Profit Distribution and Payment of Profit Shares: Why a Positive Financial Result Is Not Enough #2

Profit distribution and the subsequent payment of profit shares are among the key decisions made by capital companies. Although at first glance this may seem to be merely a matter of distributing earned funds among shareholders, the legal framework sets out a number of conditions that must be met for such a decision to stand from both a legal and economic perspective.

Financial Statements as the Basic Requirement

The basic prerequisite for any decision-making on profit distribution is the approval of ordinary or extraordinary financial statements by the general meeting. Without this step, profit distribution cannot even be considered. The financial statements serve as the primary source of information on whether the company has actually generated a profit and what its amount is.

Test of the Maximum Amount Available for Distribution

Another important condition is compliance with the so-called test of the maximum amount available for distribution.

This amount includes the profit or loss for the current accounting period, retained earnings from previous years and, where applicable, other profit-based funds that the company may use for distribution. Conversely, accumulated losses from previous years and mandatory allocations to reserve or other funds required by law or the company’s constitutional documents must be deducted.

The result of this test is therefore the maximum amount that may be distributed. If the result is zero or negative, no profit may be distributed.

Compliance with the Balance Sheet Test

A separate requirement is compliance with the so-called balance sheet test, sometimes also referred to as the equity test. Its purpose is to prevent the company from weakening its equity below the legally protected threshold by distributing profit.

A company may therefore not distribute profit if its equity shown in the financial statements, or its equity after the profit distribution, would fall below the subscribed share capital increased by funds that may not be distributed under the law or the company’s constitutional documents.

Even if a certain amount is available for distribution under the test of the maximum amount available for distribution, it may still not be possible to distribute it if the balance sheet test is not satisfied.

Limitation Where Development Costs Are Recognised

If a company reports development costs among its assets, the unamortised portion of those costs reduces the amount of profit that may be distributed among the shareholders. The company may therefore distribute profit only if, and only to the extent that, a positive amount remains available even after those costs have been taken into account.

The purpose of this rule is to reflect the fact that development costs constitute an asset which, although it increases the accounting value of the company’s property, is not in itself a liquid resource. The rule thus prevents the distribution of profit that has effectively been “consumed” in development and is not covered by distributable funds.

No Insolvency as a Result of the Payment

Another basic condition is that the payment of profit, which is decided upon by the statutory body, must not cause the company’s insolvency.

It is therefore not sufficient to verify only whether the company has enough cash at a given moment to pay its currently due debts. The statutory body must also assess the expected development after the payment of profit, in particular whether the company will remain able to meet its obligations and whether the payment will not impair its overall financial stability.

If the payment of profit would lead to the company’s inability to pay its debts or to over-indebtedness, the profit must not be paid.

Audit of the Financial Statements: Is It Necessary to Wait?

The law does not expressly provide that profit may be distributed only on the basis of audited financial statements. The mere existence of an audit obligation therefore does not automatically mean that it is impossible to decide on profit distribution before the audit has been completed.

However, a decision on profit distribution adopted by the general meeting before completion of the audit may pose both legal and economic risks. The financial statements have not yet been verified by the auditor and the figures contained in them may subsequently be adjusted, for example, as a result of the creation of provisions, valuation allowances or other accounting adjustments.

If, after completion of the audit, it turned out that the statutory conditions for profit distribution had not been met, the general meeting’s decision on profit distribution might, to the relevant extent, have no legal effects. Profit should not be paid on the basis of such a decision; and if payment had already been made, this could give rise to consequences such as an obligation to return the payment and liability of the statutory body.

Although the law does not expressly impose an obligation to wait for the audit, in the case of audited companies it is standard practice, and also the safer approach, to decide on profit distribution only on the basis of audited financial statements.

Summary

In light of the above, profit distribution and the payment of profit shares are not merely a formality. They are decisions that must take into account not only the company’s economic situation, but also the legal rules protecting the company and its creditors.

The key conditions include, in particular, ordinary or extraordinary financial statements approved by the general meeting, compliance with the test of the maximum amount available for distribution and the balance sheet test, respect for the limitation relating to development costs, and ensuring that the payment does not cause the company’s insolvency. Only once all these conditions have been met may the company proceed with the distribution of profit and the subsequent payment of the profit share.