The purpose of the prohibition on loans is to establish protection for the capital and creditors of public limited companies (AS) or private limited companies (OÜ). Sections 159 and 281 of the Commercial Code establish the rules, respectively, that a private limited company may not grant a loan to a shareholder who holds more than 5% of the share capital and a public limited company may not lend to a shareholder whose share represents more than 1% of the share capital. The same principle of prohibited loans applies to the company’s parent’s shareholders and other members. It is also prohibited for the company to grant loans to their management board and supervisory board members or procurators. Neither public nor private limited companies may finance acquisition of their shares in the company.
The Commercial Code also sets forth an exception – subsidiaries have the right to grant a loan to their parent or to a shareholder or member in the same group as the subsidiary, as long as this does not harm the financial state of the public or private limited company or the interests of creditors.
A transaction that violates the loan prohibition is void. The proceeds of a void transaction must be returned to the company. In decision no. 3-2-1-109-04, the Supreme Court has stated that violation of the loan prohibition is a significant legal violation since the purpose of imposition of the prohibition has been breached – i.e. protecting the interests of creditors and minority shareholders. According to Section 87 of the General Part of the Civil Code Act, a transaction contrary to a prohibition arising from law is void. Subsection 84 (1) of the same act states that a void transaction has no legal consequences from inception. Anything received on the basis of a void transaction shall be returned pursuant to the provisions concerning unjust enrichment unless otherwise provided by law. The limitation period for submitting a claim arising from unjust enrichment is three years as of becoming aware of the violation but no later than ten years after. The limitation period for a claim arising from unjust enrichment shall be three years from becoming aware of the enrichment and no more than ten years of occurrence of the unjust enrichment (Section 151of the General Part of the Civil Code Act).
In order to establish the voidness of a transaction, creditors and minority shareholders and partners may issue a claim to the company, which shall be resolved either by agreement between the parties or in court in the form of an action.
Insofar as a company is headed by a management board, the violation of loan prohibition may result in liability of a management board member (e.g. if the counterparty fails to return the loan and related gains), since the management board member has violated the duty of care and loyalty expected of a decent business person. Subsections 37 (1) and (2) of the General Part of the Civil Code Act stipulate that the members of the company’s management board who have caused damage to the company through violation of obligation shall be jointly and severally liable to the company. A claim for damages against a management board member may also be filed by a creditor if the creditor is unable to satisfy its claims from the legal person’s assets. The limitation period on a claim brought against a member of a management body of a legal person ends five years after the violation of the obligation.
I would also note that if shareholders have been issued loans in violation of law, the auditor may address such transactions and related risks in a memorandum or auditor’s report.
In itself, a loan prohibition does not result in a tax liability, considering that the economic content and not the form of the transaction is what counts for the purposes of taxation. The main requirement is that the loan must be granted for business purposes and be economically sound, which generally means that interest or, in certain cases, some other monetarily appraisable benefit is received for the loan. Otherwise there is the risk that the tax authority may deem such a loan a concealed profit distribution to the owner and that income tax will be assessed on the loan disbursement (subsection 50 (1) of the Income Tax Act). The risk of reclassification may also exist if other major conditions of the loan transaction are clearly unreasonable, e.g. loan is granted without a term, collateral and regular interest payments.
If, after all circumstances are assessed, the form of the loan transaction appears reasonable and if, in addition to economic considerations (such optimisation of income tax on dividends) there is also some other objective that yields economic results, the risk of reclassification of the loan transaction is low.
Yet in the case of even an economically justified loan transaction, it should be considered that in the context of a loan prohibition, the transaction is one that is executed between related parties – thus, transfer pricing applies. In the case of a loan transaction, the transfer price is considered to be the loan interest margin, which must be in line with market value. If interest on the loan is substantially under market levels, income tax is levied on the part of the interest income that was not received but which the lender would have been expected to receive in the case of a similar transaction with an unrelated person (subsection 50 (4) of the Income Tax Act).
If the loan transaction was executed with employees (including members of management and supervisory bodies) and comes under the rules on fringe benefits, the minimum level of interest specified in Section 94 of the Law of Obligations Act as at the date on which the loan was granted must be adhered to. If the employee is granted a loan at an interest lower than that specified in legislation, the interest income forgone will be subject to fringe benefit taxes.
The Commercial Code sets out the principle of prohibited loans, but since legislation does not directly provide for penalties, the granting and guaranteeing of such loans does tend to happen in everyday business activity. Violation of the prohibition may result in legal expenses in connection with claims filed by creditors under judicial procedure seeking the establishment of voidness. Violation of the prohibition may also invite scrutiny from tax authorities as to the economic content and purpose of the transaction, even if the company receives interest on the loan. For that reason, I recommend adhering to the principles of protection of company’s capital and creditors’ claims, set forth in the Commercial Code, and if necessary, to perform an additional tax and legal analysis for identifying concealed risks.
