TECH 02/10 Guidance On The Determination Of Realised Profits And Losses In The Context Of Distributions Under The Companies Act 2006

In a nutshell

Guidance on distributable profits has moved with the times. The revised guidance issued by the ICAEW and ICAS has been enhanced and expanded to address some new – and often complex – situations, including foreign currency share capital, use of a presentation currency and 'cash box' structures.

Discussion of the earlier guidance was included in our June 2010 Quarterly Newsletter and in our full iGAAP 2010 and ukGAAP 2010 manuals.

Introduction

The law about payment of dividends has remained substantially unchanged for thirty years. Financial reporting has, however, moved on a long way in that time. Law that seemed uncontroversial and easy to apply in the days of 'prudent' historical cost accounting has become much more difficult to apply today.

In 2003, the Institute of Chartered Accountants in England and Wales (ICAEW) and the Institute of Chartered Accountants of Scotland (ICAS) published guidance known as TECH 07/03. It ran to 25 pages. The latest successor to this guidance has recently been published and is now 168 pages.

TECH 02/10 Guidance on the determination of realised profits and losses in the context of distributions under the Companies Act 2006 provides comprehensive and up to date guidance. It summarises the law on distributions and provides guidance on the meaning of 'realised profits' which, under the law, is a matter of generally accepted accounting practice. Distributions can be made only out of realised profits. The meaning of realised profits can evolve over time to cope with changing circumstances.

TECH 02/10 supersedes the previous guidance, TECH 01/09, with immediate effect. However, almost all of the guidance from TECH 01/09 has been carried forward. The changes, although extensive, are almost entirely concerned with addressing new issues or providing more detail in areas that were covered only briefly in TECH 01/09.

This iGAAP Alert addresses only the new and amended material. A discussion of the earlier guidance can be found in our publications iGAAP 2010 IFRS reporting in the UK and ukGAAP 2010 Financial reporting for UK unlisted entities.

An article on practical issues about distributable profits appeared in the June edition of our iGAAP Newsletter. The additional guidance includes:

how to apply the 'linkage' principle that requires a group or series of transactions to be viewed as a whole, particularly if they are linked or artificial or circular; the circumstances in which 'cash box' structures, sometimes used to raise equity finance, generate distributable reserves; the implications of foreign currency share capital; use of a presentation currency that is different from the functional currency of the company; the circumstances in which profits arising from a reduction in an acquired liability are realised profits; the application of section 846 of the Companies Act 2006, which deals with distributions in kind, to replacement assets and fungible assets; distributions settled by set off where an existing debtor balance due from the parent is reduced or eliminated by the distribution; clarification of the circumstances in which profits regarded as realised may subsequently become unrealised and vice versa; group treasury balances; goodwill written off to reserves and surplus shares held in an ESOP trust where existing guidance has been redrafted to eliminate references to superseded accounting standards; the circumstances in which profits arising on the construction of an asset for use in a service concession arrangement in accordance with IFRIC 12 will be realised profits; hedging relationships involving more than one company in a group; and IFRIC 5 and decommissioning funds. Linkage

Transactions and arrangements should not be looked at in isolation when assessing whether profits are realised. The overall commercial effect of a group or series of transactions or arrangements should be considered, particularly if they are artificial, linked (legally or otherwise) or circular. TECH 02/10 provides guidance on the factors that should be taken into account when deciding whether transactions need to be assessed for their combined effect.

The principle of linkage is of particular relevance to intra-group transactions but is not limited to them.

Example: Steps in a group reorganisation plan

Group reorganisations often involve a series of interconnected steps which would not be undertaken in isolation. A profit may arise on step 1 which is represented by cash and therefore, in isolation, appears to be a realised profit. But if step 2 involves that cash being paid out again it is necessary to look at the combined effect because the profit may not be represented by 'qualifying consideration' and may therefore be unrealised.

Example: Transaction with a third party

A subsidiary is sold for cash to a third party on the condition that the cash is applied in subscribing for shares in the purchaser. The substance or overall commercial effect of the transactions...