Converting a company’s liability into capital can be a way to “heal” its balance sheet. This can increase the company’s credibility with counterparties and reduce the risk of insolvency. Conversion can also generate tax benefits, for example by reducing interest expense to below the deductible limit.
The benefits of debt-to-equity conversion are not affected by the manner in which it is carried out, i.e. in-kind contribution or an increase in the company’s share capital through a cash contribution.
Legal and practical issues
Under the currently prevailing position in the case law and legal literature in Poland, in both an in-kind and a cash contribution, conversion of a liability into share capital can be carried out without amending the articles of association. In such a situation, the current articles must allow for capital increases without amending the articles, by indicating the maximum amount of such an increase (by how much) or the maximum amount of capital (up to what amount), and the deadline for making such an increase.
When the capital is raised in this way through a non-cash (in-kind) contribution, it cannot be described in the articles of association (which, after all, are not being amended). Instead, the obligation to describe the contribution can be fulfilled in the resolution on the capital increase, also identifying the shareholder making the in-kind contribution as well as the number and nominal value of shares taken up in exchange. This resolution (like the articles of association) is a publicly available document in the National Court Register. The description of the contribution and revision of the amount of share capital after the increase without amending the articles of association may then be explicitly reflected in the wording of the articles of association in the future, at the same time when other amendments need to be made.
However, due to the evolving interpretation of the provisions in this regard and previous divergent positions, we suggest a cover letter with the application to the registry court pointing out the current position in the doctrine. This should avoid delays in registering the increase.
Dispensing with the need to visit a notary to amend the company’s articles of association or perform any other acts saves both time and money. The only stage of a capital increase that may take longer is entry of the capital increase in the National Court Register, required for it to be effective. But the contribution itself is effective as soon as the relevant agreement is signed (assignment or setoff). Thus, the debt is expunged earlier than entry of the capital increase in the National Court Register.
Potential problems when increasing share capital under the existing articles of association may arise with a larger number of shareholders. In such a situation, the shareholders should be entitled to new shares pro rata to their existing shares. Thus, if the capital is increased without amending the articles of association, the parity of shares between the shareholders must be maintained. On the other hand, rare situations occur where the value of the converted debt corresponds ideally to the shareholders’ stakes, and in such case converting them in full would mean increasing the value of all shares at the expense of the shareholder whose debt was worth more.
On the other hand, a change in parity implies the need for the involvement of a notary and the standard procedure for increasing capital by amending the articles of association (i.e. by a notarial deed). Here, in turn, the shareholders who do not want to convert their claims, do not hold claims, or whose converted claims are of lesser value, face potential dilution of their stake in the company.
Tax issues
Another extremely important aspect of the conversion is its proper accounting for tax purposes.
Income on the part of the shareholder
In light of the well-established practice and case law of the Supreme Administrative Court of Poland, regardless of the conversion model adopted (in-kind contribution of the claim or setoff of the debt against the cash contribution), conversion of debt to equity will be considered a non-cash contribution for tax purposes. The practical consequence of this is that a shareholder must recognise revenue in an amount equal to the value of the contribution as specified in the articles of association or equivalent document. In doing so, the revenue cannot be less than the market value of the contribution.
At the same time, a shareholder may recognise a corresponding deductible expense, provided that the principal of the loan was transferred to the company’s account. In practice, this will mean no additional tax to be paid on the conversion (i.e. tax neutrality). However, a condition defined for recognising a deductible expense may lead to a lack of neutrality of the conversion when the loan was paid out other than in cash to the borrower, for example through a remittance to another creditor of the borrower (przekaz). In the case of conversion of non-loan liabilities, the expense will be the value of the debt previously included in taxable income. Importantly, a conversion performed by one shareholder does not affect the tax liability on the part of the remaining shareholders; any potential increase in the value of their shares resulting from the conversion will be taxed only when they sell their shares.
Under Polish regulations, if a shareholder is a foreign entity, revenue does not necessarily arise.
Withholding tax
If the conversion includes an interest portion payable to a foreign shareholder, it is also necessary to examine the company’s potential withholding obligations. In particular, this includes collecting documents necessary for application of a preferential rate or exemption from withholding tax, exercising due diligence in verifying the rationale for such a rate or exemption (including determining whether the recipient is the beneficial owner of the payment), or applying the pay-and-refund mechanism.
A tax liability arises on the payment of interest in any form, including, for example, by setoff. In the case of conversion, unlike cash interest payments, the economic burden of withholding tax will most often lie with the debtor, as there is no payment on which tax can be deducted, leading to the effective grossing up of interest. Such a configuration may mean that in the withholding (pay and refund) procedure, the entity entitled to claim a tax refund will be the company repaying the loan. However, this does not exclude contractual arrangements effectively shifting the cost of the tax to the lender.
Civil transaction tax
A share capital increase is subject to the tax on civil-law transactions (0.5% of the value of the increase). The amounts transferred to the capital reserve (agio) are not taxable. Since the Commercial Companies Code give leeway in determining the proportion of share capital and agio, the question arises whether the tax authorities can challenge such an allocation as aiming to understate the tax base. In principle, the answer to this question seems to be affirmative. But in assessing such risks, it should be borne in mind that the allocation of even a large portion of the increase to the capital reserve may have a legitimate economic justification.
For example, when a conversion is dictated by the need to improve the company’s financial indicators (e.g. eliminating negative equity), it is reasonable to increase the share capital to a minimal extent. In such a situation, the purpose of the conversion is not to increase the share capital, and the process itself is driven by external factors (e.g. to meet covenants imposed by banks lending to the company). Also, the allocation of the increase may be justified by the existing equity structure. On the other hand, in the case of a joint-stock company, the argument for allocating the increase to the capital reserve may be that an increase in the share capital results in the need to increase the value of the capital reserve. Therefore, an excessive increase in share capital may adversely affect the company’s ability to pay dividends.
Consequently, the existence of a business case for the allocation should be assessed in each instance, including for the purpose of properly fulfilling potential obligations to report on tax schemes. Indeed, to determine the reporting obligation, it may be necessary to assess whether the “main benefit” criterion is met, i.e. in simple terms, to determine whether the tax benefit is the main benefit or one of the main benefits that the participant expects to achieve in relation to carrying out the conversion.
Notary fee vs. transaction tax
The notary fee payable on capital increases with an amendment to the company’s articles of association reduces the base for calculating the tax on civil-law transactions. Therefore, the best tax solution is usually for the company itself to pay the notary fee, which will be subject to VAT in Poland.
This may not be possible if the notary’s fee is paid by a foreign shareholder. If the shareholder is from outside the EU, then the notary fee is not subject to VAT. If the foreign shareholder is based in the EU, two cases are possible:
- When the shareholder is an active VAT payer and does not hold an EU VAT number, then Polish VAT will be added to the notary fee
- When the shareholder is an active VAT taxpayer and holds an EU VAT number, then the notary fee will be exempt from Polish VAT (under the reverse-charge mechanism).
Not charging VAT on the fee means no reduction in the company’s cost associated with the need to pay the transaction tax.
Information regarding the payer of the notary fee should be provided to the notary in advance so that they can make the appropriate calculations. In doing so, it should be borne in mind that the notary, as the remitter of the transaction tax, must receive from the company the amount of tax for subsequent payment.
Converting a company’s liability into its share capital can serve a variety of purposes, ranging from tax benefits to improving credibility in the market due to reduced debt levels, or reducing the risk of insolvency. In this process, we have advised entities from many different industries and fields, such as SPVs investing in and implementing renewable energy projects or managing real estate. We have also applied similar mechanisms in M&A, real estate and financing transactions, when a party to the transaction or the provider of the financing for whatever reason does not wish for the continued existence of the converted liability.
Jakub Macek, attorney-at-law, tax adviser, Tax practice, Wardyński & Partners
Marek Dolatowski, adwokat, M&A and Corporate practice, Energy practice, Wardyński & Partners
Cyryl Jachimski, M&A and Corporate practice, Wardyński & Partners
