While a typical small or medium-sized family business consists of a single company, large enterprises tend to work in the form of a company group, made up of numerous companies. How do company groups form and what justifies their formation? When is it worth establishing a company group? These are the questions we seek to answer.
Company groups are often formed due to an external reason. For example, a company group is created when a company acquires another, but also when a company starts its cross-border activities through a separate foreign company. However, becoming a company group is often based on a conscious, internal decision of the owners, usually driven by the desire to protect the company’s assets, or by tax or business considerations.
When limited liability won’t protect you
Running any business involves risks. Deficient performance or a defective product may give rise to a warranty liability for your company. The tax authority may discover a tax shortfall due to an error in calculating the tax consequences of a transaction or other taxable event. In such cases, the entire net worth of the company – assets that the founders have often worked for decades to build up – can be wiped out in the blink of an eye.
The company can protect itself against this risk by spinning off the tangible and valuable assets from the operative entity (i.e. the company producing the goods or services). This way it is possible to establish, alongside the operative company, a firm that is engaged in real estate or some other asset management activity and that can keep the assets of the company away from the operational risks. The operative company can then lease back the spun-off assets so that it can continue to use them for its operations, this time as a lessee.
And tax is important, too
Setting up a company group is not just about protecting your assets – there are often important tax reasons for doing so, too. If, in order to secure his assets, an owner wants to withdraw excess cash from his business – in the form of dividends, for example – then this will have tax implications. However, if the owner establishes a holding company (i.e. a company that has no other function than to hold shares in other member companies of the group) between himself and his company, then he can take the dividends without incurring tax. In addition, the dividends thus withdrawn can be invested, likewise tax-free, in other members of the group. Holding companies can also play a very important role if the owner plans to sell one of his businesses, because through a holding company, the profits from the sale of the business can be rendered exempt from tax.
Often, tax considerations also persuade a company to spin off some of its assets (such as intellectual property) into a separate entity set up for this purpose as, both in Hungary and in certain foreign countries, the holding, the licence and the use of intellectual property is subject to favourable tax terms. Thus, for example, if a business develops, in a separate company, proprietary intellectual property utilised within the company group (such as software or a patentable invention) and grants a licence for the use of these to the operative group companies, then it only needs to pay 4.5% corporate tax on the invoiced royalties (while the operative company is able to account for the fees thus invoiced as a cost, at a 9% tax rate).
Concentration of organisational functions
Although not the first step in establishing a company group, organising certain suport functions – financial, legal or even a call centre – into a separate entity can often assist an existing company group to conduct its operations more effectively. It is also common to establish a financing company within the company group, that is then responsible for financing the other members of the group and for ensuring their liquidity. Many businesses employ a solution that involves establishing an intra-group service company in order to ‘concentrate’ HR-related risks and administrative tasks. In such cases, the other member companies use the services of this specialised company and pay a market rate in consideration.
Pros and cons...
As with any reorganisation, there are costs and drawbacks to becoming a group company. Thus, maintaining several businesses can result in more administration and additional costs. What’s more, the appropriate pricing of transactions between member companies needs to be ensured. However, the immediate benefits arising from the favourable tax treatment and the future advantages of asset and wealth protection far outweigh, in most cases, these costs.
By Istvan Csovari, Partner, Jalsovszky