The most common form of corporate financing among owners is still the member’s loan. But many forget that while granting a member’s loan is relatively easy, it hides several ticking time bombs – as a recent Supreme Court decision confirmed. Fortunately, there’s already a risk-free capital contribution option.
Equity financing: the tricky option
The primary form of financing for companies is the provision of equity capital, where the member provides a contribution to the share capital of its company. Such a capital injection, however, is in several respects problematic under company law. For one thing, the capital injection itself is subject to a decision of the company’s general meeting and to registration with the company court. And it only gets worse if the member in question wants to withdraw the capital it contributed to the company. This is because it can only do so by means of a capital reduction, which, besides a decision of the general meeting, is conditional upon publication on more than one occasion in the Companies’ Gazette, and possibly on having to provide collateral to the creditors. Not to mention the fact that the member won’t see his or her money for at least another 4-5 months following the decision. This deters many from embarking on the capital injection route in the first place.
A member’s loan – but for how much?
It’s not surprising that member’s loans are widespread in businesses circles – it is, after all, one of the easiest and most flexible ways of providing financing to a company. In many cases, not even a formal loan agreement is signed between the member and the company – the mere transfer of the money is enough to create the loan relationship. And repaying the loan isn’t a problem either – it can essentially be done at any time, without serious documentation, whether in part or in full.
However, the problem with member’s loans, as many have long known, is the rate of the interest that needs to be charged on them. Most members would like to give a loan to their company interest-free, but under the transfer-pricing rules, they have to charge market rates on the loan to keep the tax authority from interfering in the matter. Besides the additional administration involved, this represents a tax risk.
When a member’s loan becomes a serious burden
The downside to member’s loans, however, is most often encountered when businesses want to dissolve. It’s by no means rare for a business to reach the end of its days burdened with a loan debt, to its members. This is when the real complications begin. While the member in question can waive the claim, this will generate a profit and a tax base for the financed company. Nor can this be offset if the company accumulated a loss in the previous years, as this loss can only be deducted to a limited extent from the profit in the given tax years. And that’s when a tax liability arises.
An obvious answer would seem to be to convert the member’s loan into a contribution in kind before the company goes into voluntary liquidation. That way the obligor and the beneficiary of the loan become one and the same person and the loan ceases to exist. However, this approach has on several occasions been reclassified by the tax authority as debt forgiveness, resulting the application of the above tax consequences. Moreover, the courts have in most cases ruled in favour of the tax authority.
A Supreme Court ruling published a few weeks ago further reduces the room for manoeuvre in the event of a voluntary liquidation. Savvy taxpayers have figured out that if it’s no longer possible to extinguish the debt by converting it into a contribution in kind, they can achieve the same result by financing the transaction: the member increases the capital in the company with cash, from this cash the company then repays the member’s loan and the circle is closed. Or that’s how it was... The decision of the Supreme Court published a couple of weeks ago explains that a capital increase may only be provided for the continued, ongoing operation of a company. If the capitalised company is subsequently wound up, the purpose of the capital injection cannot be to ensure its continued operation. Such a capital increase therefore, according to the court’s decision, disguises what is in effect a debt waiver and is thus taxable under the aforementioned debt waiver rules. From now on, it will essentially be impossible to clear member’s loans in a pre-liquidation situation. Unless someone wants to pay tax...
But there’s a ray of hope: the supplementary payment
Before we finally give up on trying to finance our company in a simple and easy manner, it’s worth taking a look at the latest amendments to the Civil Code that are set to take effect on 1 January of next year. These extend the scope of the supplementary payment (in Hungarian: pótbefizetés) option in several respects: for one, an obligation to make a supplementary payment can now be prescribed for privately held joint-stock companies as well (not just for limited companies), and secondly, the criterion that supplementary payment must be returned if it is not needed to offset the company’s losses no longer applies. What’s more, the administrative requirements associated with the supplementary payments in one-member companies have been vastly simplified.
From now on, supplementary payment can be made in a relatively flexible way, and companies may also depart from the framework terms provided by the law in their articles of association. There’s no need to set interest for supplementary payments; its repayment can be made flexible, and moreover, no one is going to ask what this additional contribution is doing on the balance sheet of the financed company if it chooses to dissolve itself. It would be no surprise if member’s loans were soon dropped and replaced by supplementary payments.