Holding and operating companies: separating risk from assets

A business that has been running for a few years usually has two things worth protecting: the cash and assets it has built up, and the trading business that earns them. When both sit in the same company, a single large claim or failed contract can put everything at risk. Separating them into a holding company and an operating company is one of the most common ways to reduce that risk, but it only works if it is set up and run properly.

The basic structure

In a typical arrangement:

• The operating company runs the business. It employs the staff, signs the customer and supplier contracts, holds the trading risk and keeps only the working capital it needs.
• The holding company owns the shares in the operating company and, often, the valuable assets: surplus cash, investments, intellectual property or equipment that it leases or licenses to the operating company.
• The holding company itself is often owned by a family trust, which adds flexibility in how dividends are eventually distributed to family members; see Discretionary (family) trusts explained.

Where there is real property, such as the business premises, it is often held in a separate trust or company again, and leased to the operating company on commercial terms.

Why separate risk from assets

If the operating company is sued, cannot pay a supplier or fails, its creditors can generally only reach assets the operating company owns. Cash and assets properly held by the holding company, or another entity, are not automatically available to them.

The benefit is greatest for businesses with real trading exposure, such as construction, professional services, hospitality, transport, or any business relying on large contracts or employing many people.

Moving profit up to the holding company

The usual way to keep the operating company's surplus out of harm's way is for it to pay dividends to the holding company on a regular basis.

• Dividends between companies can carry franking credits, so the holding company generally does not pay further tax on a fully franked dividend from the operating company, although how this works depends on the companies' tax rates.
• A tax consolidated group can be formed where the holding company wholly owns its subsidiaries. Inside a consolidated group, transactions between the companies are generally ignored for income tax, and the group lodges one return. Consolidation has its own rules and is not right for every group, so get advice before electing.
• If the operating company lends money to the holding company, or to a related trust, instead of paying a dividend, check whether Division 7A applies; see Division 7A: taking money out of your company the right way.

Timing matters. Moving funds out when the operating company is already in financial difficulty can be unwound by a liquidator. Regular, documented dividends paid while the business is solvent are far more robust.

An illustration

Suppose an operating company earns a healthy profit each year and has built up $1 million in cash over time. A large customer dispute arises and the claim is significant. If the $1 million sits in the operating company, it is exposed. If, over the previous years, the operating company had paid regular franked dividends to its holding company, and kept only the working capital it needed, most of that cash would sit outside the claim.

This is a simplified example. Whether the arrangement holds up depends on how and when the transfers were made.

The limits of the protection

A holding structure moves assets away from trading risk. It does not move them away from you, your guarantees or your decisions as a director.

• Personal guarantees. If you have guaranteed the operating company's lease or loan, the creditor can come to you personally, and through you to anything you own.
• Cross-guarantees and security. Banks often require the holding company to guarantee the operating company's debts, or take security over its assets. That can put the protected assets straight back at risk.
• Director duties. Directors can be personally liable for insolvent trading and, under the director penalty regime, certain unpaid tax and superannuation.
• Clawback. Transactions made when the company is insolvent, or that are uncommercial, can be reversed by a liquidator.
• Commercial terms. Leases, licences and loans between the entities should be documented and at arm's length. Informal arrangements are easier to attack.

Tax considerations

• Base rate entity status. A holding company earning mainly dividends and interest may not qualify for the 25% rate and may pay 30%. Franking still applies.
• No CGT discount for companies. Growth assets that may be sold one day are sometimes better held in a trust than in a company, because companies do not get the 50% CGT discount.
• Selling the business. A holding company can make a future sale cleaner, because the buyer can acquire the operating company's shares while the valuable assets stay behind. Whether the small business CGT concessions are available depends on the structure and the tests at the time of sale, so plan early; see Structuring your business today for a sale tomorrow.

Setting it up

New businesses can be set up this way from the start at relatively low cost. For an existing business, moving to a holding structure is a restructure, and inserting a holding company above an existing operating company can raise CGT, duty and other issues. There are rollovers available in some cases, with conditions. Read Restructuring an existing business and have a lawyer prepare constitutions, share transfers and any intercompany agreements.

A practical checklist

1. Identify which assets are worth protecting and which risks the business really carries.
2. Decide which entity should own each asset, including any property and intellectual property.
3. Put intercompany leases, licences and loans in writing on commercial terms.
4. Set a regular dividend policy while the business is profitable and solvent.
5. Review what guarantees and security your lenders hold.
6. Keep separate bank accounts, records and minutes for each entity.

How we can help

We help business owners design a structure that fits the risks they actually carry, implement it alongside their lawyer, and run the dividends and records that keep it effective. To review your structure, contact us or read about our business structuring services.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.