Subordinated debt as a method of equity restoration

One method of equity restoration included in the Estonian Commercial Code is a subordinated loan. How a subordinated loan is reflected in equity depends on the substantive purpose of this financial instrument.

PwC Legal Services attorney-at-law Karen Root discusses the possible approaches according to the objectives:

If the entity has a contractual obligation resulting from the given instrument to pay the lender a predetermined amount of money, the instrument must be recognised as a financial liability. In cases where the issuer of the financial instrument is not obliged to make payments in the agreed amount (for example, the lender participates in the company's profits or net assets), it is considered an equity instrument.

Attention should also be paid to preferred shares. Despite the name, it may not necessarily be an equity element. If fixed interest is paid (or interest accumulates in the absence of profit) or if the subordinated loan agreement includes an obligation to repay the loan in cash, it is not considered an equity element.

In tax accounting, the declaration of a subordinated loan as equity also depends on the future conditions of this loan: whether the loan must be repaid at a fixed time, whether fixed interest must be paid. If, according to the contract, the lender does not have the right to demand the the loan back and it is paid back only when the company's financial condition allows, this is an argument for why the subordinated loan should be reflected in equity. 

In this case, the contribution must also be declared in Annex 7 of the TSD. However, it should not be forgotten that if such a loan is repaid when the conditions arise, then the amount in equity must be correspondingly reduced, and the reduction must also be declared.