Declaration and Payment of Dividends: Understanding Section 123

Dividends represent a slice of a company’s profits shared with its owners, the shareholders. For shareholders, receiving dividends is a rewarding aspect of their investment, offering a return on their trust and capital. For businesses, distributing dividends often signals financial stability and success, boosting investor confidence. However, this distribution isn’t arbitrary; it’s carefully regulated in India. The core of this regulation lies within the Indian legal framework for dividends. Understanding the rules surrounding the declaration and payment of dividends is absolutely essential – for companies to ensure legal compliance and avoid penalties, and for shareholders to understand their rights and tax obligations.

This blog post aims to demystify the key regulations governing dividends in India. We will delve into Section 123 of the Companies Act, 2013, the primary legislation on this topic. Our goal is to simplify and explain the essential aspects of everything about Section 123 dividends in India, covering the process, permissible sources, mandatory conditions, timelines, and compliance requirements. For those interested in the intricacies of company registration, you can explore Company Registration in India.

What is Section 123 of the Companies Act, 2013?

Section 123 of the Companies Act, 2013 is the specific provision within India’s corporate law that lays down the rules and procedures for how companies registered in India can declare and distribute dividends to their shareholders. Think of it as the official rulebook for sharing profits. Its main purpose is to ensure that the process of declaration and payment of dividends is conducted fairly, transparently, and responsibly. This involves ensuring that dividends are paid only out of genuine profits or specified reserves, thereby safeguarding the company’s financial health (solvency) and protecting the interests of creditors and shareholders alike. Understanding Section 123 of dividends is therefore fundamental for any company operating in India that intends to reward its shareholders through dividends, as it applies universally to all such companies.

Sources for Declaring Dividends Under Section 123

Section 123 strictly defines the sources from which a company can legally pay dividends. Using funds from other sources is generally not permitted. The dividend declaration process India must adhere to these limitations:

From Current Year’s Profits

The most common source for dividends is the profit earned by the company during the current financial year. However, this isn’t simply the raw profit figure. Before declaring dividends from current profits, the company must calculate this profit after accurately accounting for and deducting:

• Depreciation: As per the provisions of Schedule II of the Companies Act, 2013.
• Taxes: Applicable corporate taxes for the year.

Only the remaining profit after these deductions is available for potential dividend distribution from the current year’s earnings.

From Past Accumulated Profits (Reserves)

A company can also declare dividends out of profits earned in previous financial years that were not distributed and have been accumulated over time. These are often referred to as ‘accumulated profits’ or ‘free reserves’. However, declaring dividends from past reserves, especially if the company has inadequate or no profits in the current year, comes with specific conditions outlined in Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014:

• Rate Limit: The rate of dividend declared cannot exceed the average of the rates at which dividends were declared by the company in the three immediately preceding financial years. (This condition doesn’t apply if the company hasn’t declared any dividend in the past three years).
• Withdrawal Limit: The total amount drawn from such accumulated profits cannot exceed 10% of the company’s paid-up share capital plus its free reserves as per the latest audited financial statement.
• Utilization of Withdrawal: The amount drawn must first be used to set off any losses incurred in the financial year in which the dividend is declared before distributing any dividend.
• Remaining Reserve Balance: After withdrawing the amount for dividend distribution, the balance of reserves must not fall below 15% of the company’s paid-up share capital as per its latest audited financial statement.

From Money Provided by Government

In some specific cases, dividends can also be paid out of money provided by the Central Government or a State Government for this purpose, usually in pursuance of a guarantee given by that government. This is a less common source compared to profits and reserves.

Key Conditions for Declaration and Payment of Dividends

Beyond having permissible sources, companies must satisfy several mandatory conditions before they can proceed with the declaration and payment of dividends. These conditions enforce financial discipline and protect the company’s long-term stability. Key Indian companies dividend payment rules include:

Provision for Depreciation

This is a non-negotiable requirement. Before declaring any dividend (whether from current or past profits), the company must provide for depreciation for the current financial year according to Schedule II of the Act. Furthermore, if there are any arrears of depreciation (depreciation not provided for in previous years), those must also be provided for out of the current year’s profit or past reserves before declaring dividends.

Setting Off Past Losses

Financial prudence dictates that past wounds must be healed before distributing profits. Section 123 mandates that any losses incurred by the company in previous financial years or any unabsorbed depreciation from previous years must be set off against the profits of the current year before any dividend can be declared. This ensures dividends are paid from true distributable profits.

Transfer to Reserves (Optional)

Previously, the Companies Act, 1956 mandated that companies transfer a certain percentage of their profits to reserves before declaring dividends. However, under the Companies Act, 2013, this requirement has been made voluntary. Companies are now free to decide, at the discretion of their Board of Directors, whether or not to transfer any portion of their profits to reserves before declaring dividends. This provides greater flexibility but also places more responsibility on the Board to ensure adequate reserves are maintained for future needs. Compliance with Section 123 dividends India still requires careful consideration of reserve levels, even if transfers aren’t mandatory. Businesses looking to further understand corporate structures may find the article on Comparing Business Structures insightful.

Free Reserves Definition

When dividends are declared out of accumulated past profits, the term ‘free reserves’ becomes critical. Free reserves generally mean those reserves which, as per the latest audited balance sheet of a company, are available for distribution as dividend. Importantly, this typically excludes amounts like:

• Any amount representing unrealized gains, notional gains, or revaluation of assets.
• 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.

Only genuinely realized, distributable profits accumulated over time qualify.

The Dividend Declaration Process in India

The legal process dividends India follows involves specific steps and approvals, differentiating between final and interim dividends. Understanding this dividend declaration process India is crucial:

Board Recommendation (Final Dividend)

The process for a final dividend usually begins after the financial year ends and the accounts are audited.

1. The Board of Directors meets to review the company’s financial performance.
2. They assess the profits available for distribution after considering depreciation, past losses, and future needs.
3. If they decide to distribute dividends, the Board determines the rate (e.g., ₹X per share or Y% of face value) of the final dividend they wish to recommend.
4. This recommendation is then included in the Directors’ Report presented to the shareholders.

Shareholder Approval in AGM (Final Dividend)

The Board’s recommendation is just that – a recommendation. The actual declaration power for a final dividend rests with the shareholders.

1. The recommended dividend is proposed as an agenda item at the company’s Annual General Meeting (AGM).
2. Shareholders vote on the proposal, typically through an ordinary resolution (requiring a simple majority).
3. Crucially: Shareholders can approve the rate recommended by the Board, or they can approve a lower rate. They cannot approve a dividend rate higher than what the Board recommended.
4. Once approved by shareholders at the AGM, the final dividend is formally ‘declared‘.

Declaration of Interim Dividend

Companies can also choose to pay dividends during the financial year, before the final accounts are ready. This is known as an interim dividend.

1. The Board of Directors has the authority to declare an interim dividend at any time between two AGMs.
2. This declaration is made out of the surplus in the profit and loss account or out of profits generated in the financial year until the quarter preceding the date of declaration.
3. Important Difference: Shareholder approval is not required at the time the Board declares the interim dividend. However, the Board must ensure the company’s financial position justifies the payment and should consider the full year’s likely financial performance.
4. The amount of interim dividend paid is typically presented for noting/confirmation in the subsequent AGM.

Timelines and Payment Regulations for the Declaration and Payment of Dividends

Once a dividend (final or interim) is declared, strict timelines and dividend payment regulations India kick in, primarily governed by Sections 123 and 127 of the Act. Adherence is critical for compliance with Section 123 dividends India.

Deposit into Separate Bank Account

Within five days from the date of declaration (the date of the AGM for final dividend, or the date of the Board meeting for interim dividend), the company must deposit the total amount of dividend payable into a separate bank account maintained with a scheduled bank. This account should be specifically earmarked, often named “[Company Name] – Dividend Account”. This ensures funds are ring-fenced for shareholder payments.

Payment to Shareholders

The company must pay the declared dividend to the entitled shareholders within thirty days from the date of declaration. This is a strict deadline. The payment must be made to the shareholder whose name appears on the company’s register of members on the ‘record date‘ or to their order or their banker.

Modes of Payment

Section 123 stipulates acceptable modes for dividend payment:

• Cheque or Dividend Warrant: A physical instrument sent to the shareholder’s registered address.
• Electronic Mode: Direct credit to the shareholder’s bank account through methods like NEFT, RTGS, IMPS, etc.

Payment of dividends in cash is generally prohibited. Companies usually request shareholders update their bank details to facilitate electronic payments, which are faster and more secure.

Handling Unpaid/Unclaimed Dividends (Briefly mention Section 124)

What happens if a dividend isn’t paid or claimed within the 30-day window?

1. Any dividend that remains unpaid or unclaimed after 30 days from declaration must be transferred by the company to a special account called the “Unpaid Dividend Account” (UDA).
2. This transfer must happen within seven days from the expiry of the initial 30-day period.
3. The company must also prepare a statement containing details of the shareholders whose dividends are unpaid/unclaimed and place it on its website and on a government-specified website.
4. If the dividend remains unclaimed in the UDA for seven consecutive years from the date of transfer, the company must transfer the amount, along with the shares pertaining to that dividend, to the Investor Education and Protection Fund (IEPF) established by the Central Government. Shareholders can later claim their rightful dividends/shares from the IEPF Authority following a prescribed procedure. See IEPF Authority Website for details.

Consequences of Non-Compliance with Section 123 & 124

The Companies Act, 2013 treats non-compliance with dividend regulations very seriously. Failure to adhere to the rules regarding the declaration and payment of dividends, especially the timelines, can lead to significant penalties under Section 127.

• Penalties on the Company: If a declared dividend is not paid or the dividend warrants are not posted within 30 days of declaration, the company becomes liable to pay simple interest at the rate of 18% per annum for the period of default.
• Penalties on Directors/Officers: Every director of the company who is knowingly a party to the default in payment within the stipulated time can be subject to punishment. This includes:
  • Imprisonment: Which may extend up to two years.
  • Fine: Which shall not be less than one thousand rupees for every day during which such default continues.

These stringent penalties underscore the importance of meticulous compliance with Section 123 dividends India. Companies must ensure robust internal processes to manage dividend declaration and payment accurately and on time. If you’re a small business owner looking to integrate best practices, refer to Set Up An Accounting System for My Small Business.

Impact on Shareholders (Small Business Owners & Salaried Individuals)

For shareholders, including small business owners who hold shares and salaried individuals investing in the stock market, understanding dividends involves knowing how they are taxed and reported.

Taxation of Dividends

This is a critical area that saw a major change with the Finance Act, 2020.

• Abolition of DDT: Prior to April 1, 2020, companies were liable to pay a Dividend Distribution Tax (DDT) on dividends declared, and the dividend received was generally tax-free in the hands of shareholders (subject to certain limits).
• Dividends Now Taxable for Shareholders: DDT has been abolished. Now, dividend income is taxable in the hands of the shareholders.
• How it’s Taxed: The dividend received is added to the shareholder’s total income for the financial year and taxed at the applicable income tax slab rates relevant to that individual or entity. Whether you are a small business owner or a salaried individual, the dividend income gets clubbed with your other income (like salary, business profit, capital gains, etc.) to determine your final tax liability.
• TDS on Dividends (Section 194): To ensure tax compliance, the company paying the dividend is now required to deduct Tax at Source (TDS) if the dividend amount paid to a resident individual shareholder exceeds ₹5,000 in a financial year. The standard TDS rate is typically 10% (unless a higher rate applies due to non-furnishing of PAN). The company deposits this TDS with the government, and the shareholder can claim credit for it when filing their tax return. For detailed information on TDS rates and rules, you can refer to the Income Tax India Website.

Receiving and Reporting Dividend Income

As dividend income is now taxable, shareholders must be diligent:

• Track Dividend Income: Keep a record of all dividends received during the financial year from different companies. Form 26AS available on the income tax portal usually reflects TDS deducted on dividends, which can help track this income.
• Report in ITR: Ensure that all dividend income is accurately reported under the head ‘Income from Other Sources’ when filing your Income Tax Return (ITR). Failing to report this income can lead to scrutiny and penalties from the tax department. Salaried individuals often receive Form 16 for their salary income, but they must separately account for other income sources like dividends.

Conclusion

The declaration and payment of dividends is a vital corporate action, reflecting a company’s success and rewarding its investors. Section 123 of the Companies Act, 2013 provides a comprehensive framework for this process in India. We’ve seen that it strictly governs the sources (current profits, past reserves under specific conditions), mandates prerequisites (like accounting for depreciation and past losses), details the declaration process (Board recommendation followed by shareholder approval for final dividends; Board power for interim dividends), and enforces strict timelines (deposit within 5 days, payment within 30 days) and payment methods. Understanding Section 123 of dividends and adhering to its provisions, including the rules for handling unclaimed dividends under Section 124 and the implications of Section 127 for non-compliance, is critical for good corporate governance and maintaining stakeholder trust. These Section 123 dividend declaration insights highlight the balance the law seeks between rewarding shareholders and ensuring corporate financial health.

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Frequently Asked Questions (FAQs)

• Q1: Can a company declare dividends if it has incurred losses in the current financial year?

  A: Yes, potentially. While dividends cannot be paid from current year losses, a company can declare dividends out of its accumulated past profits (free reserves) even if it has incurred losses in the current financial year. However, it must strictly adhere to the conditions specified in Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014, concerning the rate of dividend, withdrawal amount, utilization, and remaining reserve balance.

• Q2: What is the main difference between an interim dividend and a final dividend?

  A: The main differences lie in timing and approval. An interim dividend is declared and paid during the financial year (between two AGMs) solely by the Board of Directors, usually based on profits earned up to the preceding quarter. A final dividend is recommended by the Board after the financial year ends and the accounts are finalized, but it must be formally declared (approved) by the shareholders at the Annual General Meeting (AGM). The dividend declaration process India therefore varies slightly.

• Q3: Who is liable if a company fails to pay declared dividends within the stipulated 30 days?

  A: If a company defaults on the declaration and payment of dividends timeline (fails to pay within 30 days of declaration), the company itself is liable to pay simple interest at 18% per annum for the period of default. Additionally, under Section 127 of the Companies Act, 2013, every director who is knowingly a party to the default can face penalties, which may include imprisonment for up to two years and a minimum daily fine for the duration of the default.

• Q4: How are dividends taxed for shareholders in India after 2020?

  A: Since the abolition of the Dividend Distribution Tax (DDT) effective April 1, 2020, dividend income is fully taxable in the hands of the shareholder receiving it. The dividend amount is added to the shareholder’s total income and taxed according to their applicable income tax slab rate. The paying company is also required to deduct Tax at Source (TDS) under Section 194 if the dividend amount paid to a resident individual exceeds ₹5,000 in a financial year.

• Q5: Is it mandatory for a company to transfer a portion of its profits to reserves before declaring dividends?

  A: No, it is no longer mandatory under the Companies Act, 2013. While the previous Companies Act, 1956 had such requirements, the current law leaves the decision to transfer profits to reserves entirely at the discretion of the company’s Board of Directors. They can choose to transfer any amount or no amount to reserves before declaring dividends, based on their assessment of the company’s financial position and future needs.