It is not uncommon for start-up companies in Hungary to make losses in their early years. Due to accumulating losses, a company’s equity may fall significantly, and it can even become negative.
Based on the Hungarian Civil Code, if a company’s equity falls to half of its share capital, or below the minimum share capital defined by law (HUF 3 million – approx. EUR 9,600 – in the case of a Ltd.), the managing director must convene the quota holders’ meeting without delay. Equity is usually examined when the annual report is approved, and it is advisable then to define the steps needed to make up for the losses, steps which have to be taken within three months.
What are the options for solving of the capital situation?
The most evident solution is an additional capital payment, which was designed for this very purpose. One possible difficulty is that this is only allowed if such a provision is included in the articles of association. The advantage though is that if the company turns a profit later on, and the additional capital payment is no longer necessary to cover the loss, this amount has to be paid back to the owners.
Increasing the capital reserve parallel to a capital increase is another possibility. Here, the premium generated upon increasing the share capital, which can either be cash or other permanent asset transfers, is allocated to the capital reserve. So the solving of the capital situation issue is resolved, but the drawback is that corporate documents need to be modified. Another difficulty is that if the (liquid) assets made available are no longer needed, they can only be repaid to the owners after modifying the corporate documents again and effecting a simultaneous and proportional decrease of the share capital and the capital reserve.
The role of the loans in the making up for the losses
In many cases, the parent company ensures the funds necessary for the company’s operations through loans. If solving of the capital situation requires an increase of equity, loans can be converted into equity either in share capital, or in the capital reserve with a simultaneous increase of share capital. This requires a modification of corporate documents too, and in this case again, the amount can only be repaid to the owner if the share capital and the capital reserve are decreased simultaneously and proportionally. Given that the share capital and the capital reserve are not increased with a cash contribution, the company has an obligation to prepare transfer pricing documentation.
Forgiving loans or other liabilities to the parent company is also an option in Hungary, which is therefore accounted for as income and improves the company’s equity through the profit after tax. Non-repayable cash transfers (donation) from the owner operate in a similar way. The disadvantage of both is that they might have Hungarian corporate tax implications, and in the case of private individual owners, they may result in a gift duty payment obligation. If the parent company is abroad, it must be examined whether any tax or duty payment obligation arises in another country because of this.
Naturally, the easiest way to make up for losses is the company turning a profit again, which can be supported during the year even by preparing an interim balance sheet. In the case of intercompany transactions, it is worth developing standard prices so they provide sufficient cover for operating costs and can be properly supported in the case of a tax inspection.
In light of the various possibilities and the extra costs arising by implementing the individual solutions, it is advisable to plan the method for financing operations when establishing the company in Hungary, and to define the tools for covering any potential losses, because a fall in equity can be prevented with appropriate planning.