Conversion of a Shareholder Loan into Reserve Capital

When a Failed Transaction Does Not Constitute Taxable Income

Does a failed conversion of a loan extended by a foreign shareholder into the company’s reserve capital give rise to taxable income? The tax authorities were convinced that it did – maintaining for nearly four years that a bookkeeping entry made in 2016 constituted a release from debt and, consequently, income under Article 12(1)(3)(a) of the Corporate Income Tax Act. The amount in dispute: PLN 9,830,894 in tax.

The Voivodeship Administrative Court in Poznań – for the second time – annulled the authority’s decision, holding that the tax authority had disregarded the binding legal assessment expressed in the first judgment and had once again predicated its determination on the same, insufficient evidence.

Loan from an Offshore Jurisdiction – An Oral Agreement, a Conversion, and a Dispute over the Parties’ Intent

The case concerned a Polish limited liability company (I. B.), whose shareholder – P. I., registered in a jurisdiction employing harmful tax competition (the judgment anonymises the name of the state) – had extended a loan of up to PLN 100 million on the basis of an oral agreement. On 31 December 2016, the company made a bookkeeping entry transferring the amount of PLN 52,765,974.47 from the long-term loan account to the reserve capital account, treating this as a conversion of the loan into equity.

The difficulty was that the conversion had not been effected in the manner prescribed by the Commercial Companies Code – there had been no formal increase of the share capital, no requisite resolution had been adopted, and no declarations had been made in notarial form. The company itself acknowledged that the conversion had proved ineffective and corrected its bookkeeping entries in 2021. The creditor, for its part – first at an Extraordinary General Meeting in 2022, subsequently by letter of 2024 – unequivocally demanded repayment of the loan, confirming that it had never waived the receivable.

The Tax Authority’s Position: Bookkeeping Entry = Release from Debt = Taxable Income

The tax authorities of both instances consistently treated the bookkeeping entry of 31 December 2016 as evidence of a release from debt (Article 508 of the Civil Code) coupled with a donation – and consequently as taxable income under Article 12(1)(3)(a) of the CIT Act (value of forgiven liabilities). In the tax authority’s view, the parties’ intention was the transfer of untaxed funds from a tax haven, and the subsequent actions – the correction of bookkeeping entries, the demands for payment, the repayment agreement – constituted nothing more than a “line of defence” designed post factum to impugn the clear entries in the books.

Upon reconsideration of the case (following the first annulment), the authority examined a witness – J. S., the foreign shareholder’s representative – who, however, testified that he had not been present at the conclusion of the loan agreement and had no knowledge of the events of 2016. The company’s president, when summoned, exercised his right to decline to give evidence (Article 199 of the General Tax Ordinance). Notwithstanding the absence of any new evidence confirming the thesis of forgiveness, the authorities once again upheld their classification.

The Court Annuls the Decision a Second Time – Why Article 153 of the Administrative Courts Procedure Act Is Not a Suggestion

Already in its first judgment (I SA/Po 343/23 of 10 October 2023), the Voivodeship Administrative Court in Poznań had unequivocally held that: (1) there was no evidence whatsoever that the creditor had waived any part of the loan; (2) the evidence gathered established only that the parties had attempted to convert the loan into capital, which proved legally ineffective; and (3) from the ineffectiveness of the conversion one cannot infer a release from debt – an ineffective transfer of the amount to reserve capital means that the creditor’s receivable continues to exist.

Article 153 of the Administrative Courts Procedure Act is of absolutely binding character: the legal assessment and the directions for further proceedings expressed in a court’s judgment bind both the authorities and the courts. An authority may not, upon reconsideration of the case, formulate new legal assessments that are inconsistent with the view previously expressed. Where successive complaints are filed, the court verifies the manner in which the authority has discharged the directions – it does not revisit the substance covered by the earlier assessment.

The Voivodeship Administrative Court in Poznań stated plainly: the authority had failed to comply with the legal assessment and the directions contained in the first judgment, relying once again on the same evidence (the 2016 bookkeeping document, the explanations of the proxy holder, the entries in the books) that the Court had previously found to be insufficient. Where the evidence does not demonstrate that the loan was forgiven, the authority should have accepted the taxpayer’s explanations as credible.

The Court annulled only the decision of the Director of the Tax Administration Chamber (not both instances, as in the first judgment) – which means that the Director must reconsider the appeal, this time respecting the legal assessment expressed in both judicial decisions.

It should also be noted that the Court did not accept the objection that the initiation of fiscal criminal proceedings to suspend the running of the limitation period was instrumental in character – this question had already been conclusively determined in the first judgment, which forecloses this line of defence.

Practical Significance – Loan Conversion, Taxable Income, and the Limits of Interpreting the Books

The judgment confirms several principles of considerable practical significance.

A bookkeeping entry does not, of itself, determine the tax classification of a transaction. The transfer of an amount from the loan account to the reserve capital account does not automatically mean that a release from debt giving rise to taxable income has occurred. The authority must ascertain the actual intention of the parties – and where the agreement took oral form, this requires, at a minimum, the examination of the persons who participated in the transaction.

The invalidity of a civil-law transaction is not synonymous with the creation of taxable income. Where a conversion of a loan into capital fails for non-compliance with the requirements of the Commercial Companies Code, the lender’s receivable continues to exist. One cannot then speak of “forgiveness of a liability” within the meaning of Article 12(1)(3)(a) of the CIT Act.

Article 153 of the Administrative Courts Procedure Act is absolutely binding. An authority may not, upon reconsideration, disregard the court’s legal assessment and once again construct its determination on evidence that the court previously found insufficient – even where the supplementary evidentiary material “did not alter the picture.” Where new evidence does not confirm the authority’s thesis, the authority should modify its classification rather than persist in its prior interpretation.

Loans from tax havens demand meticulous documentation. The case vividly illustrates the risks attendant upon the oral form of loan agreements with shareholders domiciled in jurisdictions employing harmful tax competition. The absence of written documentation of the parties’ agreements furnishes the authorities with a pretext for classifying economic events in accordance with a presumption of tax-avoidance intent – even where the objective evidence does not support the thesis of forgiveness. Every intra-group transaction involving offshore entities – a matter best addressed through strategic tax advisory – should be documented in writing, with an unambiguous articulation of the parties’ intent and in compliance with the formal requirements of commercial law.

Robert Nogacki

Robert Nogacki is a Polish attorney at law (radca prawny), the founder and managing partner of Kancelaria Prawna Skarbiec (Skarbiec Law Firm), which has operated continuously since 2006.

The law is equal for everyone, but the parties rarely are: on one side stands an organization with time, money, and lawyers, on the other a person with one business, one nest egg, and one life.

Clients rarely come to him with a legal problem. They come with a problem that also has a legal side: an audit that began with a single invoice, money entrusted to someone who has disappeared, a company that has to be passed on before it is too late. Most such matters are decided long before the first letter is written, in decisions made without asking and in deadlines nobody remembered. So he begins by asking how the client got here, not what the client should have done.

He advises entrepreneurs and families from more than a dozen countries, including those whose accounts the tax office has just seized and who do not know what to do tomorrow morning. He defends them in tax audits, customs and fiscal inspections, disputes with the tax authorities, and criminal tax proceedings. He represents victims of investment fraud and Ponzi schemes. He helps families set up family foundations and plan succession, so that a life’s work outlasts a single generation.

Not every case can be won. Every case can be run so that the client knows where they stand. Since 2006 he has represented the victims in the WGI case (Warszawska Grupa Inwestycyjna, the Warsaw Investment Group), one of the longest criminal cases in the history of the Polish financial market, because some things must not be left half finished, even when they take two decades. In the case of the collapsed cryptocurrency exchange Zonda (Zondacrypto, operated by BB Trade Estonia OÜ), he represents several hundred victims in the criminal investigation conducted by Poland’s National Prosecutor’s Office and in the Estonian bankruptcy proceedings.

Kancelaria Prawna Skarbiec is listed in the rankings of Poland’s largest tax advisory firms published by Dziennik Gazeta Prawna and Rzeczpospolita, and it is a four-time recipient (2015 to 2018) of the European Medal awarded by the Business Centre Club and the European Economic and Social Committee. Robert Nogacki publishes regularly, in the press and on the firm’s website, for people who have a problem rather than a law degree, because a legal opinion the client cannot understand protects only the lawyer.

He believes that the best legal advice is the kind that means the client never has to appear in court.