In June 2014 many companies that filed annual reports received a letter informing their management board of the fact that their equity does not meet legal requirements. The owners are given a warning that if measures are not taken the company will be deleted from the register.
A reminder: the Commercial Code mandates that companies’ net assets must amount to at least half of their share capital, but not less than the minimum share capital stipulated in legislation, i.e. at least 2,500 euros in case of a private limited company and 25,000 euros in case of a public limited company.
A couple of practical recommendations
If a company’s share capital does not meet the legal requirements, but the annual report is still to be submitted, there are several ways of resolving the situation. Two potential solutions are as follows:
- Before filing the annual report, we advise noting briefly in either the management report or the section concerning events occurring after the balance sheet date what the company has decided to do with the non-conformant equity. Yet the procedures can only be detailed in the post-balance sheet date events section if the shareholders have actually made such decisions and there is a signed decision.
- If it emerges from the annual report that equity does not meet the requirements of law and the company will rectify the problem during the subsequent financial year, we advise companies, once the problem is rectified, to send a notification and the new balance sheet to the Commercial Register at their own initiative. The new balance sheet should make clear that the equity meets the requirements set forth in legislation.
Measures for correcting equity
If the company’s net assets amount to less than half of the share capital or less than the minimum share capital specified in the Commercial Code, the shareholders must decide:
- to reduce or increase the share capital on condition that the amount of net assets thereby make up at least half of the share capital and at least the minimum share capital specified in the Commercial Code, or
- to take other measures as a result of which the amount of net assets makes up at least half of the share capital and at least the minimum share capital specified in the Commercial Code;
- dissolution, merger, division or restructuring of the private limited company, or
- filing for bankruptcy.
What other measures could be taken?
The above list notes that other measures can be exercised as well. This is a legislative passage that leaves quite a lot of room for interpretation as to what the measures could be. The most common other measures involve covering losses directly by the shareholders (making a so-called gift) or giving up a loan from owners, which takes place through the income statement and is harmful for the owner as it could result in an additional tax obligation.
At the same time, from time to time other measures include establishing voluntary equity reserves through contributions from owners, in order to bring the equity to the required level. But in very many cases, this was not done in harmony with legislation, and the reserves set up in this manner are not actually restricted shareholders’ equity.
Other reserves established by owners’ contributions can be recognised as a part of restricted shareholders’ equity only if it meets the definition of restricted shareholders’ equity – i.e. restrictions are established on disbursements from the reserve, and the purpose of the reserve and the procedures for formation, use and termination (including disbursement) of the reserve are set forth in the company’s articles of association.
If no restrictions have been established for termination of the reserve (e.g. the articles of association allow disbursements to be made from the reserve solely pursuant to a shareholders’ decision), no other reserve can arise and the contribution passes into equity through the income statement.
The above distinction between other reserves belonging to restricted shareholders’ equity and contributions that are not part of restricted shareholders’ equity is important also from the taxation aspect. Namely, if the case involves other reserves established with direct contributions from the owners and it can be treated as a part of restricted shareholders’ equity, then disbursements are taxed on the same grounds as a reduction of share capital. But if the owners have made a contribution that cannot be treated as other reserves and it passes into equity through the income statement, a disbursement of such a contribution to the owner is taxable as a dividend.