Facts
Company C is a trading company.
Over several successful years it has accumulated retained profits that it re-invested into the business.
Question
How can the retained profits be protected against the trading risk of the company?
Answer
Company C issues a redeemable preference share to Company I and declares a dividend to Company I. Subsequently, Company I lends the funds back to Company C under a secured loan arrangement.
Tax Tip
Firstly, some may ask why not interpose a holding Company H (which will wholly own Company C) and declare a dividend from Company C to Company H and subsequently Company H lends the funds back to Company C?
This will indeed remove the retained profits from Company C.
However, it is important to be aware of section 588V of the Corporations Act 2001 (Cth) which provides that a holding company can be liable for debts of the subsidiary if one of the directors of the holding company was aware there were reasonable grounds for suspecting the subsidiary is, or would become, insolvent when the subsidiary incurred the debt.
In the SME market, the directors, or at least one of them, of the subsidiary is/are also the director(s) of the holding company.
In this case, we could have Dad as sole director of Company C and Mum as sole director of Company H. However, it is reasonable to argue that Mum and Dad would talk to each other about the business and Mum is aware or, worst, Mum is only the sole director on paper as Dad is in effective control of the entire structure.
Section 588V is a real risk and is an option available to creditors.
The better option is to form Company I which must be owned by the same shareholders of Company C. This has importance in regards to the tax implications of paying the dividend.
Company C issues a redeemable preference share (RPS) to Company I. The RPS must be automatically redeemed after 4 years to ensure there is no value shift under Division 725 of the ITAA 1997 and no CGT event K8 under section 104-250 of the ITAA 1997.
The shareholders of Company I and Company C are the same to ensure there is no argument about dividend stripping under section 177E of the ITAA 1936 because there is no tax benefit as the same tax consequences apply both before and after the issue of the RPS, that is:
before - the shareholders were taxed on the dividends of Company C; and
after - the same shareholders are to be taxed on the dividends that flowed from Company C to Company I.
Note, the dividends ought not be paid until the holding period has lapsed.
Once the dividends are paid, Company I can lend the money back to Company C under a secured loan arrangement.
Company I is not a holding company of Company C, because Company I does not wholly own Company C, and therefore section 588V does not apply.
This achieves better asset protection of the retained profits.
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