Tax-exempt Reserves and Profit Distribution in a Société Anonyme (S.A.)

The strategic management of corporate profits is critical to the sustainability and growth of sociétés anonymes (S.A.) and other capital companies. The formation of tax-exempt reserves offers significant advantages for the implementation of investments; however, their subsequent distribution triggers a complex legal and tax framework. This article presents the main categories of tax-exempt reserves, their tax treatment upon distribution, and the legal framework governing them, while also highlighting practical issues that may arise.

Introductory Remarks

Within the framework of the law governing sociétés anonymes (S.A.), reserves are mainly distinguished into legal reserves, statutory reserves, hidden reserves, and extraordinary or optional reserves, their clear purpose being to strengthen the capital adequacy of the legal entity. At the same time, tax legislation has, from time to time, allowed the formation of tax-exempt reserves.

Tax-exempt reserves are reserves formed out of corporate profits that were not subject to taxation, namely corporate income tax, during the financial year in which they were formed. This may occur either due to specific tax exemptions and incentives introduced by development laws or other special legislation, or due to the accounting treatment of certain items that were not recognised as taxable income for the relevant financial year. The above applies on the condition that such amounts remain tied up within the company for the financing of specific business or investment purposes.In this light, the term “tax-exempt” does not, as a rule, correspond to a definitive tax exemption, but rather to a deferral of taxation, which is subject to the suspensive condition of the future distribution or capitalisation of the relevant amounts.

The de facto need of shareholders to obtain liquidity, or a change in the company’s business planning, often leads to a decision to distribute such reserves. This act, however, radically alters their tax treatment, since the distribution retroactively removes the original exemption and triggers immediate tax obligations for the company.

Categories of Tax-Exempt Reserves

The tax-exempt reserves encountered in Greek business practice are classified, on the basis of their source and the applicable legislation, into the following main categories:

a. Reserves under Development Laws

These reserves are formed pursuant to the special development and investment laws enacted from time to time, such as Law 1892/1990, Law 2601/1998, Law 3220/2004, Law 3299/2004, Law 3908/2011, Law 4399/2016 and, currently, Law 4887/2022, as an incentive for carrying out investments in Greece. An enterprise that brought an investment within the scope of the applicable development law was entitled to set aside profits in tax-exempt reserves, which it was required to use exclusively for specific investment purposes.

b. Reserves from the Revaluation of Assets

Successive laws have provided for the possibility of revaluing fixed assets, mainly real estate, and forming tax-exempt reserves representing the difference between the revalued amount and the carrying amount of such assets, for example under Law 2065/1992, Law 2166/1993 and Law 3229/2004. Reserves falling within this category remain on the liabilities side of the balance sheet until their distribution or capitalisation, at which point they become taxable.

c. Reserves Arising from Accounting Differences

The application of IFRS and the Greek Accounting Standards, under Law 4308/2014, creates accounting differences between the accounting basis and the tax basis for the measurement of assets, provisions and other items. Certain reserves arising from such differences are characterised as “tax-exempt”, insofar as they have not been taxed at the time of their formation. Examples include the accounting recognition of a gain arising from fair value revaluation which is not immediately taxed for tax purposes, or revaluation reserves arising upon transition to IAS/IFRS.

In such cases, the deferred tax liability is separately recognised in the financial statements, in accordance with IAS 12 or the corresponding rules of the Greek Accounting Standards, in particular Article 23 of Law 4308/2014.

d. Other Special Tax-Exempt Reserves

These reserves derive from specific categories of income which are either expressly exempt from income tax or are taxed under a special, final withholding regime at source, such as capital gains from the sale of certain securities or financial instruments, subject to specific conditions.

This category includes, among others:
(i) the technical reserves of insurance companies, as provided under Law 400/1970 and now Law 4364/2016;
(ii) the tax-exempt reserves of shipping companies under special tax regimes;
(iii) reserves of capital companies carrying out certain regulated activities, such as special purpose vehicles under Law 3156/2003; and
(iv) reserves formed pursuant to Articles 22A, 22B and other provisions of the former Income Tax Code, namely Law 2238/1994, which were not absorbed or capitalised before the entry into force of the new Income Tax Code on 1 January 2014 and to which the transitional provisions of Article 72 of the current Income Tax Code, Law 4172/2013, apply.

Tax Treatment upon Distribution

The taxation of tax-exempt reserves in the event of their distribution takes place at two levels: at the level of the company, where they are taxed as income from business activity, and at the level of the shareholder, through the withholding of dividend tax. A critical parameter in this respect is the time at which the reserves were formed.

a. Taxation at Company Level – Article 47 of Law 4172/2013, Income Tax Code

Pursuant to Article 47(1) of the Income Tax Code, profits distributed by legal persons, which have not been taxed at the level of the legal person, are taxed as income from business activity at the time of their distribution or capitalisation. They are aggregated with the company’s other results, whether profits or losses, in the income tax return filed by the company for the relevant fiscal year. See also Circular POL.1059/18.3.2015.

More specifically, the company is required to pay corporate income tax, pursuant to Article 58 of the Income Tax Code, at the rate applicable at the time of distribution. Currently, the applicable tax rate is 22%, pursuant to Law 4799/2021. Since the reserve appears in the balance sheet as a “net” tax-exempt amount, it must be grossed up for tax purposes by adding the corresponding tax, so that, after deduction of such tax, the distributed amount is obtained. See Circular POL.1014/2018.

b. Transitional Provisions – Reserves from Prior Fiscal Years, Article 72 of the Income Tax Code

The transitional provisions of Article 72 of the current Income Tax Code are of particular importance, as they regulate the treatment of certain reserves formed up to 31 December 2013 under the previous Income Tax Code, Law 2238/1994, in particular under Articles 38 and 24. Tax-exempt reserves formed under development laws were expressly excluded.

Those reserves that were not “exhausted” through the special standalone arrangements applicable during the years 2014–2015, under which separate taxation at a rate of 15% or 19% was provided, now follow the general rule of Article 47 and are taxed at the current rate of 22%.

It should nevertheless be noted that the Plenary Session of the Council of State, in judgments CoS Plenary 2562–2563/2022, held that the above standalone taxation under Article 72(12)–(13) of the Income Tax Code is contrary to the prohibition of retroactivity laid down in Article 78(2) of the Constitution, insofar as it applies to reserves formed earlier than the year preceding the imposition of the tax. This is because the retroactive imposition of tax also includes the restriction or abolition of an existing tax exemption.

The applicable tax regime depends on the manner in which the relevant profits were taxed, or were not taxed, at the time of their formation. In particular, the following cases may be distinguished:

– Reserves from entirely tax-exempt profits: These are taxed at the rate applicable at the time of their distribution or capitalisation, and their distribution is also subject to withholding tax on dividends.

– Reserves from profits taxed on a lump-sum basis or at a reduced rate: In such cases, for example profits of listed S.A. companies that were taxed at a proportional rate on the amounts distributed, the distribution is, in principle, subject to taxation under Article 47 of the Income Tax Code, with a deduction or credit for the tax already paid at the time of their formation. See Circular POL.1059/2015. Additional corporate tax therefore arises only to the extent that the current tax rate exceeds the tax already paid, while withholding tax on dividends is due in any event upon their distribution.

– Reserves from profits that were subject to full corporate taxation under Law 2238/1994: These are distributed without additional corporate tax, since corporate tax had already been paid at the time of their formation. However, they are subject to withholding tax on dividends upon distribution.

c. Special Regime for Development Law Reserves

As regards reserves formed under development laws, their premature or unauthorised distribution, namely their use for purposes other than those lawfully prescribed, results in retroactive taxation, together with late-payment interest and penalties. This is because the tax exemption was granted on the express condition that the amounts would be used for the specific investment purpose.

It should be noted that older tax exemption regimes have been examined by the European Commission as unlawful State aid under Article 107 TFEU, creating an active risk of recovery with interest for undertakings that maintain unauthorised reserves.

d. Taxation at Shareholder Level

Irrespective of the tax imposed at the level of the company, the distribution of tax-exempt reserves to the shareholders of an S.A. is subject to withholding tax on dividends at a rate of 5% on the gross amount distributed, pursuant to Articles 36(2) and 64 of the Income Tax Code.

For individual shareholders, this withholding tax is final, provided that they do not carry on business activity.

For corporate shareholders, where the distribution qualifies as an intra-group dividend distribution, namely where a subsidiary company generates profits and distributes them to its parent company as dividends, double taxation may be avoided, provided that the statutory conditions for exemption under Article 48 of the Income Tax Code are cumulatively met. These conditions include a minimum holding of 10% in the distributing S.A., a minimum holding period of 24 months, and the status of a legal person falling within the scope of the Parent-Subsidiary Directive 2011/96/EU.

The above exemption does not apply automatically. It is expressly excluded where the distributing company is established in a non-cooperative State or in a State with a preferential tax regime, within the meaning of Article 65 of the Income Tax Code. It is also excluded where the dividends received by the parent company are tax-deductible from the profits of the subsidiary company, as may occur in the case of hybrid financial instruments.

At the same time, the possible application of the general anti-abuse rule must be examined in cases of artificial arrangements that lack economic substance and are aimed exclusively at obtaining a tax advantage.

De Facto Impact on Cash Flows & Practical Example

The decision to distribute a tax-exempt reserve causes an abrupt cash burden for the company, as opposed to the distribution of profits that have already been taxed in previous fiscal years.

In order to illustrate the scale of this burden, the following comparative table is provided, based on the distribution of a net amount of EUR 100,000 to shareholders, assuming corporate income tax at 22% and withholding tax on dividends at 5%:

Comparison Item	Distribution of Already-Taxed Profits	Distribution of Tax-Exempt Reserve
Net Amount in Shareholder’s Pocket	€100,000	€100,000
Withholding Tax on Dividends (5%)	€5,263	€5,263
Gross Amount before Corporate Tax	No recalculation required	€134,953
Corporate Income Tax (22%)	Already paid in previous years	€29,690 (Paid now)
Total Cash Cost for the Company	€105,263	€134,953
Note: The table shows cash cost at the time of distribution. For already-taxed profits, the tax had already been paid in previous years; the comparison therefore concerns the company’s liquidity at the time of distribution, not the total tax burden.

As shown in the table, in order for the shareholder to receive exactly the same net amount, the company, in the case of a tax-exempt reserve, is required to pay EUR 29,690 out of its cash resources at the time of distribution, due to the immediate lifting of the tax exemption under Article 47 of the Income Tax Code.

Distribution – Corporate Restrictions & Pitfalls

In addition to the tax implications, the decision to distribute profits and reserves is strictly regulated by corporate law, namely Law 4548/2018, with a view to protecting the capital adequacy of the S.A., its creditors, and minority shareholders.

a. Statutory Restrictions under Corporate Law, Law 4548/2018

– Exclusive Competence of the General Meeting, Article 117(1) of Law 4548/2018: The approval of the distribution of reserves falls within the exclusive competence of the General Meeting of shareholders, which resolves under ordinary or increased quorum and majority requirements, depending on the nature of the reserve and the specific provisions of the articles of association.

– Net Asset Protection Rule, Article 159 of Law 4548/2018: No distribution to shareholders is permitted if, on the closing date of the last financial year, the company’s equity is, or would become following the distribution, lower than the amount of the paid-up share capital, increased by the reserves whose distribution is prohibited by law or by the articles of association, the other credit items of equity that may not be distributed, and the credit items of the income statement that do not constitute realised profits. The determination of the distributable amount is made on the basis of the approved annual financial statements.

– Safeguarding the Minimum Dividend, Article 161 of Law 4548/2018: The formation of optional or tax-exempt reserves out of the profits of the financial year is subject to the limitation that the shareholders’ right to the minimum dividend is not prejudiced. The minimum dividend amounts to 35% of the net profits after deduction of the legal reserve, unless a resolution of the General Meeting is adopted with increased quorum and majority.

b. Alternative Strategies & Tax Pitfalls

Capitalisation: As an alternative to distribution, the company may resolve, by decision of the General Meeting, subject to increased quorum and majority requirements where a share capital increase is involved, to capitalise tax-exempt reserves, namely to convert them into share capital through the issuance of new shares distributed free of charge to the shareholders.

Capitalisation entails an obligation to pay income tax at the level of the company, pursuant to Article 47 of the Income Tax Code. However, it does not entail withholding tax on dividends, provided that no cash distribution is made to the shareholders.

It should further be noted that a share capital increase carried out through the capitalisation of profits, reserves or provisions is exempt from capital duty, pursuant to Article 22(2)(b) of Law 1676/1986.

A risk arises in this case where the S.A. subsequently resolves, within a certain period following the capitalisation, for example within the five-year or ten-year period prescribed by the applicable development law, to reduce its share capital with a return of capital to the shareholders. In such a case, the tax authority may presume that the capitalised reserves are returned first and may retroactively impose the withholding tax on dividends that was avoided, treating the arrangement as artificial.

De Facto / Indirect Distribution: The lifting of the tax exemption and the assessment of tax on the reserves do not always occur through a formal corporate resolution. They may also arise compulsorily, on a de facto basis, following a tax audit, pursuant to Article 47(3) of the Income Tax Code, in cases such as, indicatively, the following:

– Cash withdrawals or loans: Amounts withdrawn by shareholders from the company’s cash resources, without sufficient taxed profitability to justify such withdrawals.

– Coverage of non-business expenses: Personal expenses incurred for the benefit of shareholders and borne by the company, which are disallowed by the tax audit as non-deductible.

– Set-off against losses from previous fiscal years: This is considered to constitute a withdrawal of the reserve followed by a contribution of that amount for the purpose of covering losses. See, for example, Council of State judgment 1436/2023, Thessaloniki Dispute Resolution Directorate decision 1316/2021, and Thessaloniki Dispute Resolution Directorate decision 973/2019.

c. The Role of Tax-Exempt Reserves in Mergers & Acquisitions (M&A)

The transfer of a business that includes tax-exempt reserves does not automatically constitute a taxable event. However, the purchaser, as universal successor, de facto assumes all latent tax risks associated with the relevant amounts.

Accordingly, during the legal and financial due diligence of the company, such reserves should be treated as a latent tax liability that may be triggered in the future. Their existence directly affects the final valuation and, in many cases, justifies a corresponding reduction of the purchase price or the inclusion of a specific indemnity clause in the share purchase agreement (SPA), so that the purchaser is protected against future assessments by the tax administration.

By Way of Conclusion

Tax-exempt reserves constitute an important financing tool for businesses, as they allow the reinvestment of profits with zero or reduced tax cost at the outset. However, their retention on the balance sheet of an S.A. creates a latent tax liability, which comes to the surface when the shareholders decide to “liquidate” them.

Therefore, when assessing the advisability of distributing or capitalising tax-exempt reserves, the following issues are critical: the identification of the category and time of formation of the reserves, the applicable transitional or current tax regime, the overall tax cost at both company and shareholder level, the possibility of applying the dividend exemption between legal persons, and the provisions of each applicable development law, where the relevant reserves are concerned.

Accordingly, it is clear from the above that the decision to distribute or capitalise such amounts should not be taken lightly. On the contrary, each case must be examined thoroughly before a distribution decision is adopted, in order to ensure the company’s financial equilibrium and its full compliance with the requirements of corporate law and the tax administration.