Kapitalizace pohledávky

What is debt capitalization and when should it be used?

Debt capitalization can be used, in particular, in situations where:

• The company is facing cash flow problems and is unable to repay its debts in cash

• There is a risk of bankruptcy or insolvency, and the business needs to quickly strengthen its equity

• A parent company wants to financially support a subsidiary while also consolidating its ownership structure

• A preventive restructuring is underway according to Act No. 284/2023 Coll.

• The company needs to improve its financial indicators for banks and business partners

The lawyers at the ARROWS law firm have many years of practical experience with such situations. We will help you not only with preparing the agreements and documentation for a debt capitalization, but also with the entire preventive restructuring process, including the preparation of a restructuring plan.

How does capitalization work in practice?

Debt capitalization is carried out through the process of increasing a company's registered capital, where the receivable is set off against the liability for the subscribed equity. The Business Corporations Act (ZOK) only allows for capitalization in the form of a monetary contribution with a subsequent set-off of the receivable. This has a crucial practical impact – it is not a non-monetary contribution, and therefore it is not necessary to prepare an expert valuation.

A practical example

A parent company provided its subsidiary with a loan of CZK 10 million for a period of five years. The subsidiary repaid only 50% of the debt, and the remaining CZK 5 million will be capitalized to increase the subsidiary's registered capital. The book value of the contributed receivable is transferred to the value of the security or share.

What is the difference between debt capitalization and a non-monetary contribution?

Many entrepreneurs confuse debt capitalization with a non-monetary contribution of a receivable. The difference is fundamental, especially in the procedural steps:

Debt capitalization: This is actually a monetary contribution that is paid by setting off a creditor's receivable from the company against the company's receivable from the shareholder for payment of the contribution. An expert valuation is not required. It is a simpler and faster process.

Non-monetary contribution of a receivable: The receivable is the direct subject of the contribution, which requires an expert valuation and compliance with stricter formal requirements. However, the Business Corporations Act prohibits a shareholder's receivable from the company from being the direct subject of a contribution (Section 21(3) of the Business Corporations Act), but in the very next sentence, it allows for it to be set off.

Note: In practice, debt capitalization is more often chosen precisely because of its administrative simplicity and the absence of a requirement for an expert valuation. The ARROWS law firm has extensive experience with both procedures and will advise you on which path is most suitable for your situation.

What must the general meeting's resolution contain?

When deciding on debt capitalization, the general meeting must adopt a resolution that contains the key elements required by law:

• The new amount of the registered capital and the amount by which it is being increased

• The deadline for assuming the contribution obligation (usually 2 months)

• Identification of the shareholders who are assuming the contribution

• The method of payment – i.e., that a set-off of the receivable will be performed

• The issue price of new shares (for a joint-stock company) or the new amount of shareholders' contributions (for a limited liability company)

The general meeting's decision to change the registered capital must be in the form of a notarial deed. Without this form, the decision cannot be registered in the Commercial Register, and the entire process is ineffective. The invitation to the general meeting where the capitalization will be voted on must include this item on the agenda.

What is the procedure for registration in the Commercial Register?

After the general meeting adopts the resolution and the contribution obligation is assumed, the statutory body (the executive director for a limited liability company, the board of directors for a joint-stock company) must, without undue delay, file an application to register the new amount of the registered capital in the Commercial Register.

The effects of the increase in registered capital do not occur until the moment the new amount of registered capital is registered in the Commercial Register. Until then, the increase is recorded in account 419 – Changes in Registered Capital. Only after registration in the register is it rebooked to account 411 – Registered Capital.

The following must be submitted with the application for registration:

• The notarial deed from the general meeting with the decision to increase the registered capital

• The agreement on the set-off of the receivable

• Proof of assumption of the contribution obligation

• Documents proving the existence of the receivable (loan agreement, invoice, etc.)

The experience of the lawyers at the ARROWS law firm shows that the process of registration in the Commercial Register often encounters formal errors in the documentation, which the registration court rejects. The result is unnecessary delays, repeated applications, and an increase in the cost of the entire transaction. Our firm has years of experience preparing documentation for registration courts and will help you avoid these pitfalls. Do not hesitate to contact our office at consultation@arws.cz.

Tax aspects for the creditor (contributor of the receivable)

For the creditor (the one capitalizing the receivable), the following rules apply:

• If they capitalize the receivable at its nominal value, it is a tax-neutral operation

• For a taxpayer keeping tax records, the value of the receivable is always taxable income – even if it was assigned for a price lower than its nominal value

• The creditor ceases to have a right to a one-off payment and acquires a recurring right to a share in profits or the liquidation balance

Tax aspects for the debtor (receiving company)

For the debtor, the following changes occur:

• Extinction of the debt – the company finances from its own resources

• Reduction of external liabilities and increase in equity (better financial structure)

• Improvement of balance sheet ratios (e.g., equity/liabilities)

• Important: A business corporation into whose registered capital a receivable has been capitalized cannot create tax-deductible provisions for this receivable (with the exception of transformations under Section 24(9) of the Income Tax Act)

This prohibition has an unnecessary negative impact – if the company were to create provisions for the receivable, the tax base would increase. Therefore, it is crucial to set up the entire process correctly.

The lawyers at ARROWS have experience coordinating tax advisors and accountants during debt capitalizations. Thanks to close cooperation with tax experts, we can minimize tax impacts and ensure that the entire process is optimal from a tax perspective.

How does capitalization relate to preventive restructuring?

Since September 2023, Act No. 284/2023 Coll., on Preventive Restructuring, has been in effect in the Czech Republic. This act allows entrepreneurs in a difficult financial situation (but not yet bankrupt) to resolve their debts through preventive restructuring – a process that is less formal than insolvency proceedings and allows for greater flexibility.

Debt capitalization is one of the key restructuring measures that can be used in preventive restructuring. The law explicitly states that the method of carrying out debt capitalization must be precisely described in the restructuring plan. When capitalizing receivables, it is required to state the new composition of owners and equity interests after the capitalization.

Other restructuring measures under the Preventive Restructuring Act

In addition to debt capitalization, the following can be used:

• Extension of the maturity of receivables or change in payment terms

• Forgiveness of part of the debts (debt waiver)

• Financial injection – increasing equity through a contribution from a shareholder or the entry of an investor

• Change in the structure of liabilities (from short-term to long-term)

Important: Within the framework of preventive restructuring, it is now possible to write off a receivable from a debtor for tax purposes if the receivable is directly affected by the restructuring plan and has been extinguished by a debt waiver under an effective restructuring plan (Section 24(2)(y)(7) of the Income Tax Act). This is a significant advantage compared to regular capitalization outside of preventive restructuring.

The ARROWS law firm has experience in preparing restructuring plans and the entire preventive restructuring process. We will help you develop a recovery project, a restructuring plan, negotiate with creditors, and achieve approval of the plan. Thanks to the ARROWS International network, built over ten years, we can also handle preventive restructuring for cases with an international element, which we deal with on a daily basis.

What are the strategic advantages and disadvantages of capitalization?

Debt capitalization has a number of advantages for both parties – the creditor and the debtor – but also certain risks.

Advantages for the debtor company

• Extinction of the liability without the need to pay out cash, which improves cash flow

• Strengthening of equity, which increases the company's credibility with banks and business partners

• Improvement of financial ratios – liabilities decrease, equity increases

• Prevention of insolvency and protection against bankruptcy

• More flexible financing than external bank loans

Advantages for the creditor (contributor)

• Equity participation in the debtor – the creditor becomes a shareholder and gains the right to decide on the company's direction

• Potential profits – instead of a one-off repayment of the debt, the creditor has a chance for recurring shares in profits

• Protection of the investment – if the debtor were to go bankrupt, the creditor would not be able to collect the receivable anyway; through capitalization, they gain at least a share

Disadvantages and risks

• Loss of liquidity of the receivable – the creditor can no longer demand repayment of the debt in money

• Business risk – the creditor becomes a shareholder and bears the risk of loss and business failure

• Change in ownership structure – original owners may fear dilution of their shares

• Administrative complexity – the process requires a notarial deed, registration in the register, and accounting and tax treatment

• Risk of errors in the process – an incorrect procedure can lead to the rejection of registration by the registration court, tax implications, and even the personal liability of the statutory body

Hidden pitfalls of debt capitalization

• Tax implications: Incorrect tax treatment of capitalization can lead to additional tax liabilities, penalties, and interest. The tax administrator may challenge the valuation of the receivable or order an increase in the tax base.

• Procedural deadlines: A late filing of the application for registration in the Commercial Register can have negative accounting and tax consequences.

• Formal requirements: A missing notarial deed, an incomplete general meeting resolution, or an incorrectly prepared set-off agreement can block the entire process.

• Links to other regulations: Debt capitalization is affected not only by the Business Corporations Act, but also by the Income Tax Act, the Act on Accounting, the Act on Reserves, and possibly the Preventive Restructuring Act.

• Creditor protection: When reducing registered capital (often associated with restructuring), you must comply with protective measures for creditors, otherwise the statutory body faces personal liability.

• Coordination of multiple experts: Successful capitalization requires the coordination of a lawyer, an accountant, a tax advisor, and possibly a notary.

This is precisely why it is safer to entrust the entire process to experts who handle this agenda daily. The ARROWS law firm is insured for damages up to CZK 500,000,000, so it is safer for the client to have the matter professionally handled. We also regularly partner with in-house lawyers to resolve special matters.

How can you minimize the risks?

Minimizing the risks of debt capitalization requires careful preparation, coordination of multiple experts, and compliance with all legal requirements. The ARROWS law firm can help you with this as follows:

Comprehensive legal services from ARROWS for debt capitalization

• Preparation of complete documentation: Set-off agreement, draft general meeting resolution, notarial deed, application for registration in the Commercial Register

• Legal consultation: Analysis of your situation, assessment of tax implications, choice of the optimal restructuring strategy

• Coordination with tax advisors and accountants: Ensuring the correct tax and accounting treatment of the entire transaction

• Representation before registration courts: Filing the application for registration, communication with the registration court, correction of any deficiencies

• Preventive restructuring: Preparation of a recovery project and restructuring plan, negotiation with creditors, representation in court

• International dimension: Thanks to the ARROWS International network, we can also handle debt capitalizations in cases with an international element, which we deal with on a daily basis

Our experience from providing long-term services to our clients plays a crucial role. Our portfolio includes more than 150 joint-stock companies, 250 limited liability companies, and 50 municipalities and regions. We pride ourselves on speed and high quality. Connect with us and get a tailor-made legal solution.

When is it better to choose a different strategy than capitalization?

Debt capitalization is not a universal solution for all debt situations. In some cases, it is more appropriate to choose a different restructuring strategy:

Alternative debt restructuring strategies

1. Contribution outside of registered capital: Faster and simpler than capitalization, does not require registration in the register. Suitable for short-term bridge financing.

2. Installment agreement: If the debtor has a prospect of improving cash flow, an installment plan with an extended maturity can be agreed upon.

3. Forgiveness of part of the debt: As part of a preventive restructuring, part of the debt can be forgiven and the receivable can be written off for tax purposes.

4. Entry of a new investor: A financial injection from a strategic or financial investor can provide fresh capital without burdening the debtor with liabilities.

5. Sale of the business or part of it: In some cases, the best solution is to sell part of the business and use the proceeds to repay debts.

The ARROWS law firm will help you choose the most suitable strategy for your specific situation. We can connect clients with each other if they have interesting investment or business opportunities. We are also happy to listen to interesting entrepreneurial or business ideas. If you are looking for financing or a business partner for a purchase or sale in a particular area, do not hesitate to contact us.

Conclusion: Debt capitalization as a strategic tool that requires a professional approach

Debt capitalization is an effective tool for restructuring corporate debt and strengthening a company's equity. It allows for the transformation of liabilities into an equity stake, thereby improving the company's financial structure and preventing insolvency.

However, the capitalization process is not as simple as it may seem at first glance. It requires the coordination of lawyers, accountants, and tax advisors, compliance with strict formal requirements, and mastery of a number of procedural steps. Errors in the process can lead to the rejection of registration in the Commercial Register, tax implications, and even the personal liability of the statutory body.

If you do not want to risk errors, damages, or fines, you can safely entrust the entire matter to the ARROWS law firm. Our experience from handling this issue daily, our liability insurance of up to CZK 500,000,000, and our extensive portfolio of more than 150 joint-stock companies, 250 limited liability companies, and 50 municipalities and regions are a guarantee of a high-quality and fast solution. We also regularly partner with in-house lawyers to resolve special matters.

Thanks to the ARROWS International network, we can also provide legal services in cases with an international element, which we deal with on a daily basis. Do not hesitate to contact us – just contact our office at consultation@arws.cz.