Why sisters are better than parents: How to avoid the dreaded locked-in capital gain

New Zealand has an overwhelming fascination with using Holding Company structures in business.   The Holding Company may be entirely passive or may undertake management services for its subsidiaries. Each subsidiary is likely to operate separate businesses or projects, which is particularly prevalent in the building, construction, infrastructure and IP industry segments but extends to almost all industries.

We have no issue with using separate companies to operate separate businesses or projects. It, in fact, makes very good asset protection sense by limiting cross-contamination risk i.e., one business suffers losses for whatever reason without potentially bringing down the other business entities. You just have to refer back to the leaky buildings saga to see the benefits of separate entities for separate projects.

But the use of Holding companies can create what we call locked-in tax-free capital gain.

NZ is one of only 27 countries in the world that has no capital gains tax (with some exceptions around land transactions). Prominent among those countries without a capital gains tax are Hong Kong, Singapore, Thailand, and Malaysia. Most of the other countries are tax havens, which have other serious drawbacks.

Notwithstanding that NZ does not have a capital gains tax, too many businesses are held in structures that prevent them taking full advantage.

A NZ company can only make three types of distributions to shareholders:

• A dividend (taxable either via imputation or Resident Withholding Tax (RWT))
• A share capital repurchase (limited to the paid-up capital and subject to other restrictions)[1]
• An advance (subject to interest at the Fringe Benefit Tax (FBT) deemed rate).

If a company makes a capital gain that is not taxable, it can then only distribute that gain to the shareholders using one of the above. None of those are particularly palatable and a dividend simply turns a non-taxable capital gain into a taxable amount.

That often occurs in the following scenarios:

• You sell a portion of the shares in a subsidiary to either employees or someone that can assist with that company’s growth. The proceeds from that sale are then received by the Holding Company. The shares were held for long term hold, and hence, the proceeds are tax-free capital gain.
• You sell all the shares (or the business) exiting from that particular industry segment or project. Again, the proceeds are tax-free capital gains received by the Holding Company.

The Holding Company will have very limited imputation credits (and may in fact have none). Distributing those capital gains to the shareholders tax-free requires the full liquidation of the Holding Company. Anything else has full tax consequences, in effect changing the tax-free capital gain into a fully taxable revenue distribution (and sacrificing at least 33% of that tax-free gain into income tax).

Liquidating a Holding Company is a major undertaking that also requires a re-organisation of all subsidiaries. And if the Holding Company has employees or assets, then there are also employee and depreciation issues to manage.

All the above can be easily avoided. Instead of having a Holding Company, you have a series of sister companies. All the ultimate shareholders own the shares in each company directly rather than via a Holding Company. You can have as many or as few sister companies as you want. The only change is the shareholders of those companies is not a Holding Company.

This then means that the sale of any of the shares of any of the sister companies is derived directly by the ultimate shareholders tax-free. There is no need to restructure any of the other sister companies, liquidate a Holding company, reorganise the shareholdings of any of the other sister entities or pay 33% tax.

A “group” of sister companies can still avail themselves of the consolidated income and GST tax group regime. And, in our experience, the banks view the group in the same way they would a Hold Co subsidiary structure.

If you would like to learn more about locked-in capital gain and sister companies, please contact me.

[1] Many NZ companies have paid up capital of less than $1k severally limiting this option.