# Declaration of Dividend out of Free Reserves [Section 123(1) — proviso]

## When Does This Apply?

When the company has inadequate or no profits in the current FY but still wants to declare a dividend, it may dip into accumulated profits transferred to free reserves in prior years — subject to four conditions.

## The Four Conditions (Final Dividend)

### Condition 1 — Rate Ceiling

The rate of dividend declared shall NOT exceed the average rate of dividend declared during the immediately preceding 3 FYs.

Exception: This rate cap does NOT apply if dividend was NOT declared in all 3 preceding FYs.

### Condition 2 — Amount Ceiling

The amount drawn from accumulated profits shall NOT exceed 10% of (Paid-up Share Capital + Free Reserves) as per the last audited financial statements.

### Condition 3 — First Adjust Current Year Loss

The drawn amount must first be utilised to set off the loss of the FY in which the dividend is declared.

### Condition 4 — Floor on Remaining Reserves

The balance of reserves (after withdrawal AND adjustment of loss) shall NOT fall below 15% of paid-up share capital (as per last audited FS).

## Interim Dividend in Loss Situations

If a company has incurred loss during the current FY upto the quarter preceding declaration of dividend, then the interim dividend rate shall not be higher than the average rate of dividend declared during immediately preceding 3 FYs.

## Carve-out

This provision does NOT apply to a 100% government company (where the entire paid-up capital is held by CG, SG, or both).

## Implicit Assumption About Free Reserves

If the question specifies a year to which free reserves relate, assume that the current year loss is already adjusted. Otherwise, you must adjust the current year loss from free reserves.

## Key Memory Hook

"Four locks on dividend out of reserves: (1) rate ≤ 3-yr avg, (2) drawal ≤ 10% of (capital + reserves), (3) drawal first absorbs current loss, (4) leftover reserve ≥ 15% of capital."

Worked example

### Example 1

Example (Textbook): C Ltd. has paid-up capital of ₹ 200 lakh and free reserves of ₹ 240 lakh. It incurred a loss of ₹ 30 lakh during the FY but wants to declare a dividend. In the 3 preceding FYs, it declared dividend at 9%, 10%, and 12%.

Step 1 — Average dividend rate (Condition 1):

(9 + 10 + 12) / 3 = 10.33% → maximum permissible rate.

Step 2 — Maximum drawal (Condition 2):

10% of (Paid-up Capital + Free Reserves) = 10% × ₹ 440 lakh = ₹ 44 lakh.

Step 3 — Adjust current year loss (Condition 3):

From ₹ 44 lakh, set off loss of ₹ 30 lakh → only ₹ 14 lakh remains available for dividend.

Step 4 — Check floor on reserves (Condition 4):

Balance reserve = ₹ 240 - ₹ 30 (loss) - ₹ 14 (dividend) = ₹ 196 lakh.

15% of paid-up capital = 15% × 200 = ₹ 30 lakh.

₹ 196 lakh > ₹ 30 lakh ✓ Condition satisfied.

Conclusion: Maximum dividend that C Ltd. can declare = ₹ 14 lakh = 14/200 = 7% of paid-up capital. This is below the 10.33% rate cap, so all four conditions are satisfied.

⚠️ Common exam mistakes

Applying the rate cap (Condition 1) when dividend was not declared in any of the preceding 3 FYs — the cap doesn't apply in that case.
Forgetting to first set off the current year's loss from the drawn amount.
Computing the 15% floor on (Capital + Reserves) — it is only on paid-up share capital.
Calculating the 10% amount cap on paid-up capital alone — it is on (paid-up capital + free reserves).
Applying this provision to a 100% government company — they are exempt.
Forgetting the rule applies to interim dividend too when there is loss up to the preceding quarter (rate-cap only, in that case).

Reference: Section 123(1), second proviso, read with Rule 3 of Companies (Declaration & Payment of Dividend) Rules, 2014 — Companies Act, 2013

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Declaration of Dividend in Case of Inadequacy or Absence of Profits

Worked example

⚠️ Common exam mistakes