Converted Loan Agreement in IT. The nuances of taxation in Diia City.

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Starting any business begins with an idea, which requires funds for its implementation. There are many ways for a business to attract financial resources:

  • investing the founders' own funds;
  • obtaining a bank loan;
  • borrowing from relatives or friends;
  • getting grants;
  • raising investments.

In this article, we will focus on one of the relatively new investment tools for business in Ukraine, which is called a convertible loan, and explain how this tool can be used by business in Ukraine.

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The essence of the convertible loan agreement and its main conditions

A convertible loan is one of the investment tools, when an investor gives funds for business development and has the right either to get a refund with/without interest or get a share of the company.

This instrument (Convertible note (debt/loan)) is commonly used abroad and has become available for Ukrainian IT business only with the advent of the Diia City legal regime.

A convertible loan, like other types of investment, has its pros and cons.

Advantages of a convertible loan agreement:

  • no need for evaluation of the company at the early stages;
  • no collateral.

Disadvantages of the convertible loan agreement:

  • lack of legal regulation in some countries (so attention should be paid to the place of registration of the non-resident investor);
  • risks for the investor (if the startup idea proves to be a "lame").

Today, the law regulates the conclusion of convertible loan agreements only for Diia City residents.

The conclusion of the agreement must be accompanied by the following conditions:

  • a unanimous decision of the participants of the Diia City resident to conclude a convertible loan agreement;
  • the possibility of concluding a convertible loan agreement is stipulated by the Charter of the Diia City resident;
  • availability of a properly executed and signed convertible loan agreement (agreement between a Diia City resident and investor-lender);
  • fulfillment of obligations by the borrower to the investor-lender;
  • the lender has confirmed his desire to receive a share in the company in lieu of repayment of the loan.

The process of determining the size of investments and the terms of their provision (including under a convertible loan agreement) usually depends on a number of factors, namely (without limitation):

  • the stage of development of the startup/existing company and its development prospects;
  • the financial history of the business;
  • the investment appeal of the proposed business plan and its financial model;
  • the number of potential investors (including their interest in investing).

A prerequisite for a convertible loan is the execution and signing of the agreement.

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What aspects must be taken into consideration before entering into a convertible loan agreement?

When concluding an agreement, our experts advise paying attention to the following mandatory provisions:

1. The total amount that the borrower plans to receive under the convertible loan.

Please note! The total amount of a convertible loan may be borrowed simultaneously from several investors, but executed under different agreements.

2. Terms of payments (e.g., payment is made in one payment or in installments).

3. Terms of disbursement - on interest or interest-free terms.

Please note! Interest can be paid to the investor-lender either in the form of cash payments or converted into shares.

4. Loan term - the period for which the loan is granted, at the end of which the borrower must repay it or convert it into a share of the company.

Note: usually this period is 1-3 years (but the period is different for each project).

5. Terms of loan use - what expenses the borrower is allowed to use the loan for.

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Conditions for conversion of debt into authorized capital of IT company

We have covered the basic terms of the agreement and procedure for granting a loan, but of course, you, as the owner, are interested in what share of the company you have to give to the investor.

The size of the lender's share is determined by the following formula:

Loan amount / (Loan amount + Borrower's authorized capital)

For example, you are a resident of Diia City on the general system of taxation. As of the date of the convertible loan transaction, your share capital is UAH 12 million. You signed a convertible loan agreement with an investor-lender, according to which the investor loans you UAH 8 million for 1 year (on interest-free terms).

In 1 year from the day of granting the loan, the investor has the right to receive a share of your company in the amount of 40 % (UAH 8 mln. / UAH 8 mln. + UAH 12 mln. = 40 %).

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Taxation of convertible loan agreement transactions

One of the important issues of any business transaction is its taxation. Given that Diia City residents have the right to be both under the general system of taxation (income tax + VAT / without VAT), and under the special tax regime, we will discuss the taxation for each regime separately.

Taxation of the convertible loan agreement for Diia City resident under the general taxation system (18% income tax + 20% VAT/ without VAT).

Under the current Tax Code, accounts payable conversion transactions (including refundable financial assistance) are not subject to income tax or VAT.

That is if you have concluded a convertible loan agreement on an interest-free basis, at the moment of debt conversion there is no obligation to accrue and pay taxes.

If we are talking about an interest-bearing loan (a loan that provides for interest accrual or discounting), the legislation obliges us to consider the interest as the borrower's income.

The borrower's income (for lending funds) is taxable under current law:

  • a natural person (resident) - 18% of personal income tax and 1.5% of military tax;
  • a legal entity (resident) - 18% income tax or 5% single tax (depending on the taxation system);
  • a non-resident - 15% tax on income of non-residents.

The same taxation applies to the situation where the investor wishes to convert the interest from the loan into share capital.

In both cases, the borrower's business transactions are not subject to taxation.

Taxation of the convertible loan agreement for Diia City residents under the special taxation system (9% income tax on certain transactions)

The terms of the special tax regime provide for the accrual of income tax within the limits of the transactions defined in the Tax Code. Transactions under the convertible loan agreement are not included in that list, so similarly to the general taxation system, transactions under the interest-free convertible loan agreement are not subject to income tax and VAT.

As for the interest loan, the Diшa City resident (lender) accrues and pays a 9% income tax on the amount of interest paid to the borrower.

As for the borrower's income in the form of interest, it is subject to tax similar to the general system of taxation:

  • a natural person (resident) - 18% of personal income tax and 1.5% of military tax;
  • a legal entity (resident) - 18% income tax or 5% single tax (depending on the taxation system);
  • a non-resident - 15% tax on income of non-residents.

For the borrower, the convertible loan agreement:

  • allows you to reduce the debt to the lender without taking money out of the company's turnover;
  • gives no/minimal loan taxation costs;
  • minimizes any risks, because the contract does not require collateral;
  • makes it possible to attract foreign investors using the usual investment method.

Our company offers a range of services for IT companies in Ukraine, including:

  • obtaining residency in Diia City;
  • comfortable transition to Diia City mode of operation for the company and its employees;
  • the assistance of a professional team of lawyers and accountants to organize the accounting of the IT company;
  • services for automation or robotization of accounting processes in the IT company;
  • solving important issues for the business organization, such as its financing, tax optimization, etc.

If you want to get information about your case, don't hesitate to contact our experts.

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Publication date: 25/10/2022

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