Sources of Dividend: Where Do Companies Get the Money?

Every year, thousands of Indian companies announce dividends, and shareholders check their bank accounts hoping for a payout. But where does this money legally come from? A company cannot simply pull cash out of thin air and hand it to shareholders. The Companies Act, 2013 draws a strict boundary around what counts as a legitimate source of dividend, and understanding this boundary is central to company law. Let’s break down exactly where companies are allowed to get the money for dividends, and just as importantly, where they are not.

The legal foundation: Section 123 of the Companies Act, 2013 🔗

The rules on dividend sources sit in Section 123 of the Companies Act, 2013. This section lays down that no company can declare or pay a dividend for any financial year except from specific, clearly defined sources. Interestingly, the right to declare a dividend itself is not something the Act creates from scratch. It is an inherent power of a company as a corporate entity; the Act and the Articles of Association only regulate how and when that power is exercised. Section 123, in particular, controls the money trail: it decides which pool of funds a company can lawfully dip into.

According to legal commentary on the provision, the section essentially recognises three broad sources of dividend: current year profits, past years’ profits, or a combination of both, along with a special route involving government-guaranteed funds. Let’s look at each one.

Source 1: Profits of the current financial year 🔗

The most common source of dividend is the profit a company earns during the financial year in question. But there’s a catch: this profit must first be adjusted for depreciation. Companies cannot treat gross earnings as distributable profit. Depreciation, calculated as per Schedule II of the Companies Act, has to be charged first, and only what remains after this adjustment is available for distribution.

This rule exists for a simple reason. Depreciation represents the wearing out of machinery, buildings, and equipment. If a company ignores this cost while calculating profit, it risks distributing money that should have been set aside to maintain or replace its assets. Over time, this would quietly erode the company’s capital base while shareholders keep receiving dividends, a dangerous illusion of prosperity.

Source 2: Profits of previous financial years 🔗

A company doesn’t have to distribute all its profit in the same year it is earned. Profits that remain undistributed from earlier years, after the required depreciation adjustments were made in those years, continue to sit in the company’s books as accumulated or retained profits. These, too, can be used to pay dividends in a later year.

This is particularly useful for companies going through a temporarily weak year. Even if current profits are thin, a company with healthy reserves from previous profitable years can still maintain its dividend record, provided the money genuinely represents past undistributed profit and not some other type of reserve.

Source 3: A combination of both 🔗

Companies are not restricted to choosing only current or only past profits. Section 123 explicitly allows the dividend to be paid out of both current year profits and previous years’ accumulated profits together. In practice, boards often use this flexibility to smooth out dividend payouts across fluctuating business cycles rather than dramatically increasing or cutting the dividend rate every year.

What cannot be used: Unrealised gains and asset revaluation 🔗

Here’s where many students trip up. Not every credit balance in the reserves qualifies as a “profit” for dividend purposes. The law is explicit that certain figures must be excluded while computing distributable profit.

Specifically, any amount that represents unrealised gains, notional gains, or gains from the revaluation of assets cannot be counted while working out how much dividend a company can pay. If a company revalues its land or building upward on paper, that increase in book value is not real cash in hand. Similarly, if the value of an asset or liability changes because it is measured at fair value under accounting standards, that change also gets excluded. As one recent legal analysis puts it, this rule ensures dividends are distributed only from actual earnings and not from paper gains or fluctuating asset values.

This restriction protects the very core idea of dividend law: shareholders should only be paid out of money the company has actually earned and can afford to part with, not out of accounting adjustments that never converted into cash.

Source 4: Money provided by the government under a guarantee 🔗

A lesser-known but still valid source of dividend is government funding. If the Central Government or a State Government has given a guarantee for the payment of dividend to a company, and money is provided by that government under such a guarantee, the company can use those funds to pay dividends. This provision is relatively rare in practice and typically applies to certain government undertakings or specially structured entities where the government has extended a dividend guarantee as part of an investment or policy arrangement.

Free reserves versus profits: a distinction that matters 🔗

Company law also draws a sharp line between “profits” and “free reserves,” even though the two terms sound similar in everyday conversation. Free reserves are reserves that, as per the latest audited balance sheet, are genuinely available for distribution as dividend. A detailed legal analysis on this point notes that surplus profits and free reserves are not interchangeable for the purposes of Section 123, and free reserves can be tapped for dividend only in special circumstances, namely when current profits are inadequate or absent.

In other words, a healthy reserve balance sitting in a company’s books doesn’t automatically mean shareholders can be paid from it. The law requires those reserves to first qualify as free reserves, and even then, dipping into them for dividend purposes is treated as an exception rather than the default route.

Transferring profits to reserves before declaring dividend 🔗

Before declaring a dividend, a company has the option to transfer a certain percentage of its profits for that financial year to its reserves, as it considers appropriate. This is a matter of managerial discretion rather than a fixed statutory percentage under the current law. Companies often do this as a matter of prudent financial planning, building a buffer that can support future dividend payments in leaner years, fund expansion, or absorb unexpected losses.

This practice becomes especially relevant when profits in a given year are inadequate or entirely absent, but the company still wants to maintain its dividend track record for shareholder confidence.

Declaring dividend out of reserves when profits fall short 🔗

What happens when a company has had a rough year with little or no profit, but its board still wants to declare a dividend using accumulated profits transferred to reserves in earlier years? This situation is specifically governed by the Companies (Declaration and Payment of Dividend) Rules, 2014, particularly Rule 3. A recent commentary on this framework describes it clearly: such a declaration can only be made after complying with the restrictions prescribed under Rule 3 of these Rules.

Rule 3 lays down three key conditions that must all be satisfied together:

There’s also a fourth safeguard worth remembering: after such a withdrawal, the balance left in the reserves cannot fall below 15% of the paid-up share capital, as detailed in the text of the Companies (Declaration and Payment of Dividend) Rules, 2014. Together, these conditions prevent companies from wiping out their reserves just to maintain an impressive dividend record during a bad year. It’s a system designed to protect the company’s long-term financial stability, not just short-term shareholder sentiment.

Why these rules exist: the bigger picture 🔗

Step back for a moment and look at the pattern across all these provisions. Every rule, from excluding unrealised gains to capping reserve withdrawals, serves one underlying purpose: making sure dividends represent real, distributable wealth rather than accounting fiction or borrowed prosperity. As one overview of the framework summarises, Sections 123, 124, and 127 together form a cohesive framework governing dividend distribution, from permissible sources right through to safeguarding unclaimed amounts.

This matters for a simple reason. Dividends are often read by investors as a signal of a company’s financial health. If companies could pay dividends from any source, including paper gains or reserves meant for other purposes, that signal would become meaningless, and worse, could mislead investors and creditors alike. The framework under Section 123 keeps that signal honest.

Putting it all together 🔗

To summarise the permissible sources of dividend under Indian company law: current year’s profit after depreciation, previous years’ undistributed profit after depreciation, a combination of the two, or government funds provided under a guarantee. Unrealised gains, notional gains, and asset revaluation reserves are firmly off the table. And when profits fall short, companies can still tap into free reserves, but only within the tight boundaries set by Rule 3.

For commerce students, this topic is a favourite in exams precisely because it tests whether you can distinguish “profit” from “reserves,” and “real gains” from “paper gains.” Once you internalise that distinction, the rest of the section falls into place logically.

What do you think? 🔗

What do you think? If you were advising the board of a company that had a loss-making year but strong reserves from the past, would you recommend declaring a dividend under Rule 3, or holding back to protect the reserve cushion? And why do you think the law is so strict about excluding revaluation gains, even though the asset’s value has genuinely increased on paper?

References

1. https://blog.ipleaders.in/section-123-of-companies-act-2013/
2. https://www.credencecorpsolutions.com/blog/companies-act-section-123-bg1504
3. https://www.corporateprofessionals.com/articles/from-profits-or-free-reserves-decoding-the-legal-anatomy-of-payment-of-final-dividend/
4. https://corporate.cyrilamarchandblogs.com/2024/01/declaration-of-dividend-interplay-of-law-and-business-dynamics/
5. https://ibclaw.in/the-companies-declaration-and-payment-of-dividend-rules-2014/
6. https://www.drishtijudiciary.com/ttp-company-law/declaration-and-payment-of-dividend-under-the-companies-act-2013