Accounting Policies and Dividend Limitation: A European Comparison

2.1 The Origins of Capital Maintenance Rules

The issue of restrictions on dividend distribution is closely linked to the concept of capital maintenance.

We refer here to the concept of capital maintenance as used in the field of Company Law and still mentioned in the CLD.^[2] Capital maintenance refers to a set of legal rules designed to guarantee that a company maintains the necessary capital to ensure the ongoing concern of the business and the protection of its creditors (Hannigan, 2018). More specifically, these rules are designed to prevent shareholders from recovering capital from a company before the closing thereof, encompassing issues such as: minimum subscribed capital, legal reserve, purchase of own shares, capital reduction and restrictions on dividend distribution.

The doctrine of capital maintenance emerged in the early nineteenth century in the UK and in the USA, more precisely under the concept of “legal capital” to prevent the spoliation of creditors by shareholders (Manning, 1977).

Around the same period, the issue of fictitious or illegal dividends was often raised by the judicial courts in the cases of bankruptcy of public companies in Europe (Bryer, 1998; Lemarchand & Praquin, 2005).

Consequently, like the United States, most Western European countries adopted capital maintenance rules for public limited companies in the late nineteenth century (Oddy, 1974; Rickford, 2004). These rules persisted over time. The second European Directive (77/91/EEC) included capital maintenance rules for public limited companies regarding minimum subscribed capital, basis of dividend distribution and specification on undistributable reserves. As regards dividend distribution, it imposes at minimum a two-fold test:

1. a balance sheet test: “no distribution to shareholders may be made when, on the closing date of the last financial year, the net assets as set out in the company’s annual accounts are, or following such a distribution would become, lower than the amount of the subscribed capital plus those reserves which may not be distributed under the law or the statutes” (Art 15.a).

2. an accumulated running account profits test: “The amount of a distribution to shareholders may not exceed’ the amount of the profits at the end of the last financial year plus any profits brought forward and sums drawn from reserves available for this purpose, less any losses brought forward and sums placed to reserve in accordance with the law or the statutes” (Art 15.c)

In the mid-seventies, the doctrine of capital maintenance started to be debated by academics and practitioners. Some took the view that the capital maintenance rules were not appropriate to determine the real capacity of distributing dividends. At that time, according to Manning (1977), the legal capital rule had been proved ineffective to protect creditors for many years and its persistence in the corporate law of many states (in the US) resulted essentially from a difficulty to repeal old regulations.

Based on the contributions of Manning (1977), the US Corporate Law was amended in the 1980s (Hanks, 2011) and since then, dividend distribution has no longer been based on capital maintenance. Instead, a balance sheet test, like in the European Directive (77/91, see above) and an equity-insolvency test have been introduced.^[3] According to the equity-insolvency test, no distribution may be made if the company would not be able to pay its debt in the usual course of business after the distribution.^[4]

2.2 The European Debate on Capital Maintenance Rules

In Europe, capital maintenance rules were debated in the 2000s when the revision of the second Directive came into question. A group of experts, the so-called “Winter Group” had been designed by the EC to make proposals for a modern regulatory framework for company law in Europe, with view to assessing whether the incumbent European regulation might discourage investors.^[5]

Based on the results of a survey that included 119 respondents, the Winter Group concluded that the only function for legal capital “is to deter individuals from light-heartedly starting a public limited company”. However, if legal capital was seen as an ineffective protection for creditors according to a majority of respondents, it was not an obstacle to business. Consequently, the Winter Group recommended maintaining the legal capital requirement for public limited companies. Nevertheless, as regards to dividend distribution, the Group proposed the requirement of a twofold test: a balance sheet test and a liquidity test, in order to ensure real protection for creditors. Following the Winter Report, the EU decided to make sweeping changes to its Corporate Law regulations in the short and medium term.

The Winter report was published shortly before the final decision to adopt IFRS’s in Europe (EU, 2002). However, the issue of the potential impact of the application of IFRS on capital maintenance rules is barely mentioned.^[6]

Soon after, an initiative led in the UK by experts in corporate law and accounting, resulted in the publication of the Rickford report (Rickford, 2004).^[7] It consisted in a review of the capital maintenance rules, made urgent, according to the authors, by the recommendations of the Winter report and the further application of IFRS in Europe (§2.3).

The Rickford report finally recommended that the EU should repeal the traditional CMRS (including the requirement of a minimum subscribed capital) and should instead require a solvency test, that may be certified by legal auditors, and a balance sheet test.^[8]

The Rickford report also included a comparative study dedicated to the implementation of CMRs legal substitutes for such rules. The report examined these rules in six European countries (France, Germany, Ireland, Italy, Spain and the UK) with reference to the European Regulation, and in five non-European countries and American States (United States, Delaware, California; Canada, New Zealand)

The authors identified two groups among the five European countries: the first, including Germany, Ireland and the UK, with a stricter approach to implementing the second Directive than the second group, composed of France, Italy and Spain, which adopted a more flexible approach.

The Rickford report did not reach a consensus in Europe. In response to its perceived revolutionary recommendations, a group of German and European company law experts published a volume including essays and reports, with Marcus Lutter as editor (Lutter, 2006), on issues such as CMRS, creditor protection, insolvency laws, and accounting regulation in different European countries. In the preface of the report, Marcus Lutter observes that the results of this collective work differ from those of the Rickford group and confirms the usefulness of the concept of legal capital. He recommends the EU to maintain the provisions of the second Directive, which did subsequently happen. The CLD, which replaces the second Directive still contains the same provisions on dividend distribution (Art. 56).

2.3 Capital Maintenance Rules and Accounting Standards

When dividend distribution rules are based on an earnings test and/or a balance sheet test, as prescribed by the EU regulations, the link between these rules and the accounting regulations becomes apparent.

In the US context, Sanders et al. (1938), in their statement of accounting principles commissioned by the American Institute of Accountants, had already identified cases where the application of accounting rules could raise issues in determining the distributable profit basis.

In Europe, in order to avoid any potential inconsistencies between the CMRS and accounting rules, the fourth European directive (1978]) included DDRs that still exist in the AD (§3.2).

The adoption of IFRS in 2002 clearly raised the question of their impact on financial statements and thus on dividends that could be legally distributed.

The Rickford report (Rickford, 2004) thus claimed that “rigid linkage of distribution limits to company balance sheets and profit and loss accounts produces distortions. These accounting statements provide an incomplete and unreliable basis for distribution decisions. The modern trend towards “fair value” (or more realistic) accounting principles produces more volatile “bottom line” outcomes which impede stable distribution policies”.

The Rickford report raises the issue of fair value without explicitly mentioning IFRS, but it is assumed that IFRS application would involve more fair value than under local GAAP in a great number of European countries.

Fair value accounting versus cost accounting has been an ongoing debate for decades, and has been put back in the spotlight with the adoption of IFRS by the EU (Biondi, 2011) and the 2007–2008 financial crisis (Biondi, 2017; Biondi & Giannoccolo, 2015; Laux & Leuz, 2009). Most opponents to fair value accounting put forward its implementation issues, its adverse effects in terms of financial stability and information needs by other stakeholders than financial investors. The fair value accounting versus cost accounting dispute is also part of a broader debate on what is income and profit, as well as on the main function of accounting: stewardship or decision-making usefulness.

The possible effect of fair value accounting introduced in most European countries with IFRS on dividend distribution is explicitly questioned by Richard (2015). Based on a historical analysis of the evolution of capitalism in four prominent countries (France, Germany, UK and United States), Richard (2015, p. 25) asserts that “the change to fair value valuation has been caused mainly by a trivial question of dividends, not of information”. According to him, the IASB’s push toward fair value aims at complying with shareholders’ wish of quicker and bigger dividends, since fair value leads to the recognition of unrealised gains. The underlying understanding is that the distribution of unrealised gains could be detrimental to the survival of the business over time.

Interestingly, the Rickford report questions the extensive use of fair value, not because it could lead to higher profit distribution, but because it could increase volatility in profits and consequently in distribution of dividends.^[9]

These contradictory conclusions on the potential impact of IFRS on dividends distributed by companies stem from two different accounting traditions: continental accounting, and Anglo-American (Nobes, 1992). Continental accounting countries are usually civil law countries with a financing model based on debt-financing and self-financing by earnings retention. Anglo-American countries have a predominantly common law jurisdiction where equity-financing by share issuance on capital markets is much more widespread.

Panetsos (2016) makes an association between accounting tradition and CMRs. The latter would be consistent with conservative accounting standards that prevail in continental European countries, where debt-financing and self-financing have been more prevalent than equity financing. On the other hand, Anglo-American countries, where equity-financing is dominant, would prefer less conservative accounting standards and would be reluctant to maintain traditional CMRs. From the beginning, the EU regulation has been based on the conservative approach of continental jurisdictions. Clearly, the adoption of IFRS, which are perceived as less conservative than incumbent national GAAP of continental jurisdictions, questions the relevance of CMRs.

Since member states can decide whether to permit the use of IFRS or not for individual financial statements, Panetsos (2016) advises the maintenance of conservative local GAAP in countries where equity financing is relatively low, in order to maintain the protection of creditors. On the contrary, applying IFRS to individual financial statements in countries where equity financing is prevalent, would not be a problem.

In this article, we intend to contribute to the debate on the potential effects of IFRS on dividend distribution by European companies. More precisely, we aim at investigating further the interactions between accounting standards and dividend distribution rules in Europe that apply to public limited companies.

3.1 Prescriptions of the Company Law Directive

The CLD still includes the same provisions as the previous directive (Article §2.1) regarding dividend distribution (Article §56).

Each member state is free to add some specific requirements. The CLD does not provide any definition of “profits”, leaving the room for interpretation. In particular, it does not specify if profits include only realised profit or could also include unrealised gains, while this is a crucial issue, especially when financial statements are under IFRS.

From an analysis of the national corporate law of the EU member states and the UK, we observe that a large majority of countries (23) mention explicitly the existence of a distributable profit and/or distributable reserves as a necessary condition to decide on dividend distribution, as required by the CLD (Appendix 1).

However, four countries (Belgium, Estonia, Latvia and Netherlands), only refer to the provision of shareholder equity (or net assets) being at least equal to the total of share capital and undistributable reserves after distribution.

Romania is the only country that does not explicitly mention conditions to be met for dividend distribution in its corporate law.

When distributable profit is mentioned, it is usually defined as the net profit for the financial year minus the loss carried forward from the previous year and amounts to be transferred to reserves due to legal or statutory obligations.

For Ireland, Malta and the United Kingdom, company law requires that only realised profit may be distributed. Greece mentions the existence of undistributable reserves which include unrealised profits. However, in all these four cases, the corporate law does not include any specific definition of “realised”.

3.2 Limitations on Dividend Distribution Required by the European Accounting Directive

The AD refers to five optional accounting treatments for which it recommends that members states impose limitations on dividend distribution:

1. Capitalisation development costs

2. Capitalisation of start-up costs

3. Revaluation of intangible and tangible assets

4. Revaluation of financial assets

5. Equity method to measure investments in subsidiaries

Moreover, the AD talks about a sixth accounting option that could involve the recognition of unrealised gains, either in net income or directly in equity, but without mentioning any DDRs: the possible use of the fair value option (Art 8).

These optional accounting treatments and their potential impact on dividends will be detailed in Section 4.

The recommendations of the AD only apply to the national regulation, i.e. local GAAP. The AD is silent on the case of member states that would require or allow IFRS for individual financial statements, involving, for example, a company possibly deciding to use the equity method in its IFRS financial statements, even if it is not authorised under local GAAP.

However, the European Commission issued a note in 2018^[10] stating that some specific articles of the AD also apply when IFRS are used for individual financial statements: Art. 9 (7) that refers to the use of the equity method and Art. 12 (11) that concerns development costs. On the other hand, the revaluation of fixed assets and starts-up costs are not mentioned. This note further specifies that the European regulation about profit distribution, included in the CLD (Article §3.1), should apply to companies that use IFRS for their individual financial statements.

3.3 Financial Statements Used for Profit Allocation in Europe

The European regulation (EU, 2002) requires all publicly traded company groups to prepare their consolidated financial statements in accordance with IFRS. As regards to individual financial statements, it leaves the choice between IFRS and local GAAP to Member States.

We observe that almost all member states (26 out of 28) refer exclusively to individual financial statements as a basis for profit allocation, while Estonia and Denmark also mention consolidated financial statements.

The Estonian Commercial Code mentions that on the group level, the parent company may refer to consolidated financial statements to distribute dividends, but under additional conditions regarding the net assets of the parent company. This shows that the group profit allocation is not completely independent from the individual financial statements of the parent company, but still restricted by them.

The Danish companies act specifies that “the company’s central governing body is responsible for ensuring that distributions do not exceed a reasonable amount having regard to the company’s financial position and, for parent companies, the group’s financial position, and that no distribution is made to the detriment of the company or its creditors”.

With regards to accounting rules applying to individual financial statements, member states made different choices at the time of IFRS adoption and some of them have changed their position since. As shown in Table 1, in 2021, a majority of member states (75%) impose or permit IFRS in individual financial statements, at least for some specific companies.

Since 2005, there has been a move towards requiring or authorising IFRS in individual financial statements in Europe. Only six countries still refuse the application of IFRS to individual financial statements: Austria, France, Germany, Hungary, Spain, Sweden (Table 1). Thus it is not possible to infer a correlation between legal origins and the decision to authorise IFRS for individual financial statements, even if those six countries belong to the civil law group. It could be assumed that countries for which local GAAP are the most distant from IFRS would be the most reluctant to allow or require IFRS for individual financial statements (Nölke, 2013; Ramanna, 2013).

Thus, in a majority of European countries, profit allocation is based on individual financial statements that could be prepared either under IFRS or under local GAAP.

4.1 Capitalisation of Start-Up Costs

According to the AD (Art. 12-11) “where national law authorises the inclusion of formation expenses under ‘assets’, they shall be written off within a maximum period of five years”. It is also specified that, in this case, member states shall require dividend distribution restriction such as for development costs.

IFRS do not permit the capitalisation of start-up costs, since they do not comply with their definition of an asset.^[14]

Illustrative example

Company A was founded on 1 January X1 with a share capital of €100,000. The start-up costs paid in X1 amount to €5000 (legal fees, taxes …). Two options are considered regarding the start-up costs:

1. Option 1: start-up costs are not capitalised

2. Option 2: start-up costs are capitalised and amortised over five years.

Net income arising from business transactions made in X1 is € 7000 before taking into account start-up costs. It is assumed that Company A does not pay corporate income tax for this year.

The balance sheets on 31 December X1 (before profit appropriation) according to these two options are as follows:

Without dividend distribution restriction, Company A could distribute as dividend on the first year:

1. Option 1: €6000

2. Option 2: only €2000

A minority of European countries (8) explicitly authorise the capitalisation of start-up costs as an option: Belgium, France, Hungary, Italy, Luxembourg, Netherlands, Portugal and Romania.

All of them require a direct or indirect restriction on dividend distribution when this option is used:

1. In Belgium: this option could lead to restrictions, since start-up costs that have not been amortised yet have to be deducted from net assets when performing the “net assets test”.

2. In Hungary, Italy, Luxembourg, Netherlands, Portugal and in Romania: no dividend may be distributed until start-up costs have been fully amortised, unless there are distributable reserves which cover the related amount.

3. In France, any dividend distribution is prohibited as long as start-up costs have not been fully amortised.

Six countries do not allow the capitalisation of start-up costs: Bulgaria, Finland, Germany, Ireland, Spain, Slovenia and the United Kingdom.

Almost half of countries (13) do not mention this option. This may imply that it is not allowed, but this hypothesis cannot be fully confirmed without further analysis.

4.2 Capitalisation of Development Costs

The AD specifies (Art. 12-11) that Member States “can authorise the inclusion of costs of development under ‘Assets’ and the costs of development have not been completely written off, member states shall require that no distribution of profits take place unless the amount of reserves available for distribution and profits brought forward is at least equal to that costs not written off”.

Under IFRS (IAS 38), development costs that meet certain conditions must be capitalised. This is a compulsory accounting treatment.

Illustrative example

In X1, company B incurred € 200 k of development costs. Two options are considered regarding the accounting treatment of these costs:

1. Option 1: they are capitalised over four years

2. Option 2: they are fully expensed in X1.

Net income arising from business transactions made in X1 is € 250 k before taking into account start-up costs. It is assumed that Company B does not pay corporate income tax.

The balance sheets on 31 December X1 (before profit appropriation) according to these two options are as follows (thousand euros), assuming that there is no legal reserve requirement:

Without any restriction on dividend distribution, Company B could distribute 200 if development costs are capitalised, but only 50 if they are not, on the year when those costs are incurred. If option 1 is chosen, according to the requirements of the European Directive, a distribution of dividend could happen only after the allocation of the amount of 150 to a non-distributable reserve, i.e. the maximum dividend would be 50, as in option 2.

Our study reveals that, under local GAAP, a large majority of member states (25) explicitly permit the capitalisation of development costs. All of them except the Czech Republic and Greece, explicitly require dividend restrictions in such a case, as recommended by the AD: no dividend may be distributed until capitalised development costs have been fully amortised, unless there are distributable reserves which cover the related amount. Greek Corporate law just mentions that only realised profit may be distributed, without defining “realised profits”.

Similar limitations on dividend distribution are observed when IFRS are applied to individual statements (Belgium, Croatia, Denmark, Estonia, Finland, Ireland, Italy, Latvia, Luxembourg, Malta, Poland, Portugal, Romania, Slovakia, Slovenia, Netherlands, United Kingdom).

Bulgaria and Lithuania are the only countries that do not explicitly authorise the capitalisation of development costs under local GAAP. Nor do they mention any dividend distribution restriction when IFRS are applied to individual financial statements (Appendix 2, Table 1A).

4.3 Revaluation of Tangible and Intangible Assets

The AD (Art. 7-1) stipulates that Member States “may permit or require (…) the measurement of fixed assets at revalued amounts”. It adds that in case of revaluation, the difference between the revalued amount and the carrying value must be recognised in a revaluation reserve that cannot be distributed unless the gain is actually realised. Even if the AD refers to all fixed assets, including financial assets, in this section we pay attention to intangible and tangible assets only, as explained previously.

Under IFRS (IAS 16 & IAS 38), there are two options to measure tangible or intangible assets:

1. The cost model

2. The revaluation model, that can be used only if a market value can be reliably determined, which means that the revaluation model can be used for intangible assets only in some specific cases (taxi licences for example).

Illustrative example

Company C has opted for the revaluation model of tangible assets for the first time on 31 December X1, as authorised by the national corporate law. Before the revaluation, the carrying value of its buildings and lands was €600 k. The revalued amount on 31 December X1 is €1000 k (for other tangible assets, it is assumed that the revalued amount equals to their carrying amount).

The balance sheet on 31 December X1, after the revaluation and before profit appropriation, is as follows:

According to the European Directive the revaluation reserve (€400 k) may not be distributed until the disposal of the revalued buildings and lands.

Out of our sample of 28 countries, a majority (20) explicitly permits the revaluation of tangible assets under local GAAP.

Two countries limit the revaluation to some specific tangible assets: in Greece and Slovenia, only owner-occupied properties and investment properties can be revalued.

Among the 20 countries that authorise the revaluation of tangible assets, 18 explicitly mention a restriction on dividend distribution when this option is activated, i.e. the revaluation reserve cannot be distributed (Appendix 2, Table 2)

Out of the 20 countries that authorise the revaluation of tangible assets, only nine permit the revaluation of intangible assets. The reluctance of 11 countries to allow the latter revaluation is probably due to the non-existence of observable fair values for most intangible assets.

Seven countries do not allow the revaluation of either tangible or intangible assets.

Regarding IFRS, member states that require DDRs when tangible assets are revalued under local GAAP, impose the same limitations when IFRS are used, as expected.

However, an issue is raised by the four countries which do not authorise the revaluation of tangible assets under local GAAP, but accept IFRS for individual financial statements: Italy prohibits the distribution of the potential revaluation surplus recognized under IFRS, while Bulgaria, Czech Republic, Slovakia do not mention any DDRs.

4.4 Revaluation of Financial Assets Through Equity

As explained before, according to the AD (Art. 7.1), Member States may authorise the revaluation through equity of financial assets. Accordingly, the revaluation change is accounted directly in equity, without passing through the income statement.

Moreover, the AD also states that (Art. 8) “Member States shall permit or require, in respect of all undertakings or any classes of undertaking, the measurement of financial instruments, including derivative financial instruments, at fair value”.

The AD specifies that changes in fair value of financial assets available for sale may be included in a fair value reserve for financial assets available for sale and in net profit for other financial assets, without mentioning any dividend distribution restriction for the latter case.

Under IFRS (IFRS 9), financial assets are measured either at fair value through net income, at fair value through other comprehensive income (i.e. directly in equity) or at amortised cost, depending on their nature but also on decisions made by the company in some cases.^[15] In case of amortised cost method, changes in fair values are not recognised unless realised. Financial assets are further submitted to impairment tests.

Illustrative example

Company D has opted for the fair value option for financial instruments for the first time on 31 December X1, as authorised by the national corporate law. Company D owns 5% of T shares (T is listed on the national financial market), bought for €1000 k two years ago, and has no intention of selling them in the short term. This implies the accounting method of fair value through equity, with no impact on net income. The market value of the investment in T is €1200 k on 31 December X1. D also owns stocks and bonds for trading purposes, whose book value is 100 and market value on 31 December X1 is €120 k. This implies the accounting method of fair value through net income. Before taking into account the change in fair value of bonds, net income for X1 is € 60 k. It is assumed that Company D does not pay corporate income tax for X1.

The balance sheet on 31 December X1, before profit appropriation is as follows:

The method of fair value through equity involves recognising a non-realised gain of 200 k. According to the AD, the fair value reserve (€200 k) may not be distributed until the disposal of the T shares. The method of fair value through net income involves recognising a non-realised gain of 20 k. However, depending on national corporate law, €80 or €60 k could be distributed from net income.

Only two countries do not allow the revaluation of financial assets through equity under local GAAP: Austria and Germany, which additionally do not permit the revaluation of either tangible or intangible assets. This means that all the countries that permit IFRS for individual financial statements do also accept the revaluation of financial assets through equity under their local GAAP (Appendix 2, Table 3)

Out of the 25 countries that accept the measurement of financial assets through equity under local GAAP, only four do not permit the revaluation of tangible/intangible assets: Bulgaria, Czech Republic, Slovakia and Spain.

When changes in values are recognised in equity, either under local GAAP or under IFRS, eight countries do not mention explicit dividend restrictions, while other countries do not permit the distribution of those unrealised gains.

4.5 Investment Properties Measured at Fair Value

The AD does not make any distinction between investment properties and tangible assets used for the operations of a company. However, IFRS does, and recommends the measurement of investment properties at fair value through net income (IAS 40). Even if it is not the preferred measurement model, the cost model can still be used under IFRS for investment properties.

Twelve European countries authorise measurement at fair value through net income under local GAAP (Appendix 2, Table 4) and among them, seven do not authorise the distribution as dividends of the unrealised gains recognised in net income.

Out of the eight countries that do not authorise this method under local GAAP, while accepting IFRS for individual financial statements, six impose DDRs.

Eight countries including Cyprus do not mention any DDRs when investment properties are measured at fair value, either under local GAAP or under IFRS.

The six countries that do not authorise IFRS for individual financial statements do not allow this latter method under local GAAP.

4.6 Measurement of Financial Assets at Fair Value Through Net Income

As seen previously (§ 4.4), the AD indicates that member states can authorise the fair value option for financial assets (and liabilities) (Art. 8). It specifies in which cases changes in fair value may be recognised either directly in equity or in net income. When recognised in equity, the revaluation surplus should be allocated to a non-distributable reserve. The AD does not mention any DDRs when changes in fair value are recognized in net income.

The AD also mentions that member states could authorise the use of IFRS to measure financial assets.

Under IFRS, as already seen, financial assets may be measured at fair value through equity or through net income, depending on their nature.

Out of the 25 countries that authorise the revaluation through equity under local GAAP, only two countries – France and Belgium – do not permit the recognition in net income of some changes in fair value.

All countries that authorise IFRS for individual statements accept the option for fair value to measure financial assets under local GAAP, except Belgium.

Only a few countries impose DDRs when changes in fair value are recognised in net income: full restriction (Finland and Italy) or partial restriction (Ireland, Luxembourg^[16] and United Kingdom^[17]).

Eighteen countries, including Cyprus, do not mention any DDRs. Only the Netherlands explicitly permit the distribution of changes in fair value recognized in net income (Appendix 3, Table 5).

4.7 Equity Method for Investment in Subsidiaries in the Individual Financial Statements

The AD states (Art 7. A) that “member states may permit or require participating interests to be accounted for using the equity method as provided for in Article 27”. It specifies that, when the equity method is applied, the difference between the profit attributable to the company (the investor) and the dividend received should be placed in a reserve that is not distributable. Hence, according to the AD, using this method could not imply higher distributable profits as compared to the cost method.

The equity method is one of the three methods accepted under IFRS to measure investment in subsidiaries in the individual financial statements of the parent company (IAS 27).^[18]

Illustrative example

Company F buys 100% of S company shares on 1 January X1 for €1000 k. At this date, S shareholder equity was €1000 k (i.e.: no goodwill, no revaluation of assets). On 31 Dec X1, S net income for the year was €150 k. On 30 June X2, S distributed € 60 k as dividends. On 31 Dec X2, S net income for the year is €200 k, and S shareholder equity is €1290 k (1000 + 150 − 60 + 200). F uses the equity method in its annual financial statements, as authorised by the national corporate law. For sake of simplicity, it is assumed that in periods X1 and X2, F net income is 0 before taking into account the investment in S, and that there is no corporate income tax.

The balance sheets on 31 December X1 and on 31 December X2 (before profit appropriation) are as follows:

No dividend can be distributed for year X1 and only realised profit, i.e. 60, can be distributed for X2.

The equity method to measure investments in subsidiaries is formally permitted under local GAAP in 15 member states. Among them, 10 explicitly mention that the revaluation reserve cannot be distributed as explained in the example above (Croatia, Denmark, France, Ireland, Italy, Luxembourg, the Netherlands, Poland, Portugal and Sweden).

Five countries that authorise the equity method do not mention explicit dividend distribution restriction (Czech Republic, Latvia, Lithuania, Malta and Slovakia).

This method is not accepted in nine countries (Austria, Belgium, Estonia, Germany, Greece, Hungary, Romania, Slovenia and Spain). Bulgaria and Finland do not mention the equity method under local GAAP.

Concerning the seven countries that do not authorise or do not explicitly accept the use of the equity method under local GAAP, while accepting IFRS for individual financial statements, they do not mention any DDRs when IFRS are applied (Appendix 2, Table 6)

4.8 Gains Arising from the Recognition of Deferred Tax Assets

This topic is not mentioned in the AD, but it is a well-known accounting element whose different accounting options may impact net income determination and, as such, distributable profit.

There are two accounting options to recognise corporate income tax in the financial statements. The first option, usually considered as the simplest one, involves accounting for the tax payable to the Tax Administration as an expense, and to mention deferred tax (if any) in the notes. The other option consists in recognising current income tax as an expense, i.e. income tax that would be paid if there were no temporary differences between accounting profit and taxable profit. In the case of deductible temporary differences, this method could involve the recognition of a tax deduction that has not been realised yet. Therefore, this method raises the question of its impact on distributable profit, as shown in the example below.

IFRS impose the use of the current income tax option and consequently, the recognition of deferred tax assets/liabilities in the balance sheet (IAS 12).

Illustrative example

Profit/Loss before tax for year X1 of company E is – €40,000. In accordance with the national tax law, company E does not pay any income tax for X1, the loss is carried forward and will reduce future taxable profits. According to E’s business plan, this loss will be covered by profits within two years. The local corporate income tax rate is 25%. Two options are considered (assuming that both of them are authorised by the local corporate law):

1. Option 1: only income tax payable (or realised tax revenue, in case of a carry-back for example) is recognised.

2. Option 2: current income tax is recognised. Assuming that E will use the loss made in X1 in the short term, an income tax revenue of €10,000 (40,000 × 25%) is recognized.

The balance sheets on 31 December X1 (before profit appropriation) according to these two options are as follows (thousands euros), assuming that there is no legal reserve requirement:

With option 1, no dividend can be distributed since the sum of ‘other reserves’ and ‘profit/loss’ is equal to zero.

With option 2, if the local corporate law does not require any dividend distribution restriction on deferred tax asset, it is possible to distribute 10 as dividends (40 − 30) at year X1.

A large majority of countries (23) require or authorise the recognition of deferred tax assets under local GAAP, most of the time under conditions^[19] (Appendix 3, Table 7).

However, only five countries introduce explicit DDRs when a deferred tax asset is recognized under local GAAP (either in net income or directly in equity). For instance:

1. Austria: dividends can be paid out if distributable reserves are at least equivalent to the recognized deferred tax assets.

2. Germany: dividends can be paid out if distributable reserves are at least equivalent to the positive difference between deferred tax assets and deferred tax liabilities.

3. Italy: the Civil Code does not mention a restriction when Italian GAAP are applied but since the regulation on IFRS in Italy mentions it, it can be assumed that it also applies to financial statements under Italian GAAP.

4. Ireland and the United Kingdom: according to the ICAEW guidance^[20] profits recognized as a counterpart of a deferred tax assets are not considered as realised, and as such cannot be distributed.

Twenty one countries do not explicitly mention any DDRs when a deferred tax asset is recognised either under local GAAP or under IFRS. An analysis of case law and business practice may provide further information.

Belgium and Latvia do not permit the recognition of deferred tax asset under local GAAP. Luxembourg GAAP and Hungary GAAP do not explicitly mention the possible recognition of deferred tax asset, while DDRs exist in Luxembourg when IFRS are applied to individual financial statements.

4.9 Recognition of Actuarial Gains on Benefit Pension Plans

The AD does not mention any specific accounting treatment regarding actuarial gains on benefit pension plans. Therefore, national accounting regulations can be quite diverse across Europe.

Under IFRS (IAS 19), gains and losses arising from a change in the actuarial hypotheses taken to measure the pension obligation towards employees, are recorded in OCI. In case of a gain, it raises the question of its potential distribution, as shown in the following simplified example.

Illustrative example

On 31 December X1, the pension obligation of company G towards its employees was €1200 k (to simplify, it is assumed that there are no dedicated assets to cover this liability). It has been determined based on the following actuarial assumptions: Discount rate: 1%, life expectancy of employees: 98%, probability that the employees will still be present at the retirement age: 60%.

On 31 December X2, the pension obligation is €1150 k: it has increased by €30 k due to additional advantages for employees who worked one more year, but has decreased by €80 k, due to an increase of the discount rate that is now 3%. Net income for year X2, before taking into account the change in the measurement of the pension obligation is € 300 k.

Additional benefits (30 k) are recognised in net income, while changes in actuarial hypotheses (80 k) are recognised in other comprehensive income (i.e. in equity).

The simplified balance sheet of company G, showing this information, on 31 December X2 is as follows (before profit appropriation):

If gains arising from a change in actuarial hypotheses can be distributed under the local regulation, the maximum that could be distributed amounts to €350 k (80 + 270). If there is a dividend distribution restriction, the maximum dividend amounts to €270 k.

The positions of Member States regarding actuarial gains on pension benefits are very diverse (Appendix 2, Table 8). Thirteen countries require the recognition of actuarial gains either in net income or directly in equity under local GAAP. Among them, only five impose dividend distribution restrictions: Austria, Germany, Ireland and the United Kingdom.

A significant number of countries (11) do not explicitly mention actuarial gains under local GAAP. Out of the 10 that accept the use of IFRS, only Belgium and Luxembourg require restriction on dividend distribution.

Three countries do not authorise the recognition of actuarial gains under local GAAP: Italy, Czech Republic Latvia. Only Italy imposes DDRs when IFRS are applied to individual financial statements.

Out of the eight countries that require the recognition of actuarial gains either in net income or directly in equity under local GAAP, only Ireland and the United Kingdom forbid the distribution of such gains as dividends.