Capitalization has several meanings in economics, however, from a business perspective, capitalization is the process of increasing capital, usually by converting a company's net profits or reserves into share capital. This process makes it possible to improve the perception of the company's value and balance sheet, making the company more valuable and stable in the eyes of cooperation partners.
Capitalization rules
In Latvia, the processes of changes in the share capital of companies and their conditions are regulated in the Commercial Law (KL) according to the legal form of the company. The regulation for limited liability companies (SIA) is included in Article 12, Clause 2 of the LC "Changes in share capital". For joint-stock companies (AS) - Article 13, Clause 2 of the LC "Increase and reduction of share capital".
Regardless of the legal form of the company, the capitalization process requires the execution of a series of legal actions and the preparation of documents that include information about the process, reasons and conditions for increasing the share capital. A company that has decided to capitalize must prepare:
- the minutes of the meeting of the members or the decision deciding on the increase of the share capital; the rules of the increase of the share capital signed by the board, which determine the type of increase of the share capital and the amount by which the capital will be increased;
- it is also necessary to prepare a new section of the register of members on the amount and distribution of the new shares among the owners.
All the necessary documents must be submitted to the Register of Companies, where changes in the company's capital are recorded in accordance with the company's decision.
Capitalization in the sense of the CIT Law
In the sense of the Corporate Income Tax Law (CIT Law), capitalization corresponds to the definition of conditional dividends included in the CIT Law, that is, conditional dividends are, by nature, a part of the profit, which is made up of the total amount of undistributed profit of the reporting year and previous reporting years. For this share of profit, according to the decision of the company's members, the company's share capital may be increased or the value of the share invested in the capital or the number of shares may be equated to it. By nature, the conditional dividend is a part of the profit, which consists of the total sum of the retained profit of the reporting year and previous reporting years. For this share of profit, according to the decision of the company's members, the company's share capital may be increased or the value of the share invested in the capital or the number of shares may be equated to it. In such a situation, the company reinvests the profit in its business and is not obliged to pay corporate income tax (CIT). Reinvesting profits allows companies to expand production, improve their credit rating and competitiveness, which in turn allows them to earn more in the long run.
According to Article 7 of the CIT Law and the regulation of Article 4, Part 2, it can be concluded that conditional dividends at the time of capitalization are not considered an object of CIT and the obligation to pay CIT will arise only if the company decides to reduce its share capital by the amount that was credited from conditional dividends. for dividends in the capitalization process. At the time of reduction of the share capital, the entire capitalized amount will be included in the CIT base and taxed with CIT as other income.
Investing the company's reinvested profit in capital, or capitalization, does not provide for capitalization thresholds.
Thin capitalization
When talking about other aspects of capitalization, the term "thin" or undercapitalization is often used. Thin capitalization occurs in situations where a company finances its operations through loans from both related and unrelated parties. Respectively, the company was founded with the smallest possible share capital, and in the further course, capital is not increased, but additional funds are attracted from borrowed financial resources. The following situation may arise - a company member lends his company large loans and accordingly guarantees himself a profit from interest payments, thus performing concerted actions for the purpose of tax reduction.
However, it should be taken into account that the company as a borrower in transactions with related parties may be obliged to pay VAT from increased interest within the meaning of Article 10 of the VAT Law.
In practice, such situations can manifest themselves as follows: the company constantly borrows from members to finance its business, but it works at a loss and has no financial means to increase its share capital. In that case, upon receiving a loan from the participant, the company may be obliged to pay VAT on the amount of the increased interest, if the interest exceeds four times the amount of the company's own capital. The company can also capitalize such debt into its own capital, but in the event of liquidation, the member will get his money back as an investment. Therefore, the CIT regulation limits huge interest payments to participants for loans issued.
Example
The company's equity is negative. The loan amount received from the participant is EUR 20,000, the loan interest rate is 5% per year. In this case, the company will have a taxable base of EUR 1,000 and a payable VAT of EUR -250.
However, this does not apply to loans received from credit institutions and other types of financing granted by specialized financial institutions. It should be noted that loans between related parties must correspond to the market level and the company may be obliged to prepare transfer pricing documentation.
Capitalization in the sense of the CIT law can take place by reinvesting a part of the profit in the capital, which does not create an object subject to CIT at the time of capitalization. On the other hand, at the time of reduction of the share capital, the entire capitalized amount will be included in the CIT base and taxed with CIT as other income.
Thin capitalization can be considered abusive tax planning to avoid paying taxes. The company as a borrower in transactions with related parties may have the obligation to pay VAT from increased interest and the obligation to prepare transfer pricing documentation.
Source: IFinanses