Use of Profits by Legal Entities

The allocation and distribution of profit is a crucial aspect of any business operation. Companies need to balance various needs while fulfilling specific legal requirements. This article explores the intricacies of profit distribution in Switzerland for both the GmbH and AG entities. We discuss the different ways that profits can be used and what to consider when deciding which of these uses is optimal. We also outline the importance of creating a comprehensive profit distribution plan and how to practically go about allocating profit.

How can profits of a GmbH/AG be used?

One of the most important decisions that companies have to make as the end of a financial year approaches is how to use and distribute profits (or losses). This question is more complex than it seems at first glance, as companies have to take into account the preferences of various stakeholders, the financial well-being of the company and legal and regulatory requirements.

There are primarily three ways that a company’s profits can be allocated:

1. Allocation of profit to reserves (profit stays within the company):

Firstly, the company may choose, or be required to, allocate a portion of their year-end profit to reserves. We can distinguish between statutory and voluntary reserves:

Statutory profit reserves:

The Swiss Code of Obligations (OR) stipulates that all businesses need to allocate a certain minimum amount of their profits to the statutory profit reserve. According to Art. 672 OR:

• A company must allocate 5% of their annual profit to statutory retained earnings until the reserve reaches a value of 50% of the share capital specified in the commercial register (20% for holding companies).  
• The statutory capital reserve may be repaid (i.e., distributed) to shareholders if it exceeds 50% of the share capital value specified in the commercial register, after deduction of losses.
• Losses carried forward are deducted from the profit figure before calculation of the required 5% contribution amount.

Previously, there was also a provision specifying a second allocation of profits to statutory reserves, which was calculated as a percentage of the dividend payment in excess of the basic 5% dividend payment (so-called “super dividends”). However, with the new reforms in the OR which came into effect on 1 January 2023, the requirement of the second reserve allocation was removed. This greatly simplified the calculation of the statutory profit reserve allocation.

Voluntary profit reserves:

In addition to the mandatory statutory reserves, the company may decide, through the general meeting, to allocate some of its profits to the formation of voluntary reserves which is outlined either in the articles of association or by shareholder resolution (Art. 673 OR).

It is important to note that the law stipulates that “Voluntary retained earnings may only be formed if justified in order to ensure the long-term prosperity of the undertaking, taking account of the interests of all the shareholders.” (Art. 673 OR). The issues surrounding when voluntary reserves are needed, along with the rights and interests of shareholders to a distribution of profits, will be discussed in more detail later.

2. Distribution of profit to shareholders (profit flows out of the company):

The second way that company profits can be used is to distribute them to the shareholders in the form of dividends and (less commonly) royalties. This represents an outflow of profits from the company.

• Dividends are the portion of a company’s profits which are distributed to shareholders. There are ordinary and special dividends. Ordinary dividends refer to regular dividend payments, which are typically a predetermined monetary amount or a fixed percentage of the company’s profits. Special dividends are irregular or one-time dividend distributions, which could be due to excess profit in a year, special incentives for shareholders, or general prosperity of the company.
• Royalties are another way to distribute earnings to shareholders. In Switzerland, the term can be used to refer to profit-sharing payments made to shareholders based on the revenue generated from their contributions to the business. As such, they are usually given as performance-related remuneration to members of the board of directors in addition to their regular compensation.

It is important to note that both dividend and royalty payments are subject to double taxation: firstly, at the corporate level, whereby the company has to pay a profit tax; and secondly, at the personal level, whereby shareholders have to pay income tax on the dividends and/or royalties they receive.

3. Unallocated/undistributed profit (retained earnings or carrying losses)

Finally, a company may carry forward a portion of their profit or loss as undistributed profit. Retained earnings refer to accumulated profits from previous years that have not been specifically allocated to the company’s reserves nor distributed as dividends/royalties. These profits get carried over to the next financial year. Losses carried forward are typically offset against profits in the subsequent financial year.

Considerations when deciding how best to distribute profits

Choosing how to allocate a company’s profits is not always a simple decision. There are many complex factors to be considered, such as who has a right to distributed profits, and how is this weighed up against legal and practical requirements to maintain reserves as protection against unforeseen losses. Companies need to consider various stakeholders’ requirements and wishes, including shareholders, creditors, and legal authorities.

Let’s examine some of the most important considerations when determining profit allocation:

Do shareholders have a right to distribution of profits?

Successful businesses always aim to keep their shareholders happy by distributing a share of their profits in the form of dividends. Naturally, the higher the dividends they provide, the more satisfied shareholders become.

But the question is, does it always make sense to distribute profits to shareholders? If so, to what extent? Should more profit instead be allocated to the formation of a voluntary reserve or kept as retained earnings to improve the financial strength of the company and protect it against unexpected losses?

In answering these questions, one needs to consider to what extent shareholders have a right to distribution of profits.

New corporate law reforms from 1 January 2023

Typically, a company will only distribute dividends to shareholders after they have made the necessary allocations to the statutory and voluntary reserves. The first (statutory) is defined by law and unavoidable, while the second (voluntary) is of greater contention. Here is where the company needs to weigh up the need for voluntary reserves with the rights and preferences of shareholders to receive distributions in the form of dividends.

New corporate law reforms presented in the Code of Obligations, which were enacted on 1 January 2023, make mention of a particularly important point in this context. Art. 673, paragraph 2 of the OR specifies that voluntary reserves may only be formed if they are justified to ensure the long-term prosperity of the company, while considering the interests of all the shareholders.

While this doesn’t itself provide an exact rule or formula on how to determine how much profit should be kept for voluntary reserves as opposed to distributing it to shareholders, it does open the door for some interesting considerations and perhaps even contentious legal cases. It alludes to the inherent rights that shareholders have to profit distribution which should only be withheld for valid reasons related to ensuring the longevity of the company.

Could shareholders then make a valid case against a company or the general meeting for resolving to over-allocate profits to voluntary reserves at the expense of shareholder dividends? Such questions await answers from new case law, but it certainly raises important considerations for companies when deciding how to distribute profits.

Fulfilling statutory minimum reserve requirements

Before any profits can be used for other purposes, companies are legally required to fulfil their minimum statutory reserve requirements. Currently, this means that 5% of all calculated year-end profits (after offsetting losses) should be allocated to the statutory retained profit reserve, until the sum of the statutory profit and capital reserve equals at least 50% of the nominal share capital specified in the commercial register for ordinary companies and 20% for holding companies.

The statutory reserve is required to protect creditors of the company and the company itself from unexpected losses or less profitable times. 

When are voluntary reserves needed?

The answer to the question as to when voluntary reserves are needed, in addition to the legally required statutory reserves, is a subjective one. Art. 673 OR provides details on the general meeting being able to decide on a voluntary reserve formation through the articles of association or by resolution. In most cases, it is understood that statutory reserves are sufficient in themselves to create a buffer against unexpected losses, and that a company’s statutes rarely contain provisions for the formation of additional voluntary reserves. However, if a business is in a high-risk industry or is facing difficult market conditions, the formation of voluntary reserves may be warranted.

Creating a profit distribution plan

As the distribution of profits is a complex decision-making process, it is crucial for companies to draw up a comprehensive profit distribution plan. The profit distribution plan (which is also known as the profit appropriation calculation or profit appropriation plan) indicates how much profit is available for distribution and how it will be allocated. As such, it provides information on the following:

• The total earned profit available for distribution based on the balance sheet profit calculation after adding or subtracting profit or loss carried forward (i.e., retained earnings as per the balance sheet)
• The portion of profit that will be kept in the company as reserves (both statutory and voluntary),
• The portion of profit that will be distributed as dividends and/or royalties,
• The undistributed balance of the retained profit that will be carried into the next financial year (or in some cases, losses which are carried forward)

Once the profit distribution plan has been formulated by the management of the company, it is subject to approval by the general meeting. The decision on the formation of (voluntary) reserves and the distribution of dividends is finalised through a simple majority of votes at the general meeting on an annual basis.

The exact steps to creating a profit distribution plan and allocating profit are therefore as follows:

1. Calculate the amount of profit to be distributed, which is the current year’s earned profit with the addition of retained profits or losses from the previous year’s balance sheet.
2. Allocate the appropriate amount of profit to statutory reserves, taking account of the value of statutory reserves already in existence. This step always comes prior to any other decisions about profit distribution, as the amount of the allocation is set by law and not in the company’s own hands to decide.
3. Decide how to distribute the remaining profits at the general meeting. The possible uses are to allocate profit to voluntary reserves, distribute it to shareholders in the form of dividends, and/or keep a portion as undistributed retained earnings. The resolution needs to be passed by a simple majority vote.
4. Form the voluntary reserves decided upon at the general meeting.
5. Distribute dividends/royalties to shareholders.
6. Calculate and carry forward the remaining profit/loss as retained profit/loss.