Not many legal issues in the sphere of Cyprus corporate law has attracted so much debate, uncertainty and varied responses than the issue of whether a shareholder’s contribution to a Cypriot company by way of gift is freely returnable to the same shareholder or to all the shareholders of the company without Court sanction. Apparently, the reason for this uncertainty is the lack of clear guidance in the Law and the fact that the question involves a blend of legal and accounting principles.
The purpose of this article is to provide useful hints and guidance when a legal or accounting professional is agonizing over the treatment of a shareholder’s contribution from either perspective.
Some corporate and accounting practitioners hold the view that this question is a pure legal one. Others they opt to the opposite argument that the matter is purely accounting. As already stressed above, this article supports the view that the issue should be addressed from the standpoint of both areas of practice and to our understanding its resolution is reached by answering the following question:
What is the legal nature of the “shareholder’s contribution” and how should it be accounted for in the company’s accounting records and financial statements having regard to acceptable accounting principles (for instance IFRS)?
Thus, the legal nature of the “contribution” is critical to be firstly examined, both from a legal perspective and from the perspective of the IFRS, namely whether the “shareholder’s contribution” should be considered as share capital, equity, reserves, realized profits or some other element reported in the financial statements of an entity should better characterize it, having regard to the principle that what matters is not the label that one chooses to ascribe on a transaction but rather its purpose and substance.
It is noted that the application of IFRS by Cypriot Companies is obligatory under article 143 of Companies Law, Cap. 113.
Definition of Capital
The terms “capital” and “share capital” are not defined in the Companies Law. The term “capital”, in particular, is so wide, vague and ambiguous that has given rise to numerous and varied interpretations, especially when used in different contexts. The word “capital” sometimes means, or may take the meaning of, “nominal capital”, “issued capital”, “paid-up capital”, “loan capital” etc. Also, there is no definition of the term “capital” in Cap. 113. Indeed, as stated by an honorable judge “it is impossible to say that “capital” has a single technical meaning which prima facie should be attributed to the word in any statutory provision”. It is evident that the meaning of the word “capital” takes a more precise meaning when combined with a descriptive word.
For all practical purposes, though, the “capital” represents the cash injected in a company, in exchange of shares, which is destined to be utilized for the business and investment needs of the company.
In corporate reality and law, the term “capital” or “share capital” takes the following form: (1) Nominal capital; (2) Issued capital; (3) Paid-up capital; (4) Reserve Capital; (5) Quasi-Capital Funds (i.e. share premium and capital redemption reserve fund). In all cases, the capital is associated with the holding of shares in a company and represents the share of a holder to the company’s assets after deducting its liabilities. Apparently, the “shareholder’s contribution” cannot be purely and directly associated with the notion of “capital” having regard to the absence of any allocation of shares in exchange to the contribution made by the shareholder.
Equity and Reserves
Equity is mostly an accounting notion than legal and it encompasses wider spectrum of elements within it. The term “equity share capital” used to be found in article 148 of Cap. 113, however was abolished back in 2003 at the same time when the appication of IFRS became obligatory for Cypriot companies. In IFRS, the term “Equity” is defined as “the residual interest in the assets of the entity after deducting all its liabilities”. In assessing whether an item meets the definition of equity and be included under the Equity section of the balance sheet, attention needs to be given to its underlying substance and economic reality and not merely its legal form (IFRS).
The Equity may be sub-classified into the share capital, retained earnings and reserves. The classifications are relevant to the decision-making needs of the users of the financial statements, including creditors, when they indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity (emphasis added).
In accordance with Cap. 113, in the course of the preparation of the financial statements, the only reserve funds with are recognized is the capital and revenue reserve funds. Any reserve other than capital reserve is taken as “revenue reserve”. The creation of reserves is provided in the articles of a company. Table A of Cap. 113 (article 117) provides that the reserve funds are created out of the realised profits of the company at the discretion of the directors who may decide to withhold any amounts out of the profits for investment purposes, for the needs of the company’s business or for any other purpose at their discretion (provided of course that the purpose falls within the objects of the company taking into consideration its best interests).
It has been seen that many professionals, when asked with the question as to where the “shareholder’s contribution” should be recorded they provide the simple answer: under Equity. But, having regard to the definition of Equity, this is not the end of the story. What is important to be stated and determined, of course, is the specific classification of the “shareholder’s contribution” under Equity.
Classification of Contribution by way of gift
Having regard to the above definitions and interpretations, the absence of any definite quidance in the Companies Law, the principle of both law and accounting which dictates reliance on the purpose and substance of a transaction and the fact that almost invariably the reason that a shareholder contributes in a company is, obviously, to increase its cash reserves so that the company defrays its existing and future business and investment needs, we confidently express our accord with the treatment and classification adopted by many or probably most of the accounting professionals in Cyprus who account the “shareholder’s contribution” by way of gift as a quasi-capital element under Equity and describe it as shareholder’s contribution or equity contribution or alike.
As stressed, the substance and commercial reality of this item is evident or at least anticipated: the injection of the company with additional capital/funds in order to tone up or boost the activities and business of the Company or to settle existing liabilities. A sound reason for which a shareholder may inject funds in a company by way of contribution without getting shares in exchange (as a gift) is for avoiding dilution of the existing holdings. Sometimes, however, the real reason and ultimate aim for the contribution without taking shares in exchange, is the ability and leeway which this arrangement offers to attain return of capital to the contributing shareholder without the sanction of the Court. Nonetheless, it is very much doubted that such an arrangement may stand at law as a legal and tolerable one when it, admittedly, serves as a mechanism to sidestep the provisions of the Law and clearly falls afoul the doctrine of “capital maintenance” which is recognized both in common law and by IFRS (further details about capital maintenance are outlined further down).
Besides, the argument that the contribution by way of gift should be classified as a quasi-capital item in the financial statements is supported by quite recent English caselaw which, even though it is not common law and has only persuasive power for the Cypriot Courts, having regard to the practice of Cypriot Courts, we tend to believe that it would have been followed had the issue come before them. In particular, the Court in that case ruled that capital contributions are to be treated as if they were part of paid up capital and, as such, they are NOT and should not be considered as realized profits available for distribution to shareholders. Yet, it needs to be stressed that the aforesaid caselaw did not examine the issue in question in conjunction with the IFRS rules and did not consider the question of whether a cash contribution gives rise or may also be treated as “realized profits”. Now, whether, in accordance with the accounting principles as enunciated in the IFRS, the cash contribution can be considered as realized profit and as such included in the distributable reserves, is an issued for IFRS experts to opine upon.
Position in the UK
At this point, it is important to note, at least for the sake of information and thought even though not applicable in Cyprus, that in the UK, the recognition of a cash contribution as realized profit in the books of UK companies has been incorporated into the Companies Law of the UK. In particular, section 830(2) of the Companies Act defines a company’s profits available for distribution as “its accumulated, realized profits…”. Realized profits and realized losses are defined in the Act as “such profits or losses of the company as fall to be treated as realized in accordance with principles generally accepted at the time when the accounts are prepared…”. Section 853(4) of the Companies Act 2006 includes in the definition of “profit” any amounts which are profits as a matter of law or which are treated as profits including gratuitous contributions of assets from owners in their capacity as such.
In addition to the abovementioned, ICAEW technical release (Tech 02/17BL) issued in 2017 representing generally accepted accounting practice as of 31 December 2016, suggests that a profit is realized where it arises from, amongst others, a transaction where the consideration received by the company is “qualifying consideration” which, in turn, comprises, amongst others, a gift such as a capital contribution received in the form of cash or in the form of an asset that is readily convertible to cash or in such other form of qualifying consideration (however, it goes on to clarify that it does not apply when the legal form of the transaction is a loan even though it is accounted for as a capital contribution).
The extent of the application, binding or guiding effect of ICAEW’s Technical Release to the accounting principles applying to Cypriot companies is out of the scope of this Article.
Capital Maintenance Doctrine
In light of the aforesaid and on the premise that the substance and economic reality of the gratuitous contribution paid by the shareholder to the Company is pervaded with capital elements (i.e. not a liability or some other element), it is reiterated that the contribution should be recognized and accounted for under Equity as a quasi-capital fund.
Another question which surfaces in the context of this analysis is “whether a company has the option to distribute, in any manner, to a company’s shareholder(s) a past contribution made by the sole shareholder to the company as a gift”, given that, according to the aforesaid, it will be recorded under the Equity as shareholder’s contribution.
The doctrine of capital maintenance has been adopted for the protection of the companies’ creditors and to counterbalance the limited liability priviledge that the shareholders of a company enjoy. According to caselaw, a creditor relies on the financial statements of a company before he transacts with the company and he also gives credit on the faith of the representation that the capital of the company shall be applied only for the purposes of the business and shall not be retunred back to its shareholders. In a leading common law case and, therefore, binding authority in Cyprus, the following important remarks have been enunciated:
“The capital may, no doubt, be diminished by expenditure upon and reasonably incidental to all the objects specified. A part of it may be lost in carrying on the business operations authorized. Of this, all persons trusting the company are aware, and take the risk. But I think they have a right to rely, and were intended by the Legislature to have a right to rely, on the capital remaining undiminished by any expenditure outside these limits, or by the return of any part of it to the shareholders … Whatever has been paid by a member cannot be returned to him. It also follows that what is described in the memorandum as the capital cannot be diverted from the objects of the company. It is, of course, liable to spent or lost in carrying on the business of the company, but no part of it can be returned to a member so as to take away from the fund to which the creditors have a right to look as that out of which they are to be paid”.
Further, in more recent English caselaw, the Court said or accepted the following upon citing earlier common law judgments which deal with the principle of capital maintenance and with the power of a company to make payments to shareholders from sources other than the distributable profits of the company:
“Whether or not the transaction is a distribution to shareholders does not depend exclusively on what the parties choose to call it. The court looks at the substance rather than the outward appearance … A company can only lawfully deal with its assets in furtherance of its objects. The corporators may take assets out of the company by way of dividend, or, with the leave of the court – by way of reduction of capital – or in a winding-up. They may of course acquire them for full consideration. They cannot take assets out of the company by way of voluntary distribution, however described, and if they attempt to do so, the disgtribution is ultra vires the company”.
It is a well-known principle of law that a company cannot lawfully make a distrubution of its capital. On the question whether a payment to a shareholder should be considered a “distribution” and whether has been a return of capital, it is clearly NOT a matter what label is put on a transaction but what matters is its purpose and substance. In that regard, it is very interesting to mention that in a UK case, unjustified payment of remuneration to a director who was also shareholder in the company was deemed to be an indirect return of capital and therefore the Court found the shareholder liable to return the received amounts back to the company.
The concept of capital and capital maintenance is also found in IFRS. The financial concept of capital, which is adopted by most entities in preparing their financial statements, is described in IFRS as the money or purchasing power invested in a company. As such, capital is regarded to be synonymous with the net assets or equity of the entity. This is what a creditor looks at when examining the company’s financial situation and viability to form a decision as to whether to transact with the company or not, i.e. the company’s Equity. The concept of capital maintenance, as stressed in IFRS, is concerned with how an entity defines the capital that it seeks to maintain. It provides the linkage between the concepts of capital and the concepts of profit in the sense that it sets the point of reference by or after which the profit is measured; only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit and therefore as a return on capital. Capital maintenance is a prerequisite for distinguishing between an entity’s return on capital and its return of capital (which is prohibited). Hence, profit is the residual amount that remains after expenses – including capital maintenance adjustments where appropriate – have been deducted from income.
In the absence of definite guidance, rules or principle of law in Cyprus on the issue under examination and having regard to the above-mentioned principles and definitions cited in UK legislation, caselaw and guidance (some of which are binding, other have persuasive power and other offer useful guidance) but also the practice and views of most of the accounting practitioners, we tend to the conclusion that the cash contribution by way of gift should, in most of the cases, be safely recognized and accounted for under the Equity element of the financial statements and classified as shareholders’ or equity contribution.
However, it is suggested that the cash contribution might, if the occassions permit, be recognised as “realised profit” in the form of a gain falling to the benefit of the company (not revenue) which even though has not arisen in the course of the ordinary activities of the company’s business, it still increases its economic benefits (see IFRS). Obviously, in order to ascertain whether the item in question should be accounted for under the element of Equity or Income, its nature and function in the business of the company as well as its substance and economic reality should first be examined. Needless to say that this exercise and assessment must be addressed to the people practicing IFRS or even experts of IFRS to carry out, provided they have before them all the relevant and requisite background information of the company under examination.
As one would expect, if the cash contribution is accounted for directly under Equity and take the form of a quasi-capital fund, will be clothed with the qualities, characteristics and restrictions of capital. In the aforesaid case, it should definitely NOT be recorded in the distributable reserves fund account of Equity. In such case (i.e. if goes under Equity as shareholders’ contribution), it should be returned to the shareholders (always based on their respective holdings) ONLY on the winding-up of the company or upon the SANCTION OF THE COURT which is the guardian to safeguard the interests of the creditors. In order to equip the Company with the necessary constitutional mechanisms permitting the return of cash contribution back to the shareholder(s), it is recommended that requisite adjustments are being done, or relevant provisions with appropriate wording are included, in the Company’s Articles of Association (“AoA”) and the usual reduction of capital rules and procedure provided in the Law is followed (that is, reduction of capital through Court).
If the cash contribution is deemed by the IFRS practitioner to be closer to a gain/income and thus a “realised profit”, it should be recorded in the reserves and fall under the discretion of the entity’s board of directors to decide whether will be placed in a distributable reserve and thus available for distribution to the shareholders pro rata to their holdings or to any other reserve fund that may be utilized for the purposes of the business. Again, in the aforesaid scenario, it should be recommended that the AoA of the entity in question is adjusted in such fashion as to reflect and sanction the above reporting arrangement.
Finally, it is worth underlying and someone should always have in contemplation the fiduciary position and duties of the directors to act for the best insterests of a company in the exercise of the powers vested on them. The directors have an obligation to safeguard the company’s assets and take reasonable steps to ensure that the company is in a position to settle its debts as they fall due. Directors must, therefore, specifically consider whether the company will still be solvent following a proposed distribution. Thus, directors should consider both the immediate cash flow implications of a distribution and the continuing ability of the company to pay its debts as they fall due.