R I P General Reserve!

Over The Top Distributions!!

When the board of Nestlé India Limited meets on the 19^th Oct it may declare an outsized interim dividend, larger 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^th September 2023 by the NCLT wiped out the whole of Rs837.43cr 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 which did a similar exercise in FY 2018-19 and transferred the entire general reserve of Rs2187cr 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 FY 2021-22, the general reserve of Rs 871.80cr was utilized 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 in each year.

The purpose of a mandatory reserve creation was mainly to prevent the erosion of the capital frame work and keep aside some provenance for a rainy day like a sudden tax demand or a big reversal in the business situation etc.,

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 which 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 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.

The first is that companies in the capital light sectors (FMCG) are not making major capital investments.

Taking Nestlé’ itself as an example, the aggregate PAT for the five years between CY2018 and CY2022 is Rs10,165cr. The net addition to the fixed assets (net block) during this period is less than 8% of this figure.

Whereas, the total dividend paid during this time is Rs8130cr as regular dividend and Rs2340cr as special dividend (together with DDT)!

Secondly, the tax law favours such distribution by applying a lower rate of tax on dividends earned by the nonresidents. In Nestlé’ 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 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 bench marks 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 Rs10,283cr to retained earnings so as to qualify for distribution once it is approved.

The scheme filed by the company is under process before the NCLT. The observations of 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 was communicated by the stock exchanges to the company is 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’ 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 prevails. 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 as they also get a share of the distribution periodically. However, in the case of resident HNI 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 the periodic buyback to return cash and have wiped out their past reserves for this purpose and did not go through the exercise that MNC subsidiaries did.

On a different footing, Tata Power Ltd, under a scheme of arrangement in FY 2020-21, transferred the entire balance of Rs3854cr from its general reserve to retained earnings to offset the impairment in the investments in a subsidiary, which was merged into the parent.

The biggest Indian company that normally pioneers the practices on corporate actions, Reliance Industries, has more than Rs262000cr 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 for 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 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 the recent years, especially post the pandemic. However, the corporate tax cuts introduced in 2019 have dented the overall growth in corporate tax collections.

CT collections of CAGR 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 allocation in the budget of Rs1.62tn 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 other the 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 which is not specifically annotated in the board report, or the ERP programmed for auto transfer has not been disabled after 2014?