Sitara Industries: dividend out of a revaluation surplus

Maximum lawful dividend: Rs 40 million.

Reasoning

1. Only realised, distributable profits count. The Rs 40 million of accumulated realised profits is available. The revaluation surplus is unrealised: it reflects an increase in the value of an asset still held, not a profit that has been earned. Distributing it would return capital to shareholders.
2. A reserve transfer creates no profit. Moving Rs 50 million from revaluation surplus to retained earnings is a bookkeeping entry between two equity accounts. Total equity is unchanged and no new distributable profit arises. The law, and the accounting framework, look at the nature of the reserve, not its label or location.
3. Consolidation test. After a lawful Rs 40 million dividend, retained earnings are nil, not negative Rs 30 million - but they are still below the Rs 10 million covenant level, so a covenant breach is unavoidable at some dividend level and the apparent comfort from the transfer is illusory.
4. What would change the answer. If the land were sold and the gain realised, the surplus would become a realised profit and could support a distribution (subject to the company's articles and any specific rules on the use of revaluation reserves).

Conclusion: declaring Rs 70 million would be an unlawful distribution of Rs 30 million of capital. Advise a dividend of no more than Rs 40 million, and preferably less to preserve covenant headroom.

Consequences

• Unlawful distribution. Rs 30 million is paid out of capital. Directors who authorised it are jointly and severally liable to make good the amount, and shareholders who received the dividend knowing the facts may be required to repay it. It is not cured by the reserve transfer.
• Covenant breach. With retained earnings at negative Rs 30 million, the loan is repayable on demand; the liability must be reclassified as current, which can trigger a further breach and going-concern issues.
• Related disclosures. Non-compliance with law is a matter requiring disclosure and, potentially, reporting under the relevant regulatory regime; tax treatment of the excess as a deemed dividend or benefit may follow.
• Downstream damage. Any bank covenant certificate or board representation signed on the basis of the transfer is a misstatement.

CFO's position

• Refuse to process the dividend, minute the dissent and the legal advice obtained, and put the alternative (Rs 40 million dividend, or a waiver request) to the board in writing. Escalate to the audit committee if there is one.
• Model the covenant breach and open negotiations with the bank for a waiver before the year end - a waiver obtained before the reporting date may preserve current classification.

Auditor's position

• Treat the proposed dividend and the reserve transfer as key audit matters; test distributable reserves and the articles; obtain the legal opinion.
• If the board proceeds, the financial statements are misstated (equity, liabilities, classification) and the matter is an indicator of management override; modify the opinion if uncorrected and material, and consider communication to those charged with governance.

1. Cash dividend limited to Rs 40 million. Lawful and simple; leaves no retained earnings, so the covenant is still breached - the bank must be approached for a waiver or the dividend deferred to the following year.

2. Bonus (capitalisation) issue using the revaluation surplus. This is the correct use of an unrealised reserve. A bonus issue converts reserves into paid-up share capital: shareholders receive shares, no cash leaves the company, no distributable profit is required and no covenant is affected. It gives shareholders a tangible return (more shares, potentially better EPS optics if earnings grow) without an unlawful distribution. The limitation is that it delivers no cash - it will not satisfy a shareholder who wants income.

3. Sell the land and distribute the realised gain. Converts the surplus into a realised profit that can lawfully be distributed, but the company loses an operating asset, incurs tax and transaction costs, and the timing is unlikely to be before the year end.

4. Negotiate the covenant and reduce the dividend. A waiver, or a covenant reset in exchange for a fee or higher margin, allows a lawful Rs 40 million dividend with headroom. It is the only option that both pays cash and keeps the loan as non-current.

Recommended sequence: seek the waiver first, pay up to Rs 40 million in cash if obtained, and use a bonus issue from the revaluation surplus to give shareholders the balance in a lawful form. Present all options to the board with the covenant and legal consequences quantified.