🧪 Solvency Test: Understanding the Assets vs. Liabilities Requirement

To make a legal distribution (e.g., a dividend), a company must pass the Solvency Test.

This test has two parts:

1. 📆 Liquidity Test: The company must be able to pay its debts as they fall due over the next 12 months.
2. 🧮 Balance Sheet Test: The value of the company’s assets must be greater than the value of its liabilities—after the distribution is made.

Sounds simple, right? But here’s where it gets more technical…

🎓 What Are Preferential Returns on Shares?

🔍 Definition:

Preferential returns refer to special rights granted to certain shareholders (usually preference shareholders) to receive:

• A fixed dividend (e.g., 8% annually), and/or
• Priority in return of capital during liquidation.

These shareholders get paid before ordinary shareholders.

🧾 Why Are Preferential Returns Counted as “Debts” in the Solvency Test?

When applying the solvency test for a distribution, the law says:

“Debts” include fixed preferential returns on shares ranking ahead of those in respect of which a distribution is made…

That means:

• If you’re planning to distribute dividends to ordinary shareholders, and
• There are preference shareholders entitled to fixed returns before them,
• Then those fixed returns must be treated like liabilities, even if you haven’t paid them yet.

This is important because:
✅ It prevents companies from giving profits to ordinary shareholders before settling fixed obligations to preference shareholders.
⚠️ Ignoring these returns can cause false solvency and lead to illegal distributions.

🛑 Exception: When Preferential Returns Don’t Count as Debts

“…except where the fixed preferential return is expressed to be subject to the power of the board to authorise distributions.”

This exception means:

• If the company’s Articles of Association or terms of issue for preference shares state that the board has full discretion on whether to pay or skip the return,
• Then those fixed dividends are not automatically considered debts.

✅ Example:

📊 Real-Life Scenario: Let’s Break It Down

Imagine a company with this structure:

• Assets: Rs. 20 million
• Liabilities: Rs. 10 million
• Preference shares: Rs. 5 million with a fixed 10% return annually
• Planning to distribute: Rs. 3 million dividend to ordinary shareholders

🔍 Scenario A: Preference dividends are mandatory

• The Rs. 500,000 (10% of 5M) fixed return is a debt.
• Total liabilities = Rs. 10M (normal) + Rs. 500,000 (preference dividend) = Rs. 10.5M
• After distributing Rs. 3M, if assets drop to Rs. 17M
  ✅ Assets (17M) > Liabilities (10.5M) → Solvency Test passed

🔍 Scenario B: Preference dividends are discretionary (subject to board approval)

• The Rs. 500,000 is not counted as a debt.
• Liabilities stay at Rs. 10M
• After distribution: Assets = Rs. 17M
  ✅ Assets (17M) > Liabilities (10M) → Solvency Test easily passed

🎯 Key Insight: How you define preference shares in your company’s constitution or terms of issue directly impacts the legal ability to make distributions.

⚖️ Why This Matters

If a company illegally declares a dividend while technically insolvent (by ignoring mandatory preferential returns):

• Directors can be held personally liable,
• Distributions may need to be repaid by shareholders,
• The company may face fines or penalties under Section 56(5).

✅ Action Points for Business Owners

1. Review your company’s preference share terms. Are fixed returns mandatory or discretionary?
2. Before making any distribution, ask your accountant or legal team to:
   • Run the full solvency test (with preferential returns included, if applicable),
   • Secure a solvency certificate from the auditors,
   • Prepare and sign the directors’ solvency statement.
3. Document everything. Keep board resolutions, certificates, and financial statements as proof of compliance.