BY: FRANÇOIS MEUNIER

Facing globalization and the development of the European market, the manager of a business must create within its group of companies « an organized infrastructure that is capable, in addition to providing the indispensable tools for effective marketing, of framing the activities and making them achievable without taking exaggerated risks».

Facing globalization and the development of the European market, the manager of a business must create within its group of companies « an organized infrastructure that is capable, in addition to providing the indispensable tools for effective marketing, of framing the activities and making them achievable without taking exaggerated risks».

A multiplicity of companies in a group generates substantial organizational costs that can hinder its competitiveness in the absence of good management.  The formation of a holding company specifically responsible for such management is thus necessary, and the role of legal counsel is to master the stakes of such a formation, and to become an indispensable guide.

The purpose of our article, based on a monolithic structure (one or more operating companies), is to identify the advantages of forming a parent company (I) and the modes of its formation (II).

I.                    Advantages of the formation of a parent company

Despite their legal independence, the companies of a group are linked by the existence of a head company of the group, a parent company[1] or a holding company[2], that directly or indirectly holds interests in each of these companies, the creation of which responds to various considerations:

-          A management unit correlative to the group’s autonomy (1) ;

-          The benefit of a preferred tax treatment (2) ;

-          The grouping under the same legal entity, of several companies conducting different activities or located in distinct geographical areas (3).

1)            Management unit: Confirmation of the aphorism «to divide in order to rule»

a-           Uniqueness of management

In addition to its essential financial role related to the management of its various financial interests, a holding company increasingly assumes the function of management and administration, thus being no longer a « pure » holding entity, but an « impure » or mixed holding entity, that conducts a commercial activity and/or preserves industrial assets.

A third scenario is possible since a holding company assumes only policy-making and overall management functions, and supports the subsidiary’s productive activity[3].  The creation of a holding company that fully owns the operating company, for instance, enables separation of the commercial activity from the strategy-marketing activity in order to localize in the holding company the power of management and the activity of a high added value.

Regardless of the nature of a holding company, its legal leverage is indisputable since it selects the representatives of the executive organs of the subsidiaries, which are then placed under its dependence and control.

b-           Durability of the Group

By controlling and managing the subsidiaries, a holding company assumes the role of a decision-making unit essential for durability of the group.  Indeed, the subsidiary is not necessarily 100% controlled, but the formation of a holding company avoids too broad a dispersion of shares. Their management is then easier, and is carried out by the holding company even in the event of conflicts between the associates or shareholders.

In addition, a holding company is a legal tool that is indispensable for maintenance of the subsidiaries’ business, particularly when changes of strategy are made due to various circumstances or to the arrival of new associates.

c-            A joint development policy

A holding company is responsible for development of the group without losing the control of its subsidiaries. Its assignments are numerous and varied: definition of the group’s policy, setting of objectives, establishment of budgets and investments to be made, extension of the group…. The subsidiary thus sacrifices its autonomy to the interest of the group.

A holding company must thus have internally competent centralized departments and substantial various resources and means such as the conducting of strategic analyses, the promotion of a product …, and any others that the operating company would not necessarily have at its disposal if it were acting alone.

These responsibilities are heavy, which, in our opinion, presumes that the holding company does not have other activity.

2)            Development factors

a-     Financial strength

The liquidities may be centralized within the holding company with the organization of a cash pool or corporate agreement.  The financial situation of the group companies will then be eased by reducing recourse to banking supports, the procurement of more favourable credit terms, and possible allocation of reserves based on what is required for the group members.

In addition, with this financial leverage, a holding company will have a substantial borrowing capacity that contributes to the group’s internal and/or external growth.  The buyout or taking of control of a company through a holding company, a technique called a leverage buyout, permits a substantial reduction in the personal contributions of those who assume control, and encourages investors to join the project.

Finally, the establishment of consolidated accounts within the group enables the holding company, which must approve them at its annual general meeting, to assess the situation of each of the companies in relation to its sister companies.

b-                                               Essential role of the parent company

The existence of a joint structure facilitates the circulation of financial flows between the member companies of the group: loans, guarantees, advances, subscription to the capital of a sister company that needs equity for its development …

The commercial partners will also be reassured by the existence of the group:

-          The holding company will accept a late payment from its subsidiary, in favour of external creditors;

-          The creditor will obtain from a parent or sister company of its contracting party guarantees of payment of its claim (security, letter of intent, declarations of commitment, formal sureties …). The commitment is made up stream when the subsidiary acts as the guarantor of the holding company.

c-            Parent company, a prerequisite recommended for listing

Listing on the stock exchange is usually preceded by the formation of an unlisted holding company that will authorize the listing. This enables the implementation of a policy for the distribution of profits among the capital shareholders, by meeting the cash requirements of subsidiaries, thus facilitating self-financing and development of the company’s external or internal growth.

d-           Tax relief

The European directive of July 23, 1990 regarding treatment of parent companies and subsidiaries at a European level, as well as the tax agreements at an international level, facilitates the payment of dividends to the holding company or to non-resident shareholders, almost tax free.

3)            Development of the subsidiaries’ business: Solution to « the diplodocus syndrome»

The groups of companies must have a clearly defined economic logic so they do not fall victim of « the diplodocus syndrome » -- i.e. as the body grows more and more voluminous, it no longer obeys the head and it can no longer move or feed itself.  The group must thus exhibit organizational and financial coherence, and keep focused on the group’s core business.

However, efficient management presumes that the responsibilities and activities are not concentrated in a single person. A company should ideally devote itself to an activity, a brand or a market in such a way that the subsidiaries remain autonomous.  The managers, senior and operational executives will thus measure the importance of their role -- a real source of motivation, and especially so with the holding company verifying the annual accounts established by each company of the group.

This classification of activities by structure facilitates the development of specific activities, the geographical organization of the group, and the segmentation of financial and operating risks.

Benefiting from the advantages afforded by the new information, communication and processing technologies such as business-to-business, or business-to-client, the holding company enables effective monitoring of performance in the group’s links by facilitating the circulation of information from the decision-making units to the operational pools.

II.                  Modes of formation of a parent company

According to the objective to be reached, the formation of a holding company may result from the transformation of a pre-existing operating company (formation from the bottom) or from the creation of a new company (formation from the top) (1). The objective may involve:

-          The buyout, transfer or listing of a company on the stock exchange;

-          The creation of a legally autonomous unit responsible for the management of several structures;

-          The growth of the group through the spinning off of certain activities, or through investors or another group that conducts an industrial or commercial business taking a position in the subsidiaries’ capital.

The tax impacts differ according to the mode of formation (2).

1)            Modes of formation of a holding company: From the bottom or the top

In the case of a formation from the bottom, the operating company provides its industrial or commercial business to one or more subsidiaries.  The operating company thus sees its financial power strengthened to the detriment of its managerial power.

In the case of a formation from the top, the operating company contributes or transfers shares to a newly created company, whose managerial power will be in a foremost position due to the number of votes that are held.  A formation from the top has several advantages serving the group’s interest:   

-          A liberty of choice regarding the country in which to establish the holding company: The dividends coming from subsidiaries based in the European Union may be received almost tax free;

-          Easier financial relationships between the group companies via the intermediate holding company.

2)            Choice of its location

Tax optimization being a major economic consideration in the formation of a holding company, particular attention must be paid to the choice of the country where it will be established.  Most foreign laws take account of the institution of a holding company, the most illustrative example being that of Luxembourg financial holding companies; and States that are eager to attract to their territory decision centres of international companies establish tax relief rules for holding companies.

Our Belgian and Luxembourg neighbours have promulgated rules that are particularly attractive.  Luxembourg has two advantages: It preserves shareholders’ anonymity and is not subject to any anti-abuse system.

Conclusion

The formation of a holding company enables associates to create a group of significant companies centralized around a head company.  Detached from contingencies related to the core business, the holding company will offer its subsidiaries services that contribute to their development: means for the definition and application of a strategy (decisions, studies, work …), information centralization, securing of expertise, linkage between the group members …, in consideration of which it will receive management fees.

The multiplication of companies in the group will imply an increasingly refined organization, reinforcing the interest in forming a holding company.

Development of a group creates disorders.  Therefore, it will be important to foresee any difficulties by updating the organization of the group that has been formed at fairly frequent intervals.

François MEUNIER

Former Tax Inspector

Partner, LEXAND, Paris

(http://www.lexand.eu)