Regular corporate finance columnist Les Nemethy looks into when it might make sense to set up a holding company.
Many small to mid-sized businesses have no need for a holding company. It may be sufficient for the company owner(s) to personally own shares or quotas directly in the company in question. This article will look at a number of instances where a holding company might, nevertheless, be advisable. I will look at three types of reasons for setting up a holding company: corporate governance; financial; and taxation.
I advised the owner of a group of companies who has numerous corporate entities which were held by him personally. He exerted his control directly over each company, and his personal control was really the only link among the various corporate entities.
Given that the companies were growing, and in related activities, the owner wished to create a management team that would manage all of the companies. This was achieved by interposing a holding company that provided a coordinated common direction among all of the operating entities.
When a strategic or financial investor puts money into a group of companies, in my experience they more often than not insist on a holding company, as it would not be practical to appoint board members to each entity, and then somehow try to coordinate multiple businesses.
It is much simpler to provide coordinated governance for a group of companies at the level of a holding company. In any situation where there are shareholders who wish to exert control over a group of companies, a holding company may considerably simplify corporate governance.
A holding company can also greatly simplify transactions. Let’s say an investor wants to take an interest of X% in five different companies under common ownership. If the owners were to establish a holding company for the five entities, the investor could achieve the same result with one transaction, taking an X% interest in the holding company. Similarly, for debt financing, the bank could enter into one loan agreement with the holding, instead of with each of the five operating entities, thereby providing financing to the entire group.
One of the advantages of creating a holding company is that it becomes possible to create consolidated financial statements at the level of the holding, generally so long as the holding owns more than 50% of each subsidiary.
These stronger consolidated financial statements open up new horizons in financing, with the ability to attract more debt or equity financing than any individual subsidiary might be able to achieve.
A holding that is larger and more diversified than any subsidiary might also have less risk, resulting in a lower cost of capital, therefore also improving valuation.
Significant tax advantages may be achieved by interposing a holding company between a company and an individual. Whereas in most jurisdictions dividends from company to individual shareholder incur taxes, dividends between a subsidiary and parent company typically flow tax-free, allowing the parent company to reinvest earnings on a tax-free basis.
This is generally true for cross-border dividends within the European Union. (Other cross-border dividends are usually subject to taxes, including withholding taxes, which may be reduced or eliminated by tax treaties). Taxes will nevertheless typically need to be paid on dividends paid from any holding company to individuals.
A holding company can also help save capital gains tax. In many jurisdictions, the sale of subsidiaries by a holding company may be free of capital gains tax. Therefore the jurisdiction in which the holding company is incorporated is of paramount importance; it generally pays to incorporate a holding company in a jurisdiction that has tax treaties with all the countries in which the subsidiaries operate. This helps avoid double taxation.
It is extremely important to obtain advice from tax experts for the purposes of tax planning (which is perfectly legal) and make sure you are not entering the realm of tax evasion (which is illegal).
In short, the reasons for creating a holding company may be quite compelling. It is very important to ensure that, when a business owner sets up a holding entity, and transfers ownership of operating companies from personal ownership to the holding entity, that this does not trigger a taxable event, or if it does, that the tax implications are manageable.
If you are contemplating building a group of businesses that spans many companies, it may be advisable to create the holding structure as soon as possible to avoid the potential tax liability upon such transfers, and to create a multi-year track record of profitability at the holding level, to facilitate raising debt or equity financing.
Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.