bank consent obtained, and a realistic 12-month cash flow prepared before any certificate is signed. Paying the dividend alone (60 million) still leaves cash of nil against 430 million of liabilities, so even the dividend is unsafe on these figures.
2. What are the consequences if the directors sign and pay anyway, and how should the buy-back be structured if it proceeds later?
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Consequences of an unlawful distribution.
- The distribution is made without satisfying the solvency test, so it is improper. Directors who sign a certificate without reasonable grounds can be personally liable to repay the amount to the company, in addition to committing an offence under the Companies Act No. 7 of 2007.
- The recipient shareholder may be required to return the money where it was paid in breach.
- The company's creditors can challenge the payment, and the bank's reaction to a covenant breach will be severe: it may accelerate the loan.
- The auditor must consider whether the accounts give a true and fair view, and report the breach to those charged with governance.
Structuring a lawful buy-back later.
- Confirm the constitution permits the acquisition of own shares and pass the required shareholder resolution, with the institutional investor abstaining.
- Establish distributable profits and fund the buy-back from them or from a fresh issue – not from borrowed working capital that the business needs.
- Satisfy both limbs of the solvency test at the date of payment, supported by a board minute and cash flow.
- Consider a staged payment (for example 50% on transfer, 50% after 12 months once the loan is refinanced) with bank consent in writing.
- Cancel the acquired shares and update the register; obtain tax advice on the character of the consideration.
3. Advise on the tax consequences of the LKR 60 million dividend for the company and both shareholders, and on the late filing of the return.
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Dividend – company. The dividend is paid out of profits and is not deductible in computing the company's taxable income. The company acts as withholding agent.
Dividend – shareholders. Dividend withholding tax at the rate applicable to residents (10%) must be deducted at source:
- Gross dividend 60,000,000; WHT 6,000,000; net paid 54,000,000.
- For the resident individual and the resident company, the WHT is a final tax on the dividend, so the 54 million is received free of further income tax on that income.
- The company must remit the 6 million within the statutory period. If it fails, the tax is recovered from the company as agent, with penalties and interest, and the shareholders are still treated as paid.
Buy-back. The 150 million paid for the shares is consideration for a capital asset, not automatically a dividend. Whether any part is treated as a distribution depends on the character of the payment and the investor's tax position, so obtain a written tax opinion before completion; do not assume the dividend treatment applies.
Late filing. The return was 45 days late. Under the Inland Revenue Act No. 24 of 2017 a penalty attaches to late filing and to any tax paid late, in addition to interest. Quantify the exposure on the actual tax payable, disclose it in the accounts as a liability if probable, and regularise the filing before the next return falls due.