This article provides an overview of the legal and tax aspects of debt-to-equity conversions in Bulgaria that are relevant for the successful implementation of a restructuring.
OBJECTIVES OF A CONVERSION AND LEGAL MECHANISMS
In a debt-to-equity conversion, a creditor converts a receivable into shares of the registered capital of the debtor. The converted debt is discharged and, in exchange, the creditor acquires shares in the registered capital of the debtor. As a result, the overall indebtedness of the debtor is decreased, while its equity is increased accordingly. Such debt-to-equity conversions may be initiated with the aim of achieving various objectives, such as:
- capitalising the debtor when its net assets fall below the figure of its registered capital;
- settlement of intra-group receivables on a cash-free basis;
- avoiding over-indebtedness and, respectively, the bankruptcy of a debtor;
- preparing the debtor for liquidation when the debtor does not have sufficient assets to repay its intra-group debts;
- preparing the debtor for sale (especially when the sale will be performed on a ‘cash-free debt-free’ basis); and
- implementing a debt work-out in relation to a distressed debtor (and in particular when restructuring remaining debt facilities).
The Bulgarian Commercial Act (BCA) 1991 allows debt-to-equity conversions for both limited liability companies and joint-stock companies. A debt-to-equity conversion may be performed through the following mechanisms:
- increase of the registered capital of the debtor through in-kind contribution of receivable;
- increase of the registered capital of the debtor through a cash contribution and subsequent repayment of the debt with the received cash;
- conversion of convertible bonds into shares in a joint-stock company; or
- contribution of the debt into the reserve fund of the debtor, if the debtor is a joint-stock company.
An economically similar effect is achieved through a waiver of debt when the creditor is already a shareholder in the debtor or its sole owner. However, such solution triggers adverse tax consequences.
The increase of the registered capital of the debtor may only be implemented with the consent of its shareholders. The required percentage of shareholders voting in favor of the debt-to-equity conversion depends on whether the company is a limited liability company (unanimity) or a joint-stock company (majority of two-thirds). The articles of association of the joint-stock company may provide more stringent requirements for shareholders’ voting required for the conversion. By way of exception, in cases of bankruptcy of the debtor, a court decision may replace the consent of the shareholders.
IN-KIND CONTRIBUTION OF A RECEIVABLE: THE UNIVERSAL SOLUTION
The increase of the registered capital of the debtor through in-kind contribution of a receivable is relatively straightforward for both limited liability companies and joint-stock companies. However, the Bulgarian Act on Public Offering of Securities 1999 prohibits the in-kind increase of registered capital of publicly traded companies subject to certain exceptions (eg banks, where the in-kind contribution is necessary for complying with capital adequacy requirements).
The procedure for in-kind contribution of a receivable requires the determination of the market value of the contributed receivable. Such determination is performed by three experts appointed by the Bulgarian Commercial Register (the Register, which registers all forms of Bulgarian companies) upon request of the creditor. The total nominal value of the shares issued in exchange for the contributed receivable may not exceed the market value of the receivable. There are two options for the amount of the total nominal value of the issued shares:
- The issued shares may have a total nominal value which is lower than the market value of the receivable, as given by the experts, and the difference will be considered a share premium; or
- The issued shares may have a total nominal value equal to the market value of the receivable.
From a Bulgarian tax point of view, usually there is no profit or loss recognition in the books of the debtor resulting from the in-kind contribution of a receivable. The debtor will report transfer from debt to equity in its books in the face value amount of the debt. In case the receivable is impaired (ie its fair market value is below its face value), there could be adverse tax consequences for the debtor arising from the conversion.
The creditor may realise deemed profit or loss from such conversion based on the difference between:
- the original cost of the contributed receivable (ie the consideration given by the creditor for the obtaining of the receivable); and
- the fair market value of the issued shares.
In practice, the fair value of the issued shares is usually regarded to be equal to the fair value of the receivable determined by the three experts appointed by the Register. When the creditor has purchased the receivable at a discount, it would likely report a profit from the operation. If the debtor is a distressed company, the creditor would likely incur losses from the conversion. This is because the fair value of the receivable would be lower due to impairment, and the creditor should subscribe shares with a lower nominal value (and with a lower fair market value, respectively). In the event that a non-resident Bulgarian tax creditor derives gain from such debt-to-equity conversion, Bulgarian capital gain taxation may be triggered, unless the creditor is able to use a tax relief under a double taxation treaty.
CASH INJECTION IN EQUITY AND REPAYMENT OF DEBT
Alternatively, the creditor may subscribe shares in the debtor against cash, and the debtor will subsequently use the received cash for repayment of the debt. Such solution would not have any adverse tax effects, but it may trigger cash disadvantages for the creditor. It is not possible to have an increase of the registered capital through a cash contribution in a limited liability company, where the nominal value of the shares is below the amount of the cash contribution (ie with a share premium) and the interests of the other shareholders may be affected. However, such problems may be avoided in a joint-stock company, where share premium in case of cash contributions is allowed.
CONVERTIBLE BONDS: AN ALTERNATIVE TO THE CLASSICAL INCREASE OF CAPITAL IN A JOINT-STOCK COMPANY
When the debtor is a joint-stock company, a debt-to-equity conversion may be performed through a conversion of convertible bonds into shares. Such bonds are issued upon a resolution of the general meeting of the shareholders, which should also determine the mechanism through which the bonds shall be converted into shares. It is also possible to convert bonds initially issued as non-convertible into shares, provided that the general meeting of the shareholders adopts a resolution specifying the conditions that the bondholder should fulfill in order to enable the conversion. In all cases of such a conversion, the total issue value of the bonds cannot be lower than the total nominal value of the shares to be issued in exchange. The tax treatment of the conversion of bonds into shares is complex due to sophisticated accounting treatment of such financial instruments, and would be assessed in each case.
SPECIFIC SOLUTIONS
In case the creditor is already a shareholder or sole owner of the debtor, the creditor may waive the loan amount and discharge the debt. A waiver under Bulgarian law is performed through an agreement between the creditor and the debtor. A waiver might have adverse tax consequences for both the creditor and the debtor. From the debtor’s perspective, the debtor has to either:
- report the waived amount as revenue; or
- include the waived amount in its profits for tax purposes when no revenue is reported.
In both cases its taxable profit may be increased. The debtor would also be subject to a Bulgarian donation tax. From the creditor’s perspective, the waived amount is not tax-deductible, ie the creditor may not reduce its taxable profit by the amount of the waived debt.
When the debtor is a joint-stock company, there is an alternative to the waiver, which, to some extent, avoids adverse tax consequences. The creditor, if it is already a shareholder or a sole owner in the debtor, may contribute the receivable directly into the reserve fund of the debtor without any shares being issued. This is allowed by the BCA 1991 if envisaged in:
- the articles of association of the debtor; or
- a resolution of the general meeting of its shareholders.
There is a ruling of the Bulgarian tax authorities that the debtor should not report revenues from this transaction. As such a conversion is, in fact, a contribution to the equity of the debtor, the creditor should not expense the discharged receivable (ie the creditor may not reduce its taxable profit by the amount of the contributed debt). However, a donation tax may be due on the contributed receivable by the debtor.
In each case, a potential-debt to-equity conversion should be carefully considered from financial, tax and legal aspects. A detailed analysis would reduce the transaction costs (and in particular tax costs) related to such operation both for the creditor and the debtor, or would allow optimisation of cash flow within the group.
Bulgarian tax rates for 2011
Corporate income tax: 10 % on the taxable profit of a Bulgarian tax resident entity.
Dividend tax: 0% on the amount of dividends distributed by a Bulgarian tax resident entity to a Bulgarian/EU/EEA tax resident shareholder; 5 % on the amount of dividends distributed to other shareholders.
Capital gains tax: 10 % on the gain derived by a tax non-resident entity from disposal of a financial asset (eg shares, receivables) issued by Bulgarian tax resident entities.
Interest tax: 5% on the amount of the interest accrued by a Bulgarian tax resident debtor to a tax non-resident creditor when (i) the income recipient is an EU tax resident entity and (ii) the creditor and the debtor are related parties; 10 % on the amount of the interest all other cases of tax non-resident creditor.
Donation tax: ranging from 3.3% to 6.6% on the waived amount depending in which municipality the seat of the donation recipient is located.