What you should consider when setting up a Holding Company
What you should consider when setting up a Holding Company
Forming a holding company – an entity that holds and manages equity participations in subsidiaries or investments – may bring a number of benefits, but also has certain caveats and considerations that one should take into account. In this article, we have reviewed potential benefits from using a holding structure as well as certain key aspects that one should consider when structuring and choosing the jurisdiction to establish it.
In future letters, we will review some potential jurisdictions you may consider to set up your holding company.
Benefits of using a Holding Structure
To begin with, a holding structure can be a powerful asset protection and risk management tool. By using an umbrella from which they hang different operating subsidiaries or certain assets such as stocks, intellectual property, immovable property, financial assets, or any other asset, a group may achieve a separation of legal and financial liability between them.
A holding structure may allow you to segregate different business assets and activities and protect them from business and financial risks and losses, or to protect certain assets from the aforementioned risks that arise when conducting commercial activities.
Holding companies also allow for keeping a consistent ownership and governance structure. For instance, if taking on venture capital, investors may insist on a common parent company which holds the Intellectual property (IP) and equity stakes in the subsidiaries, child companies.
A major benefit of a holding company is that, when properly structured, each subsidiary would have limited liability and not be liable for another operating entity’s liabilities. For instance, a subsidiary holding the intellectual property would not be held responsible for the liabilities incurred by the ‘service provider’ subsidiary or for those incurred by any other subsidiary of the holding company.
One such popular usage is for holding real properties. If a tenant should file suit or other legal issue arises, the landlord would want the least amount of properties held in the legal entity, and perhaps a different legal entity for providing management and services.
Furthermore, with a holding structure, one can leverage a greater level of financial flexibility and debt-structuring strategies.
By organizing different businesses or activities under a holding, a group structure may have more flexibility when reinvesting and allocating capital across different businesses or investments and may also benefit from a lower cost of capital and, overall, better financing terms than a stand-alone entity due to its better financial position.
One can also isolate liabilities of subsidiaries that require heavy capital expenditure from the holding or other operating subsidiaries. If a heavy indebted subsidiary fails – other entities within the structure may not be affected provided that there is no fraudulent transfer of assets to undercapitalize the company, among other aspects.
In addition, holding structures may be able to leverage intra-group financing strategies, via, for instance, lending retained earnings to its subsidiaries – which can provide a greater level of protection to profits as well as certain tax planning benefits.
Tax planning is certainly one of the potential major benefits that using a holding and operating subsidiaries structure could provide. In addition to intra-group financing strategies, if properly set up and commercial substance is in place, one could leverage business relationships between operating entities to achieve a more tax-efficient situation.
That being said, one should be careful with group structures and arrangements only put in place to create a tax advantage as they could be seen as pure tax avoidance schemes and be disregarded. There should be proper economic substance and commercial reason.
You must bear in mind that there are certain anti-avoidance and anti-abuse provisions such as transfer pricing considerations, thin capitalization rules and interest deductibility limitations in certain jurisdictions. Transactions between affiliates should be governed by the arm’s length principle and may need to be properly documented and reported. Appropriate economic substance is key in a multinational structure.
Most countries are adopting Country-By-Country (CbC) reporting and local and master file transfer pricing documentation whereby large multinational group consolidated financials must be disclosed to local tax authorities and may be shared between jurisdictions.
By using a holding one may also be able to defer personal taxes, avoid capital gain taxes, avoid withholding taxes on dividends, interests, and royalties, and use retained earnings for future investments in a tax-optimized manner. Certain jurisdictions provide for advantageous tax regimes and participation exemptions for asset holding structures.
However, one should carefully look at existing double-taxation agreements and controlled foreign company rules (CFC), among other legal and tax provisions.
Holding companies also provide a proper structure set for international growth. Companies doing business internationally might need to set up subsidiaries in various locations to penetrate different markets.
Holding companies are also used as vehicles to make investments and provide a centralized investment management structure. For instance, a given group structure could have in place an investment holding company to invest and diversify its retained earnings with the flexibility of joining and exiting operating businesses without posing any risk to the parent company or affecting other operating entities.
Holding vehicles may also be used for estate and succession planning purposes, benefitting from asset protection and tax deferral features and keeping the whole family estate in a single ownership structure. One could potentially use a Trust or a Foundation in combination with a limited company or LLC for further flexibility and protection.
That being said, there are certain caveats and key aspects one must consider when setting up and operating a holding structure. We have reviewed some of them in this article. This article doesn’t intend to be a comprehensive review and it is not legal or tax advice of any kind. Cross-border corporate structuring can be complex – professional advice tailored to your specific business activity, situation, and circumstances, is always required.
The suitability of a given legal structure would largely depend on the purpose and objective of your group or holding structure.
Most holding companies are set up as corporations. If your holding company’s purpose is segregating different business assets, activities or units, fundraising, providing financing or leveraging tax planning strategies, among others, it would make sense to use a corporation which is a company limited by shares and a taxable entity that can leverage corporate tax benefits from international tax treaties and provide for stricter governance and management structure and requirements.
If your holding company purpose is providing a layer of protection and limiting liability on certain assets such as real estate, cash, gold, and other financial assets – then you may consider an LLC structure(s). The capital of an LLC is divided into membership interests, which may not be freely transferable and they do not constitute securities.
LLCs are more simple, flexible and have less operational requirements and formalities than corporations.
LLCs are not subject to rigid procedural formalities such as corporate board meetings or board resolutions – which in the case of corporations, a failure to comply with them may allow plaintiffs to pierce the corporate veil and trigger personal liability. Furthermore, LLC agreements can be tailored to its owner(s) needs and wishes, whereas corporations’ bylaws are required to follow more rigid legal requirements – and, overall, are more protective entities.
LLCs may also elect to be (or it may be by default) tax-transparent, meaning that income can be taxed at the personal level of its owners rather than the corporate level. For certain asset holdings using a corporation which might add additional tax liability and maintenance burden may not be the best option.
If your holding entity’s purpose is estate and succession planning– then you may consider using a corporation or an LLC in combination with a Trust. Trusts are legal contracts whereby the settlor transfers assets (e.g. the holding) to a Trustee, who will administer these assets for the benefit of certain persons.
Among other benefits, Trusts may lead to avoiding probate and forced heirship and to hold specific assets such as land or an interest in a family business which might not be appropriate or practical to be split between individuals – but still distribute profits to these individuals or to protect beneficiaries with an inability to manage money. If properly drafted and structured, foreign Trusts are powerful tools for asset protection as well.
Alternatively, a Foundation can be used. Unlike Trusts, Foundations do have legal personality, but, like Trusts, they are commonly used for asset protection, the holding of wealth, and succession planning purposes – the Founder endows assets to the Foundation, which are managed by the council members for a specific purpose and/or for the benefit of the Foundation beneficiaries.
Foundations may be more suitable for individuals residing in civil law jurisdictions because many civil law jurisdictions don’t differentiate between formal and beneficial ownership and, therefore, Trusts might be disregarded. Foundations are a construct of civil law and generally speaking – foundations are a legal entity type recognized in all jurisdictions.
Underlying Holdings and Economic Activities
As commented above, the type of assets and the purpose of your holding company may have relevant importance when choosing the appropriate legal structure.
The nature of the underlying assets and their location are some of the most important aspects to consider when designing the holding structure and choosing the most appropriate jurisdiction.
One could look at the existence of tax treaties between the jurisdiction of the holding and the jurisdiction of the underlying operating companies to make sure no additional and unnecessary tax liability arise on financing transactions, profit distribution, royalty payments and other payments between affiliates.
Whether the company holds minor equity stakes in underlying companies or has wholly-owned subsidiaries would have an impact as well when determining the jurisdiction of incorporation. Certain jurisdictions provide for participation exemptions on dividends and/or capital gains provided that the holding owns a certain percentage of ownership from a subsidiary.
Likewise, if the holding is going to engage in business activities other than pure holding, one should look at how payments and transactions between affiliates are treated between jurisdictions and whether withholding taxes are applicable or are exempted or reduced under tax treaties.
IP Holding Companies
If the parent company is holding intellectual property, one should carefully seek qualified advice on how local laws secure and enforce legal rights to inventions, patents, copyrights, etc., protects the exclusive control of these intangible assets and protects the company against infringement. Also, check whether the IP income qualifies for exemptions and the requirements to access tax benefits.
Likewise, if the holding will lease assets to their subsidiaries one should look at how these payments would be taxed and make sure these transactions are carried out at a fair market value according to applicable standards and that these transactions are not seen as profit shifting or tax base erosion schemes.
When exploring suitable jurisdictions to establish a holding company used for financing, one should look at how interest payments are taxed at source and in the hands of the recipient, as well as whether interest payments are deductible by the subsidiary and whether they are subject to thin capitalization provisions or other interest deductibility limitations. Also, they must be aware of how these transactions should be done and the reporting requirements that may arise from them. US persons might also have particular difficulty financing through a non-US legal entity due to PFIC rules, but this article is generally not aimed at US persons.
One could also consider setting up a special purpose subsidiary (SPV) for financing purposes which provide certain benefits such as structuring, leverage, and risk management flexibility – especially for larger enterprises where they are involved in more complex structured finance transactions.
For investment holdings that derive most of its income from trading stocks or other assets, one may look at jurisdictions with advantageous treatment on capital gains. Note that there are jurisdictions where capital gains are usually exempted but may be taxed if they are the main activity and/or source of income of the company.
Governance and Liability
Limited companies are limited in liability to the creditors and other obligors only up to the resources of the company and the unpaid amount of their shareholdings. Therefore, a parent company should only be liable for the acts of a given subsidiary up to the unpaid amount of its shareholdings.
The segregation of liability and risk management optimization are, perhaps, the major benefits of using a holding company, as we commented previously.
As a general rule, the fact that a holding and a given subsidiary share common control shouldn’t be a decisive element to jeopardize liability protection between related entities – however, it might be a good approach to clearly differentiate control and management between the holding and the subsidiaries.
In any case, the appropriate governance and operational procedures are critical to accomplishing any separation of liability and avoiding undesired scenarios.
All transactions between a parent company and subsidiary entities should be properly documented, these are external transactions and not internal movements of cash. Each entity should have its set of books and accounting records and differentiated bank accounts. Entities should be clearly distinguished – no subsidiary should be doing business in the name or on behalf of the parent entity.
Holding structures are powerful tools for protecting assets from creditors, and one could think of undercapitalization a given subsidiary or transferring assets when liability arises towards this purpose.
This approach might be counter-productive. In a potential undesired scenario, if a transfer of assets is conducted without any kind of commercial or business reason or without the subsidiary receiving the appropriate asset value in return, this could be considered solely to place the assets out of reach creditors, and deemed as a fraudulent transfer – and a court may declare this transaction void.
Furthermore, if the commercial subsidiary is purposely undercapitalized, its assets holdings are incongruous according to its business activity, creditors might be able to pierce the corporate veil of the parent company as well. Implications of undercapitalization of subsidiaries vary across jurisdictions, so one should look at the body of law of a given jurisdiction on this matter and seek appropriate legal advice.
As we previously noted, to benefit from asset protection and separation of liability – a holding company should be clearly distinguished from its subsidiaries, operations from both holding and between subsidiaries should be clearly separated and none of them should be involved in any of the others’ activity.
Commercial or other related operating activities should be strictly conducted by the appropriate subsidiary(s) and never by the holding or on behalf of the holding. For instance, the workforce employed or contracted to carry out the sales of goods and/or the provision of services should be paid by the subsidiary carrying out these activities. This is quite obvious, but it is paramount to be scrupulous on this matter.
To achieve a greater level of protection, ideally, the holding shouldn’t conduct transactions with third parties or conduct commercial activities – this could expose the holding’s assets and defeat the main purpose of the structure.
Holding companies are usually more mobile than their subsidiary counterparts – as most of their balance sheet is made up of intangible assets, and their activities may be mainly financially related – which may not be tied to a specific jurisdiction. Therefore, one could consider a variety of structuring options available worldwide. There are certain caveats on this, some of them related to economic substance – which we will cover later.
One of the advantages of being mobile is that it may allow for a beneficial international structuring and tax planning strategy. Holding companies are set to accumulate and/or aggregate profits from subsidiaries for further reinvestment and/or distribution to the holding’s shareholders. Profits may be subject to corporate tax and dividend withholding tax at the subsidiary level, may be subject to corporate tax at the holding level and may be further subject to withholding tax when distributed to individual shareholders. Shareholders, in turn, may be subject to personal income tax on these dividends. When the holding sells the subsidiary, there may be tax applicable on the capital gains.
Tax laws vary considerably across jurisdictions – corporate tax rates can go from 0% to 40%, some countries do not levy withholding taxes, or only to payments to non-residents, some provide partial or full tax credits for foreign tax paid and other countries do not tax dividends received or provide some participation exemptions. Some jurisdictions apply the so-called ‘full imputation system’ whereby profits are only taxed once – in the hands of the operating company that initially generates these profits. For instance, Malta or Singapore, which may be suitable for holdings of subsidiaries within the same jurisdiction.
When establishing a holding, one should look at a jurisdiction where dividends received are exempt from taxes or subject to reduced rates, via full exemption from taxes or a participation exemption provided that the holding owns a certain percentage of the subsidiary.
The availability of these exemptions could also depend on the location of the subsidiary. For instance, holdings of subsidiaries located in offshore jurisdictions may not qualify for exemptions or may be subject to controlled foreign company rules.
With respect to the (intended) location of the subsidiaries, one could look at whether there are withholding taxes applicable at the source – or if there is a double taxation agreement (DTA) between the jurisdictions that exempt or reduce these taxes.
In addition, one should consider the location of the ultimate beneficial owners (UBO), whether the jurisdiction of domicile of the holding levies withholding tax on the distribution of profits to residents of the jurisdiction where the UBO is tax resident. The tax residency of the UBO(s) also plays an important role when looking at the jurisdiction to set up the holding.
Furthermore, some jurisdictions have in place ‘controlled foreign company’ rules (CFC), whereby undistributed profits from certain subsidiaries may be taxed at the holding level.
CFC rules also vary across jurisdictions, some only apply to subsidiaries’ investment income, and/or to subsidiaries without economic activity and/or physical presence in its country of domicile and/or to subsidiaries incorporated in specific jurisdictions; and may also be subject to the percentage of ownership and/or control that a given holding has.
As discussed in previous sections of this article, one should also look at how royalties, interests and other payments are taxed both at the subsidiary and holding level, and the availability of tax treaties to avoid double taxation. Taxation on capital gains is also relevant, and if these gains are taxed or not if they represent the main activity and/or source of income of the holding.
In certain jurisdictions, exit taxes may also apply to subsidiaries transferring assets to an affiliate company domiciled in another jurisdiction.
Tax planning strategies have been historically put in place – for instance, using ‘intermediate’ holding companies to access tax treaties and reduce the whole group tax burden when distributing profits to the ultimate parent entity (UPE). However, care should be taken with these artificial structures – they may be considered by certain tax authorities to have the unique purpose of creating a tax advantage and may be disregarded due to anti-abuse rules. Most jurisdictions have enacted/are enacting laws to prevent and penalize these practices, that are known as ‘treaty shopping’.
This means that economic substance is key. Optimized tax structures may only be effective if there is economic and commercial substance and are transparent to tax authorities.
In addition, most jurisdictions are increasing reporting requirements for multinational groups in line with OECD’s Base Erosion and Profit Shifting (BEPS) Action 13 and exchange of information between jurisdictions under the Multilateral Competent Authorities Agreement (MCAA).
Tax authorities are often requesting master file and local file transfer pricing documentation. The local file is aimed at disclosing and documenting the local entity’s intra-group transactions, whereas the master file reports information about the whole group global business operations and policies. Depending on the jurisdiction, certain business volume thresholds are in place that exempts certain entities from this reporting.
Furthermore, large multinational holdings that are ultimate parent entities (UPE) may need to file Country-by-Country Reports (CbCR) which provide tax authorities information about revenue, tax paid and accrued, employment, capital, retained earnings, tangible assets, and business activities, among others – from the whole group.
When designing and implementing tax structuring strategies, one should ensure that everything is watertight and transparent to tax authorities.
We’ve made several mentions of the importance of economic substance in this and other articles. Although a holding may be a ‘mobile business’, it is important when setting it up to make sure that it is effectively controlled and managed from the chosen jurisdiction of tax residency.
A company may or may not be tax resident in the jurisdiction of incorporation. There are many variables that may affect whether it may pursue tax residency in a different jurisdiction than the one it is registered in. However, this is out of the scope of this article.
Coming back to the importance of having economic substance for a holding company – to benefit from advantageous holding company regimes, intellectual property regime or access to tax treaties, among other available tax breaks, a given company may be required to be not only effectively controlled and managed, but to also have appropriate physical presence and expenditure in the jurisdiction.
Not doing so, opens the company to become tax resident in another jurisdiction such as the place of tax residency of the UBOs – which can potentially jeopardize a given corporate structuring strategy.
To achieve this economic substance, a holding could, for instance, hire local directorship (executive directors rather than nominee directors) which are qualified to hold such position, a local office where corporate documentation and accounting books will be stored and maintained, competent corporate secretary and accounting staff and carry out corporate communications within the jurisdiction such as phone, local bank accounts, and conduct annual general meetings and board meetings within the jurisdiction – the “mind and management” and strategic decisions should also occur here.
Furthermore, in certain jurisdictions, IP holdings may be required to meet the nexus approach to access patent boxes and other tax breaks. They would need to have economic substance such as but not limited to adequate R&D expenditures that contribute to the income generated by the IP.
For instance, the percentage of net income eligible for exemption may be determined based on the ratio of local R&D and other related expenditures.
We have recently talked about how most jurisdictions are modifying IP regimes towards this nexus approach. We have also discussed that British Overseas Territories, Crown Dependencies and other jurisdictions have implemented substance requirements for holding companies, companies financing or trading with an affiliate or conducting intellectual property business, among others. You can read more about it here, here, and here.
Banking and Financial Services
Your holding’s financial services needs may also play an important role when considering jurisdictions to set up.
For instance, you may want your holding to have access to bank accounts located in the same region as the subsidiaries to facilitate transactions. Or you may want your holding to access certain bank financing products. You may also be looking at certain investment products to further monetize your retained earnings. In an investment holding, depending on the capital markets targeted, you may want to have access to certain brokerage accounts, among many other variables. Or you may consider that some jurisdictions levy withholding taxes to interests and other yields derived from onshore banking products.
Accessibility to financial services may vary depending on the jurisdiction of domicile. For some banks, certain jurisdictions are considered higher or lower risk – and financial services should be something you must take into account when structuring your group.
The Bottom Line
As we have seen, using a holding company may provide a number of benefits and flexibility on how to operate or finance your business.
A business could achieve a greater degree of protection on hard-earned assets, effectively manage business and financial risks, as well as leverage tax planning strategies.
However, we’ve also seen that there are many factors that can come into play. One should carefully analyze its current and future needs and requirements when structuring their group and choosing the appropriate jurisdiction to incorporate its elements.
A holistic approach should always be taken, both the location of the holding and the subsidiaries matters and an isolated decision should never be made. Some aspects are more financially related, others more commercially oriented but both are important and should be taken into account.
Economic substance is also paramount, and it is recommended that the whole group structure have no artificial vehicles in place. In some instances, this could have negative consequences. In current times, optimized tax structures may only be effective if everything is watertight, there is economic and commercial substance and are transparent to tax authorities – providing applicable documentation and information about them.
At Flag Theory, we can help you leverage global structuring opportunities for your holding and group structure – with a global approach and jurisdictional comparison intelligence customized to your specific business circumstances – so you can benefit from the highest protection, risk and tax minimization, and smooth business operations. Contact us today, it will be a pleasure to assist you.
In the next letter, we will review a number of jurisdictions that you may consider to set up your holding company to have an initial understanding of whether they suit your specific situation.