Dechert OnPoint: Recent Developments in Corporate Governance

Dechert Georgia, through the contribution of partners Archil Giorgadze and Nicola Mariani, joined by senior associates Ruslan Akhalaia and Irakli Sokolovski, as well as Ana Kostava and Ana Kochiashvili, is partnering with Georgia Today on a regular section of the paper which will provide updated information regarding significant legal changes and developments in Georgia. In particular, we will highlight significant issues which may impact businesses operating in Georgia.

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Recent Developments – Corporate Governance

The Supreme Court of Georgia (the “Court”) recently published two important decisions on cases brought by the LEPL Revenue Service of the Ministry of Finance of Georgia (the “Revenue Service”) against directors and shareholders of limited liability companies. Both cases concerned the potential tax liabilities of limited liability companies. This edition of OnPoint reviews and analyzes one of these Decisions (the “Decision”) and its implications for the business community at large.

Factual Circumstances

The Revenue Service assessed additional taxes and tax penalties on a limited liability company (the “Company”) which was found liable for tax evasion. Due to its financial situation, the Company was not able to pay the additional taxes and tax penalties to the Revenue Service. The directors and shareholders (the “Respondents”) of the Company were later found guilty by the Batumi City Court on charges of intentional tax evasion, for which additional taxes and tax liabilities where assessed on the Company. The Revenue Service brought a civil suit against the Respondents claiming that, despite the Company’s limited liability status, they were responsible for paying the tax liabilities of the Company as compensation for damages sustained by the Revenue Service due to the non-payment of taxes by the Company.

Judgment of the Court

The Court ruled that, under certain limited and specific circumstances, the directors and shareholders of the Company may be personally responsible for the tax liabilities of the Company. The Court further clarified that in the case at hand the Respondents were responsible and liable for the taxes and tax penalties assessed on the Company if the Company was proved to be financially unable to pay such taxes and penalties.

Shareholders’ Liability

The Court confirmed that under the Law on Entrepreneurs a limited liability company is a separate legal person from its shareholders, and therefore such company is solely responsible for its own debts, including its tax liabilities. The Court, however, further noted that shareholders can be held liable for the underlying company’s debts if the shareholders abuse the limited liability nature of the Company by implementing a tax scheme. In reference to this principle, the Court ruled as follows: when a company is used as a tool for acquiring undeclared income and the clear objective of the shareholders is to evade tax obligations, the nature of the limited liability company is abused, i.e. if the privilege of the limited liability inherent in the legal entity is used to avoid liability toward third parties and, effectively, to damage them, then the shareholders may be held liable for the debts (including taxes) of the company. On the basis of this reasoning the Court confirmed that one of the shareholders of the Company, which was actively involved in the management of the Company and was deemed to have used the Company to shield itself from incurring liabilities, was liable for the debts, including the outstanding tax liabilities, of the Company.

Director’s Liability

According to the Law on Entrepreneurs the director of a limited liability company owes fiduciary duties (i.e. duty of loyalty) to the shareholders of the company, including the duty of care. According to this principle, the director is obliged to take care of the company as any reasonable person in the same position would do, and act in good faith to ensure that such action is in the company’s best interests. This, according to the Court, implies that the director should reject the instructions of the shareholders if such rejection is a better course of action for the Company.

One additional note the Court made in its Decision was that the director’s duty of care towards the Company includes proper fulfillment of the Company’s tax obligations. The Court also specified that the director’s duty to increase the Company’s profitability must not be understood to include the right of the director to resort to tax evasion. The Court also clearly ruled that in cases when a director violates said duties, the Revenue Service may bring civil action against the director and claim reimbursement of the Company’s tax liabilities on the basis of the director’s personal property.

Implications for the Business Community

The above described decision of the Court is a very important development in Georgia. Too often, the Georgian business community assumes that shareholders are immune from the tax liabilities of a company and that the Revenue Service may not claim tax liability of a company from the company’s shareholders; moreover, the business community often assumes that a director must always follow the shareholders instructions and that the director is on the safe side if he/she follows such instructions. The Court, however, clearly debunked such assumptions. Given the fact that the Decision was rendered by the Supreme Court and was made in a case involving the Revenue Service, we may expect the Revenue Service initiating similar proceedings against other shareholders and directors. So, whatever was readily assumed about separation of a company’s liabilities (including tax liabilities) from the personal liabilities of the directors and shareholders can no longer be assumed and the directors and shareholders of limited liability companies should take into account the personal implications of engaging their companies in certain tax planning schemes.

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Note: this article does not constitute legal advice. You are responsible for consulting with your own professional legal advisors concerning specific circumstances for your business.