How to get rid of them? The solutions to restoring shareholder equity are many – but not all are equal. The best may not be the most obvious. Here’s a look at your options, starting with what you may but probably should not do.
The Ugly: Raising Capital Without Capital
The most-straightforward way is to increase capital by injecting new cash, but this is an expensive, capital-intensive exercise. And while a shareholder who has loaned money to the company may hope to offset such an injection against their shareholder loan, the Civil and Commercial Code (CCC) prohibits this. The capital increase must always be met with real money.
Business types think business and always look for ways to save costs. Many increase capital in their companies without paying real cash. Instead they use checks, thinking that can help them get around the regulatory ban on setoffs. They have to be careful. The method is not defensible and won’t stand up to legal scrutiny. For example, if there is a squabble among shareholders at a later date, one shareholder could challenge the legality of the capital increase, leading a court to void the increase of capital.
That doesn’t stop people from doing it, however.
Short-circuiting an increase of capital using checks is an age-old practice going back decades. The cash-free method starts by the company issuing a check to the shareholder to pay back the shareholder loan. The shareholder then endorses the check back to the company to pay for the capital increase, without any money changing hands. Both company and shareholder falsely believe the paper trail is sufficient to satisfy the legal requirement of raising private capital.
The Bad: Endorsed Checks
Then there’s check endorsement. This is a form of transfer of a check theoretically legal under the CCC that allows the recipient to affix a few simple words specifying its transfer to a person or company to pay a debt. But the check has to carry real money in a checking account at the bank. Without the underlying bank fund, the endorsement and transfer is fictitious.
One clear piece of evidence that the method is fake is the established practice among banks in Thailand not to accept endorsed checks. Complicated check endorsement theories are subjects in legal textbooks that never actually exist in reality.
Why is this? There’s a simple reason paying for the capital increase with endorsed checks would never work – they aren’t legitimate.
When someone pays you with a check, they write your name down as the recipient. Present the check to your bank, and it will enter the check into a computerized system called the Imaged Check Clearing and Archive System run by the Bank of Thailand. Once it clears, the money from the checking account of the check’s writer will be transferred and credited into your checking account, available for your use on the next business day. This is standard stuff.
But try to countersign that check with a friend’s name – perhaps they were the intended recipient or you’re just feeling generous – and find it won’t be accepted by the bank. This has always been an established practice at commercial banks operating in Thailand, whether domestic or Thai branches of foreign banks.
Even if your bank were to accept the endorsed check for collection, it would never clear ICAS. Instead, it will bounce back with a remark from your bank: “Irregularities in collection.”
Raising capital by way of a check endorsement is thus not an option.
The Good: Lose the Loss
As removing a loss from the balance sheet by a capital increase is expensive and doing it by endorsing a check is illegitimate, another way to do it is by reducing the capital of the company – a counterintuitive method that is both cheap and effective.
Generally speaking, reducing capital means cutting shareholder equity on the balance sheet to an amount equal to the accumulated loss. One obstacle: Capital cannot be reduced to below 25 percent of the registered capital, under the law. Simple workaround? If one reduction doesn’t wipe out all the loss, just do it again and again until the loss becomes zero.
In carrying out a capital reduction of a company you need not put cash into the company, thus the process can spare unnecessary expense.
The challenge is to company’s creditors. The company is required to announce capital reductions in a newspaper and notify all creditors, whether financial or trade creditors, in writing. They have 30 days to protest. If a creditor rejects the reduction, the company cannot proceed with the process and has to pay off the creditor. The exercise can become capital-intensive and won’t work if there are a great number of creditors.
If the company fails to notify any single creditor and denies them the opportunity to protest, the shareholder who receives payment from the capital reduction remains liable to pay the creditor up to the amount of capital paid to him within two years after the registration of the capital reduction.
Of course, there are two ways to reduce capital: either reduce the par value of each share or cut the number of shares. Either way, the capital reduced will not be deemed income by the Revenue Code. Neither will it impact its account of profit and loss. But it will positively change the balance sheet because the capital, which is part of shareholder equity in the books, is now used to wash away the accumulated loss. The good news is that the company won’t have to pay corporate income tax on the capital reduction.
But if there a shareholder is paid as a result of the capital reduction, that payment is the shareholder’s taxable income not to exceed the combination of accumulated profit and legal reserves made, regardless of whether the shareholder is corporate or individual. But there is no withholding tax obligation on the part of the company reducing the capital.
If a corporate shareholder bought the shares at a price higher than par value but receives back the capital only at par, it is incurring a loss. But that loss can’t be deducted as an expense as part of year-end calculation of net profit for taxation. It has to wait until it actually sells the shares and then deduct the loss against the sale proceeds to pay tax.
On the contrary, if the corporate shareholder bought shares lower than par but receives back capital at par from the capital reduction, it has generated a profit and has to pay corporate income tax on it. The tax code, however, allows the corporate shareholder to defer payment until the time it actually sells the shares.
Wirot Poonsuwan is a practicing attorney and can be reached at [email protected].