During the preparation of the financial statements on the business year, the review of the equity situation of companies is a key area of focus. If, for example, as a result of the perhaps multiple years of loss-making operation caused by the negative impacts of the pandemic the amount of the company's equity reduces, the company must take action. It may have to change its company form but, as a worst-case scenario, insufficient equity may even lead to the company's termination.
Let us look at the most common ways of resolving equity problems used by limited liability companies and companies limited by shares pointing out a few tax aspects and questions to be considered.
When is it compulsory to take steps regarding the company's equity situation?
Equity serves as a sort of minimal guarantee for the company's partners and employees regarding the continued operation of the company and its ability to fulfil its undertakings and satisfy its payment obligations. This is the reason why regulations provide for strict requirements for companies in order to resolve potential losses of capital as soon as possible. According to the provisions of the Civil Code, in the case of limited liability companies and companies limited by shares, the following qualify as cases of capital loss requiring immediate action:
| Limited liability company | Company limited by shares |
|---|---|
| Due to loss of equity, the company's share capital reduces to a half | The equity of the company limited by shares reduces to two-thirds of the authorized capital |
| The company's equity reduces below the minimum amount of share capital prescribed by law | The equity of the company limited by shares reduces below the minimum amount of authorized capital prescribed by law |
| The company is threatened by insolvency or the company stopped making payments | The company limited by shares is threatened by insolvency or the company stopped making payments |
| The company's assets do not cover its liabilities | The assets of the company limited by shares do not cover its liabilities |
If any of the cases listed above occurs, the managing director of the limited liability company or the board of directors of the company limited by shares must immediately or, in the case of a company limited by shares, within 8 days arrange for the members' meeting/general meeting to be convened.
Also, if in two subsequent business years, the company's equity does not reach the compulsory minimum of registered capital prescribed for the given company form (3 million forints for limited liability companies, 5 million forints for companies limited by shares) and the members do not provide the necessary equity within 3 months from the date of acceptance of the financial statements of the second year, they must, within 60 days of the expiry of this deadline, make a decision on the transformation of the company, a merger or the termination of the company without legal succession.
RESOLVING EQUITY ISSUES WITH AN EXPERT
The above clearly shows that in the case of a permanent loss of equity, the members or shareholders of the company have a relatively short time of 3 months to provide the required capital. If the company would like to avoid transformation or termination without legal succession, the equity situation must be resolved as soon as possible.
How can the equity situation of the company be resolved?
1. Capital reduction
If, as a result of losses, the equity of a company reduces substantially but its registered capital significantly exceeds the minimum amount prescribed for its company form, a possible way to restore the equity/registered capital ratio can be capital reduction. In this case, the company reduces its registered capital, typically by increasing the capital reserve at the same time.
In the case of limited liability companies, this action can be taken if accepted by a resolution supported by 3/4 of the members if the nominal value of the members' shareholding is reduced in proportion to their capital contributions but the relative ownership shares do not change.
2. Additional capital contribution
An additional contribution as a means of equity situation settlement is an option that is available, above all, to limited liability companies if it is allowed by the deed of foundation (articles of association) of the company.
In this case, the members' meeting may provide that members pay additional contributions in order to cover losses. The articles of association must specify, among others, the frequency at which addition contribution may be prescribed and the maximum amount the payment of which may be demanded from a member as well as the method and deadline of meeting the additional contribution obligation.
It is important that the additional contribution may not only be provided as financial but also as non-financial (in-kind) contribution in the form of an asset satisfying the relevant conditions such as, for example, acknowledged receivables or other assets!
If the members' meeting of the company decides to settle the equity situation by prescribing additional contribution, the resolution passed in this regard must also be implemented within 3 months. No company procedure is required in the case of additional contribution, i.e. the pecuniary value provided under this title will not appear in the deed of foundation. The rules of transfer pricing do not apply to in-kind contributions, which makes additional contribution overall easier from an administrative perspective than a normal capital increase. As, by default, an addition contribution changes elements of equity in accounting on the side of both the provider and the receiver, it usually has no direct impact on profit. However, in the case of voluntary dissolution or liquidation, a reclassification risk may arise, which may have an effect on the tax base of the two parties. For this reason, additional contribution may not be the right solution for equity settlement in every case.
3. Capital increase
If the goal is to restore the ratio of equity to registered capital, a capital increase may be the solution which may take place by increasing registered capital or in the form of a capital increase by share premium. In the case of a premium capital increase, the company's registered capital is increased (typically) with a simultaneous moderate increase of the capital reserve. This should be considered, in particular, by companies that do not expect substantial profit in the coming years and a material increase of registered capital would lead to recurring equity problems. Both traditional and premium capital increase may take place in the form of financial or non-financial, in-kind contribution. The deed of foundation must be amended in both cases and the changes have to be registered by the court of registration.
In the case of capital increase by way of contribution in kind, determining the fair value of the contribution in kind is important from both a legal and a tax perspective. For legal purposes, in the case of a limited liability company, the members are liable for the value of the contribution in kind while, in the case of a private limited company, the law provides for compulsory independent valuation. In addition, between related parties, a transfer price documentation obligation may also arise in respect of the arm's length price. It must also be examined whether VAT payment obligation arises.
A special case of capital increase by contribution in kind is loan-equity conversion in the case of which the parent company provides its acknowledged receivable from its subsidiary as a capital contribution to the subsidiary. Such conversions of loan to equity require careful consideration! If such transactions are not managed correctly, they may pose a risk of reclassification from a tax perspective and may cause problems on the side of both the provider and the recipient of the capital.
4. Waiving of owner receivables
One of the most straightforward solutions for resolving the equity situation may be for the owners of the company to waive their receivables from the company in the year when the loss is made in order to improve the profit of the year.
This method may only be a solution up to the amount of the outstanding receivables and it is not enough to prepare the waiver at the time of preparation of the financial statements or after that but proper accounting and corporate tax calculations must already be performed during the year concerned and the waiver must be recorded. Precise calculation is also essential as the waived receivable represents taxable income on the side of the recipient and generates tax return filing obligation, while on the side of the provider, it will qualify as a non-acknowledged expense if the parties are related. For this reason, the company should consider whether this solution can be applied without tax payment obligation.
5. Free-of-charge transfer of funds and other assets
A solution could be if members/shareholders of the company provided funds or other assets to the company free of charge and without repayment obligation. The income recognized as a result will improve the level of equity through the profit of the year concerned. However, we have to pay attention in this case also to the obligation of corporate tax base adjustment relating to the free-of-charge transfer and to potential VAT payment obligations if the assets transferred free of charge are non-financial.
6. Setting aside a revaluation reserve
There are many companies where the assets the company owns, in particular, real estates have a much higher market value then their book value. In these cases, the company may recognize the difference between the book value and the fair market value by way of a value adjustment provided that this solution is allowed by the company's accounting policy. The revaluation reserve of the value adjustment is placed in the equity, which improves the equity situation at year-end. Of course, in these cases, the value of the asset must be supported by proper market valuation.
There are many solutions for resolving your equity situation but each company has specifics that call for careful consideration and selection of the most appropriate solution from the alternatives available. The optimal decision can only be made with experience of many transactions and cases and considering both tax and legal aspects.
WE HELP YOU IN PLANNING
THE RESOLUTION OF YOUR EQUITY SITUATION
