Legal reserve

A legal reserve refers to a mandatory reserve fund that certain corporations—especially in civil law jurisdictions—are required to create out of their profits to ensure financial stability and protect creditors against potential future losses. This reserve acts as a financial safeguard, strengthening a company’s capital base and helping it meet unexpected business contingencies.

Key Features:

Mandatory Requirement: Under specific national laws, companies are legally obliged to transfer a fixed percentage of their annual profits into a legal reserve until it reaches a prescribed limit (often a percentage of paid-up capital).

Purpose: Serves as a protective buffer against unforeseen losses, ensuring the long-term financial soundness of the company.

Usage Restrictions: The reserve is not freely distributable as dividends to shareholders and may only be used under specific legal or statutory conditions, such as covering losses or capital adjustments.

Tax Treatment: The amount allocated to a legal reserve is not tax-deductible under tax law, meaning companies cannot reduce their taxable income by the amount transferred to this reserve.

Example: In some European countries, corporations must allocate 5% of their annual net profit to a legal reserve each year until the reserve equals 10% of the company’s share capital. This reserve may later be used to offset future operational losses but cannot be distributed as dividends