The Reserve That Isn't There: Testing a Subsidiary's Distributable Profits Before the Dividend Is Declared

The pattern is familiar in multi-entity groups. Treasury identifies surplus cash in a trading subsidiary, the parent's funding committee decides to upstream it, the payment goes out, and the supporting paperwork is assembled afterwards by someone working backwards from the bank statement. The resolution is dated to the payment date, the minute records that the directors considered the position to be satisfactory, and the file is closed. Nothing in that sequence is necessarily wrong. But it is a sequence in which the evidential burden is discharged last, by people who did not make the decision, on the basis of a conclusion already reached.

Company law does not work in that order. Under Part 23 of the Companies Act 2006, a distribution is only lawful if the paying company has profits available for the purpose at the time the distribution is made, and the directors who declare it are the ones who carry the consequence if it is not. The group's consolidated strength is irrelevant to that test. So is the parent's willingness to stand behind the subsidiary. The question is narrower and considerably less comfortable: at the moment of declaration, did this company, on its own accounts, have realised profits not previously distributed?

The group balance sheet is the wrong starting point

Consolidation eliminates intra-group balances and aggregates the results of every entity in the perimeter. It is an appropriate document for shareholders and lenders assessing the group as a whole. It is not evidence of anything about a single subsidiary's distributable reserves, and treating it as a proxy is the most common root of the problem.

The distinction bites hardest in three structures. In a holding company chain, the intermediate entity's own reserves may be modest even where the sub-group beneath it is profitable, because the profits sit two levels down. Where a subsidiary has historically been capitalised by debt rather than equity, its balance sheet may show a healthy net asset position built largely from intra-group loans that will never be called — a position that looks like substance but generates no realised profit. And where a trading company has been used as the group's acquisition vehicle, goodwill and intangible write-offs may have eroded exactly the reserves the dividend is intended to draw on.

A subsidiary does not acquire distributable profits because the group has them. It acquires them by earning them.

Where the file usually breaks down

The weaknesses tend to recur in the same four places.

The reserve figure is taken from a management account that has not been tested. Management accounts are prepared for performance monitoring, not for the statutory distribution test. They may include unrealised fair value movements, capitalise development costs that ought to be expensed, or leave inter-company interest unaccrued. Each of those flatters the reserve line.

Inter-company balances are treated as neutral. Writing off a receivable from a fellow subsidiary, or converting a loan into equity on favourable terms, can itself constitute a distribution of the company's assets. If a balance is to be released as part of a group tidy-up, the board should record why it is not a distribution — or treat it as one and test it.

The minute predates the consideration. A resolution that records the directors as having reviewed the relevant accounts, when no accounts were circulated with the papers, is not a record of deliberation. It is a record of an outcome. In any subsequent dispute the difference matters a great deal.

The date is wrong. A dividend becomes a debt when it is declared, not when it is paid. The relevant accounts and the reserve position must be tested at that earlier date, and a declaration slipped into the following month to catch a better balance sheet is precisely the practice that produces an unlawful distribution.

Reading the reserve line properly

Distributable reserves are accumulated realised profits less accumulated realised losses, so far as not previously written off by a reduction of capital or a distribution. Share premium, revaluation reserve and most unrealised gains are excluded. Where goodwill has been written off to reserves historically, the effect on the realised profit pool needs to be understood rather than assumed.

Two further points deserve board attention. First, the relevant accounts must ordinarily be the company's last annual accounts prepared under Part 15, or interim accounts where those no longer reflect the position — and where the auditor's report is qualified, the auditor must have stated whether the matter is material for distribution purposes. Second, the statutory test is not satisfied merely because the accounts support the payment. Directors must also consider whether known subsequent losses mean the accounts no longer give a reliable picture. The courts have consistently declined to let directors shelter behind figures they had reason to doubt.

A pre-signature checklist for 2026

Before the resolution is put to the board, the following should be capable of being answered from documents in the meeting pack:

• Which company is paying, and is the reserve test being applied to that company's own accounts rather than to any consolidated or sub-consolidated view?
• Are the relevant accounts identified, dated, and supported by an auditor's report where one is required?
• Has the reserve calculation been adjusted for unrealised items, unaccrued intra-group interest and any balances proposed for release?
• Is the declared amount within the available realised profits, with a stated headroom figure and the basis on which it was calculated?
• Does the declaration date precede the payment date, and does the reserve test apply to the former?
• Have subsequent events up to the declaration date been considered and minuted?
• Where the recipient is an intermediate holding company, has the onward distribution been tested separately at that level?
• Is the resolution, the reserve schedule and the accounts it relies on retained together as a single distribution file?

What the minute should actually say

The minute need not be long. It should identify the accounts considered, the amount of available realised profits, the sum declared, the date of declaration and the basis on which the directors satisfied themselves that the distribution was lawful. It should also record any matter that gave the board pause. A file that shows the directors asked a difficult question is stronger evidence than one that shows they did not.

Groups that upstream cash regularly are well advised to build the distribution file as a standing discipline rather than a year-end exercise — a short schedule maintained at each entity, refreshed when the management accounts are refreshed, and tabled whenever a distribution is proposed. The cost is modest. The alternative, discovered at the point of a refinancing, a sale or a dispute, is an unlawful distribution that must be repaid, with interest, by directors who may have believed the group could afford it.

Dividends are a legitimate and efficient means of moving cash within a group. The evidence should move first.