Accounting 

Ground-breaking ruling: usability of financial statements in deciding on profit distribution

In its ruling of March 2019, the Supreme Court allowed the use of ordinary or extraordinary financial statements as a basis for the payment of profit shares until the end of the following reporting period. This broke the previously required six-month limit for the usability of financial statements as a basis for the payment of profit shares.

The earlier legal regulation contained in the Commercial Code set a six-month period starting with the end of the fiscal year when the general meeting had to approve the company’s financial statements. The Commercial Code did not specifically determine a period within which the general meeting had to decide on the distribution of profit. The case law of the Supreme Court, contained e.g. in ruling no. 29 Cdo 4284/2007 of 30 September 2009, inferred that particularly in order to protect creditors, “the ordinary financial statements prepared for the previous reporting period could not be used as a basis for profit distribution after the end of the period set for calling the general meeting for the purposes of discussing the ordinary financial statements.” The arguments were based on the fact that an older set of financial statements no longer had sufficient informative value to provide a realistic view of the company’s financial situation based on which shareholders could make a qualified decision about profit distribution.

This ruling was criticised by many experts; however, it continued to be respected in practice even after 1 January 2014, when the Business Corporations Act came into force. Companies therefore often chose to make profit share prepayments after the end of the six-month period.

A turn in this interpretation came only with ruling no. 27 Cdo 3885/2017 of 27 March 2019. In this ruling, the Supreme Court explained the changes in the legal regulation of the distribution of profit of a joint stock company brought by the Business Corporations Act compared to the regulation contained in the Commercial Code.

The Supreme Court addressed in particular the following three matters:

  1. Decisions of the general meeting on the distribution of profit and relation to the usability of the financial statements;
  2. Interpretation of the required elements of the invitation to a general meeting; and
  3. Compliance of the general meeting’s decision with good morals.

The next part of this article will deal only with the first item.

Usability of the financial statements for the pervious reporting period

First of all, the Supreme Court stated that the legal regulation of profit distribution of a joint stock company had undergone several changes with effect from 1 January 2014, and it was therefore impossible to automatically apply the judiciary conclusions adopted in the interpretation of the Commercial Code.

Although the Business Corporations Act (“BCA”) stipulates that a profit share shall be determined based on ordinary or extraordinary financial statements approved by the highest body of the business corporation (Section 34 (1) of the BCA) and simultaneously regulates the period for discussing the ordinary financial statements of a joint stock company (Section 403 (1) of the BCA), the previous case law related to the Commercial Code can no longer be applied. This is the case because the Business Corporations Act – unlike the Commercial Code – explicitly regulates the “insolvency test” (Section 40 (1) of the BCA), which should be sufficient for achieving the goal of preventing the payment of profit shares “to the detriment” of the Company’s creditors.

In addition, it is also necessary to take into consideration the fact that based on the Business Corporations Act, the rule of the “limited usability” of the ordinary financial statements for the distribution profit based on the case law can be easily circumvented if the company issues shares with fixed profit shares. The right to a fixed profit share for the preceding reporting period arises as of the first date of the following reporting period as long as profit was generated in the preceding period. Shareholders holding shares with fixed profit shares will therefore receive a fixed profit share regardless of whether and when the general meeting makes a decision about profit distribution.

According to the Supreme Court, “with effect from 1 January 2014 the ordinary financial statements prepared for the previous reporting period can therefore serve as a basis for profit distribution until the end of the next reporting period.”

In this respect it is a breakthrough ruling which will make it possible for the general meeting to make a decision about profit distribution at any time during the entire subsequent reporting period, provided that the company meets the insolvency test and would not bankrupt itself by paying out profit.

Payment of director’s fees without profit distribution to shareholders

The Supreme Court additionally addressed the matter of impossibility to pay out director’s fees unless profit is paid out to shareholders. At the time of validity of the Commercial Code, a rule applied that the general meeting could not determine the profit share of members of the Board of Directors and Supervisory Board (director’s fees) without approving profit for distribution and the shares of shareholders in the profit determined in this way (dividends). According to the Supreme Court, “with effect from 1 January 2014 the general meeting may also decide on the distribution of profit by distributing its part in the form of director’s fees to the members of elected bodies (provided that this is allowed by the company’s articles of association), or allocating it to a fund established by the articles of association and created from profit, and keeping the rest in retained earnings; however, the non-distribution of the remaining portion of profit has to be duly justified.” A valid reason for not distributing (a portion of) profit among shareholders can be (for example) a provision contained in the articles of association, regulating the handling of the company’s profits.

Amendment to the Business Corporations Act

The anticipated draft amendment to the Business Corporations Act that should come into force on 1 January 2020 explicitly states, in reaction to the new case law of the Supreme Court of the Czech Republic, that profit determined based on ordinary or extraordinary financial statements can be paid out until the end of the reporting period following the reporting period for which the financial statements are prepared.

It also limits the level of profit share prepayments to the half of the average profits achieved in the last three reporting periods.

The full text of the Supreme Court’s ruling is available here.

Source: www.nsoud.cz

The article is part of dReport – September 2019, Accounting news.

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