Loan agreement as an investment instrument: what lawyers advise to consider

The Ukrainian investment market is relatively young, so there is an abundance of legal options for fundraising. As long as the practice has not formed uniform rules for crowdinvesting, the loan agreement finds its application when business partners are unwilling to develop more sophisticated tools. However, the parties do not always fully understand the legal risks of improper execution of such relationships.

Previously we talked about investment options and formats of attracting investment, in this article we offer to elaborate on the peculiarities of entering into loan agreements specifically in the area of investment.

What is the purpose of a loan agreement?

The investor needs to understand that it is a completely passive investment with a predictable return, but without the possibility of multiple earnings and participation in the financed business. 

The company, in turn, has an unconditional obligation to repay the funds, as opposed to the format of paying a return on profit (as in the management franchise format, for example). This, in fact, entails the advantages and disadvantages of the agreement. For the company it is unconditional funds, for the investor it is theoretically guaranteed income.

A safer option for the investor would be if the loan is additionally secured by a pledge (mortgage) or a guarantee from a third party. If the borrower defaults, the lender will be able to take or sell the mortgaged property, or assign its claims to the guarantor. On the other hand, it constrains the company to some extent because it cannot dispose of the pledged property.

Notarial agreement vs. simple written loan agreement

The law allows both options. The main difference is that with a notarial agreement you can collect the debt more quickly. If the agreement contains necessary provisions, and by following the procedure of notifying the debtor in writing, the creditor can get an enforcement inscription from a notary and can apply to a public or private enforcer to enforce the debt. This avoids a lengthy court dispute and allows the debt to be collected more quickly.

Attention! In practice, unscrupulous debtors often challenge notary public enforcement inscriptions in court for formal reasons. For example, the creditor may not specify all the necessary information in the written notice (claim), which will give the debtor a reason to cancel the entire extrajudicial collection procedure. We support our Clients in such matters from the very beginning, since many nuances are not described in the laws and are dictated by judicial practice.

Also note that during martial law private executors are forbidden to use enforcement inscriptions of the notary.

What is the currency of the loan agreement in Ukraine?

It is forbidden by law to pay in foreign currency on the territory of Ukraine. We also do not recommend doing this, but we know that such cases occur in practice. For example, the contract at the time of signing fixes the transfer of funds to the borrower in hryvnia and fixes the national currency of the settlement when paying the debt. But in fact there is a transfer of foreign currency between the parties.

In such conditions it is important that the agreement stipulates the real obligations and protects the interests of both parties. However, the law allows to fix debt in foreign currency with settlement in hryvnia at the rate on the date of repayment. If the currency stipulated in the agreement is not hryvnia, the dishonest debtor can challenge the agreement in court in order not to repay the debt.

Comment of the team: Non-cash hryvnia payments in Ukraine are not limited by the legislation; if your investment capital is in currency, or if you want to bring funds to Ukraine for investment, we will help you to do everything safely! We often deal with these kinds of issues.

The problems of interest-bearing loans and practical solutions

We will not bother you with the terminology and formal differences between the loan agreement, credit agreement, refundable financial assistance (interest-free loan), and a description of the financial intermediation. Let’s just say that the tax authorities may have big questions about the granting of an interest-bearing loan by an individual to a legal entity. There is an opinion among the State Tax Service of Ukraine that financial assistance from individual entrepreneurs is incompatible with the simplified taxation system (the question is debatable, but there is a risk of claims from the tax authorities). Therefore, in practice you may find a proposal to write in the agreement that the loan is interest-free.

In general, in such cases, we always recommend being cautious about documents that are contrary to reality, and always consult with lawyers. For example, we advised the Client, an investor, on the risks of transferring into an “interest-free loan” the amount, which formally already included the annual interest for the use of funds.

Please note! Companies shall consider that even if the agreement says nothing about the interest, there is a risk of tax accrual according to the Civil Code of Ukraine at the level of the NBU discount rate.

Loan of a startup funder in Ukraine

We encountered situations in practice where the founders of a business concluded a loan agreement on their own behalf directly with an investor. This way they make a personal commitment, which gives the investor a better feeling of security. The businessman is personally liable, so the risk of default is minimal.

If you are offered this option, it is advisable to consult a lawyer. An individual should have liquid assets, which can be collected, if he/she fails to repay the debt. Startups are usually incorporated abroad, and it is only possible to recover the debtor’s share of a foreign business against the debt because of valuable legal procedures in foreign jurisdictions. The amount of the loan may not cover the costs of such actions.

Please note: When granting a loan to a legal entity, you should think about the debtor’s due diligence. We have experience in this matter, and we talked about the nuances in our publication.

What taxes shall be paid when entering into a loan agreement in Ukraine?

An interest-free loan does not create tax consequences for the lender. Interest is income, so taxes are assessed on it. For example, for an individual, it is personal income tax (18%) and military tax (1.5%). There will be no tax consequences for the borrower if it returns the loan on time. For sole proprietors, the term of the loan must not exceed 12 calendar months, otherwise the loan amount will be considered income. For corporate borrowers, the amount not returned within the statute of limitations period (3 years) will be taxable income. These are general rules, but there may be additional nuances and reservations.

Grounds for termination of the loan agreement in Ukraine

Keep in mind that the agreement should clearly state the grounds for its termination and early collection of the full amount of the loan. There are cases when companies sign notarized templates, and then are surprised that investors demand immediate return of the entire amount because of the delay of another small payment for one day. Conversely, investors need to understand their contractual leverage over the borrower.

If you don’t want to get into accounting nuances, assess the legal risks, follow the court practice and new tax regulations, you can trust us to handle all these issues. Many of our Clients focus on their business needs, and our team of lawyers, accountants and analysts professionally support all formal matters.

Our services include:

• Legal audit of your project, recommendations on the risks or benefits of its implementation;
• Development and preparation of a loan agreement and other documents for your project;
• Support for project implementation, organization and control over the deposits and withdrawals, legal consulting.

Cost of investment projects support services here.

Cost of startup support services here.