When the board of Nestlé India Ltd meets on 19th October, it may declare an outsized interim dividend, larger than the largesse it doles out multiple times each year.
The reason that this time it could be more than the normal bonanza for the shareholders is that the company has, by virtue of an order passed on 15 September 2023 by the national company law tribunal (NCLT), wiped out the whole of Rs837.43 crore in the credit of the general reserve and added it to the retained earnings.
Nestlé, in this regard, follows the footsteps of a few notable cases like Hindustan Unilever Ltd (HUL) which did a similar exercise in financial year (FY)18-19 and transferred the entire general reserve of Rs2,187 crore to retained earnings.
Another company to follow the scheme of arrangement route to exhaust the amount in general reserve is Britannia Industries Ltd. During the FY21-22, the general reserve of Rs871.80 crore was utilised to issue bonus debentures together with the applicable tax on such distribution.
The term ‘general reserve’ is so ingrained in most accountants’ consciousness that it going extinct like a dinosaur may leave at least some of that tribe in shock!
Under the company law, which was in force before the 2013 version took over, companies had an obligation to transfer some portion of the profits to general reserve, depending on the extent of the dividend declared each year.
The purpose of a mandatory reserve creation was mainly to prevent the erosion of the capital framework and keep aside some provenance for a rainy day, like a sudden tax demand or a big reversal in the business situation.
The new law did away with this requirement and also omitted to deal with the fate of the past reserves created. Hence, it is now quite prevalent that companies that accumulated reserves in the past, due to the compulsory transfer rule, are seeking to reverse it to the retained earnings.
Such cases seem to be more among companies that have a majority foreign ownership, like Nestlé, HUL and Britannia.
These companies have a policy that mandates the distribution of a substantial part of the annual profits as dividends, like the 97% that Nestlé adopts.
There are essentially three reasons for such high distribution.
First, companies in the capital-light sectors or fast-moving consumer goods (FMCG) are not making major capital investments.
Taking Nestlé as an example, the aggregate profit after tax (PAT) for the five years between calendar year (CY)2018 and CY2022 is Rs10,165 crore. The net addition to the fixed assets (netblock) during this period is less than 8% of this figure. Whereas the total dividend paid during this time is Rs8,130 crore as a regular dividend and Rs2,340 crore as a special dividend (together with dividend distribution tax - DDT)!
Secondly, the tax law favours such distribution by applying a lower rate of tax on dividends earned by the non-residents. In Nestlé’s case, the dividends distributed between CY2015 and 2019 was approximately 71% of the current profits, excluding the one-off paid in 2019.
Once DDT was abolished in 2020, in the three years between 2020 and 2022, the distribution ratio jumped to 89% on a cumulative basis.
The third reason is to protect against currency fluctuation and depreciation in the Indian rupee. Leaving the money on the Indian books with no end-use in sight has consequences for the parent in erosion, and poor alternative safe return options.
Another company that has set new benchmarks in dividend distribution is Hindustan Zinc Ltd, substantially owned by Vedanta Ltd and, ultimately, by the parent overseas.
HZL has almost emptied the past retained earnings and has now initiated a scheme of arrangement to convert the past general reserves of Rs10,283 crore to retained earnings to qualify for distribution once it is approved.
The scheme filed by the company is under process before the NCLT. The observations of the Securities and Exchange Board of India (SEBI), when the approval of the stock exchanges was sought for the scheme, raised doubts about the validity of such transfers from the past reserves even after the introduction of the Companies Act 2013.
Some of the important observations of SEBI, which were communicated by the stock exchanges to the company, are extracted to appreciate the line of argument of the regulator- (The number in each para is the number assigned to the point in the original letter extracted here)
10. Consequently, the limited freedom given to Companies through the Companies Act, 2013, is with respect to whether or not profits may be transferred to reserves, and not an untrammeled right to utilize the already existing compulsorily transferred reserves in total disregard to the restrictions on usage as contained in the Companies (Declaration and Payment of Dividend) Rules, 2014.
11. In a nutshell, the prospective nature of the Section 123 of the Companies Act, 2013 as well as the retention of restrictions on payment of dividend out of accumulated reserves as enshrined in the Companies (Declaration and Payment of Dividend) Rules, 2014, suggests that the lawmakers had neither intended unrestricted use of accumulated profits to pay dividend, nor transfer of reserves to P&L account to possibly pay dividend in this circumlocutory manner. Thus, the conduct of the Company may be at variance with the spirit of the law.
12. Once the Scheme is permitted, Hindustan Zinc Limited, is free to use the money liberally disregarding the conservative policies as are contained in Companies (Declaration and Payment of Dividend) Rules, 2014.
13. Also, in the instant case, it has not been specified how shareholder value is intended to be created. Such vagueness of purpose and conduct of the management with respect to the possible usage outlined in the paras above, may not be in the interest of shareholders.
14. In view of the above, the proposed Scheme may not be justified, both from the legal and the corporate governance point of view.
The company had responded to the reservations expressed by the stock exchanges by citing the other cases (Hindustan Unilever and Nestlé India) where no such objection was raised by the regulator.
By all accounts, HZL’s case should get approved, as the exchanges have backtracked the objections initially raised. The scheme has also been approved overwhelmingly by the shareholders which includes the government of India that owns about 29.52% of the shares.
In such corporate actions, the role of the independent directors needs to be appraised. In most of these cases, the compulsions and the dictate of the foreign parent prevail. Dividend distribution is finally decided upon by the shareholders and with the parent being the majority holder, its writ runs.
This is a corporate action where the minority may have little to complain about as they also get a share of the distribution periodically. However, in the case of resident HNI (high net-worth individuals) investors, such high distributions get taxed at the highest rate and, therefore, companies that are majority-owned by resident investors prefer a share buyback than dividend.
Cash-rich companies like TCS and Infosys use periodic buyback to return cash and have wiped out their past reserves for this purpose and did not go through the exercise that MNC (multi-national corporation) subsidiaries did.
On a different footing, Tata Power Ltd, under a scheme of arrangement in FY20-21, transferred the entire balance of Rs3,854 crore from its general reserve to retained earnings to offset the impairment in the investments in a subsidiary that was merged into the parent.
The biggest Indian company that normally pioneers the practices on corporate actions, Reliance Industries, has more than Rs2,62,000 crore as general reserves. For the promoters of Reliance, both buyback and dividends would not make sense and, hence, the money is tightly held within!
Interestingly, two subsidiaries with majority foreign ownership, Siemens and Pfizer, have notes in their accounts professing that amounts in ‘general reserve’ are available for distribution as dividend. The notes extracted may be of interest to other companies that wish to use the general reserve without any limitation
General reserve was created out of profits earned by the Company by way of transfer from surplus in the statement of profit and loss. The Company can use this reserve for payment of dividend and issue of fully paid-up shares. As General reserve is created by transfer on one component of equity to another and is not an item of other comprehensive income, items included in the General reserve will not be subsequently reclassified to statement of profit and loss. (Siemens)
General reserve forms part of the retained earnings and is permitted to be distributed to shareholders as part of dividend. (Pfizer)
However, another MNC subsidiary, Colgate Palmolive Ltd, takes a different view of the matter.
(Under the erstwhile Companies Act 1956, general reserve was created through an annual transfer of net income at a specified percentage in accordance with applicable regulations. Consequent to introduction of Companies Act 2013, the requirement to mandatorily transfer a specified percentage of the net profit to general reserve has been withdrawn. However, the amount previously transferred to the general reserve can be utilised only in accordance with the specific requirements of Companies Act, 2013)
General reserve played a crucial role when the surtax system existed till 1989. In computing the excess profits, a deduction was allowed on the share capital and general reserves, but not on retained earnings.
Corporate profits have surged in recent years, especially after the pandemic. However, the corporate tax cuts introduced in 2019 have dented the overall growth in corporate tax (CT) collections..
CT collections of CAGR (compounded annual growth rate) of 9.54% in the four years between 2018-19 and 2022-23(RE) is marginally short of the CAGR of the GDP of 9.75%, reflecting a lower buoyancy.
If the PLI (production linked incentive ) allocation in the Budget of Rs1.62trn (trillion) is viewed as a negative taxation (subsidy), the corporates’ contribution to the economy may look a lot poorer!
Experts should examine if there is a case to revisit the imposition of some levy similar to surtax on companies that earn super profits but do not reinvest in business.
At the other end of the spectrum are companies like, Abbot, Carborundum Universal, GSFC, MRF, Ramco Cement, Sundram Fasteners, Tamil Nadu News Print and TTK Prestige that still transfer annually a portion of the retained earnings to general reserve, though there is no statutory requirement at all!
Is this a conscious board decision that is not specifically annotated in the board report, or has the ERP (enterprise resource planning) programmed for auto-transfer not been disabled after 2014?
(Ranganathan V is a CA and CS. He has over 43 years of experience in the corporate sector and in consultancy. For 17 years, he worked as Director and Partner in Ernst & Young LLP and three years as senior advisor post-retirement handling the task of building the Chennai and Hyderabad practice of E&Y in tax and regulatory space. Currently, he serves as an independent director on the board of four companies)