Tests for payment of profit sharing – are you certain you can pay?
Business entities, with the exception of non-profit organisations, perform their business activity mainly for the purpose of achieving profit. In the accounting, this profit represents profit/loss of the current period and profit/loss of previous year, which are part of own equity of the accounting entity. The economic result in the form of profit may be used in several ways. It can for example be left in the accounting entity, used for settling accumulated accounting losses from previous years or creating funds of profit. All of the options increase own equity of the accounting entity year on year. Another option is dividing the achieved profit by means of paying profit sharing, the so-called dividend. The distribution of the profit/loss is at the sole discretion of the partners (shareholders) at the general meeting, when the general meeting determines the amount of the approved profit/loss to be distributed among the partners or whether the profits of previous years will also be distributed. Act no. 90/2012 Coll., on Business Corporations and Cooperatives (the Business Corporations Act), hereinafter “the Act”, stipulates several conditions that the general meeting must meet when deciding about division of profit/loss and the statutory body when deciding on payment of profit. We will present these conditions in greater detail according to the legal situation applicable as from 1 January 2021.
Condition number one – balance sheet test
The balance sheet test is provided for in article 34 paragraph 2 of the Act. Using the balance sheet test, we will find the highest possible amount that can be divided between partners. This precaution aims to prevent danger to the stability of the accounting entity. The maximum amount of profit that can be divided among partners is calculated as follows:
Profit to be divided =
+ profit/loss of the last completed accounting period
+ profit/loss of previous years
+ divisible funds
- allocation to the fund of reserves in compliance with the law or the memorandum of association
- allocation to other funds in compliance with the law or the memorandum of association
If the amount specified by partners to be divided as profit sharing is not higher than the maximum calculated amount, then the first condition for payment is met. The test should be performed by partners before they suggest the amount of profit sharing to be paid. A decision from the general meeting that is in conflict with the above-mentioned rules, that is a decision about dividing a higher amount, does not have legal effect.
Article 40 paragraph 2 of the Act further states another entry for calculation of the balance sheet test. This complementation of the balance sheet test applies to companies, which post development costs in their balance sheet assets. Companies must not divide profit or other own funds, if the amount to be divided detected according to the balance sheet test under article 34 paragraph 2 of the Act does not equal the undepreciated part of development costs at minimum. The profit that can be divided between partners is lowered by the amount of undepreciated development costs.
Condition number two – equity capital test
The equity capital test is treated in article 40 paragraph 1 of the Business Corporations Act. This stipulation says that it is not possible to divide profit or other own funds of an accounting entity in case the value of equity capital is lower than the value of subscribed registered capital raised by non-distributable funds or if payment of profit sharing would cause such a fact.
In the case the accounting entity will have equity capital higher than registered capital including non-distributable funds even after the payment of profit sharing, then the second condition for payment of profit sharing is also met. This test, too, should be performed by partners prior to deciding on profit sharing. Same as in case of the balance sheet test condition, a decision of the general meeting does not have legal effect if the condition is not met. In such a case, the amount of profit sharing should be lowered or a decision on profit sharing should not be made at all.
Condition number three – solvency test
The third and final condition necessary for responsible payment of profit sharing or advance on profit sharing is the solvency test, which is treated in article 40 paragraph 3 of the Business Corporations Act. This stipulation says that profit sharing cannot be paid if the company would thereby bring bankruptcy upon itself. This test does not govern the conditions of profit division, which is in the competence of the general meeting, but the conditions of payment itself, which is within the competence of the statutory body.
A definition of bankruptcy can be found in act no. 182/2006 Coll., the Insolvency Act. Article 3 of the Insolvency Act explicitly specifies the conditions, the fulfilment of which may qualify the economic situation of the accounting entity as bankruptcy. This is a situation, so-called insolvency, when the accounting entity has multiple creditors and financial liabilities more than 30 days past maturity. It is not capable of performing (settling) these liabilities on grounds of suspension of payments (the company does not have financial resources for payment of liabilities), or has not been performing them for a period of more than 3 months past maturity. The impossibility of satisfying the obligations by enforcement or distrainment is also considered inability to perform. Over-indebtedness, which is a second form of bankruptcy, is also considered bankruptcy and is characterised by a situation, where the company has multiple creditors (a minimum of 2) and the total of all of its liabilities (due and past due) exceeds the value of its assets.
The insolvency test should already be in the competence of the statutory body of the company, which is also responsible for checking the accuracy of the balance sheet test and the equity capital test in order to ensure that the general meeting has not divided a larger part of the profit/loss than it was allowed to, according to the tests. The statutory body should perform this entire agenda (checking the calculation of the balance sheet test, the equity capital test and the solvency test) prior to paying profit sharing or advance on profit sharing. The statutory body is obliged to act with due managerial care and diligence and in case the company does not have sufficient financial means or if payment of profit sharing would perceptibly lower the volume of financial resources needed for ensuring the economic activities of the accounting entity, it should not issue instruction for payment of profit sharing to partners and should postpone payment until the time that the accounting entity will have financial resources available, or it is possible to pay profit sharing in instalments, which will not represent such a financial burden for the accounting entity. According to the Act, profit sharing is in general to be paid within 3 months from the day, on which the related decision of the highest authority of the accounting entity was adopted, and this due date may be adjusted by means of the memorandum of association or by specification of the highest authority of the company.
In case the executive head causes bankruptcy or insolvency of the accounting entity by permitting payment of profit sharing or advance on profit sharing approved at the general meeting, this action may be qualified as failure to exercise due care and in compliance with applicable legislation the statutory authority would then be liable for incurred loss (damage).
Condition number four – record in the Beneficial Ownership Register
Act no. 37/2021 Coll. on Registration of Beneficial Owners, effective from 1 June 2021, brought a new condition for payment of profit sharing. This act forbids a trade corporation to pay profit sharing (an advance profit sharing) to a natural person, if it is not registered in the Beneficial Ownership Register (hereinafter “the register”) as a beneficial owner. It also forbids payment of profit sharing to a legal entity (or trust fund), which does not have its beneficial owner recorded in the register. Prior to paying profit sharing (pr advance profit sharing), the statutory body should always check if the condition of record in the register has been met.
Are you preparing to pay profit sharing or advance profit sharing to owners at present or in the near future? Do you perform the above-mentioned tests? If you have questions regarding this issue from the accounting, tax or legal perspective, please, turn to our company. We will be happy to provide related support to you including calculation of the given tests as a source document for the decision of the highest authority of your accounting entity.