Delaware holding companies are a byproduct of Delaware state income tax law that allows out-of-state companies to exempt some of their income from taxation. Specifically, the Delaware Code provides that:
Corporations whose activities within this State are confined to the maintenance and management of their intangible investments or of the intangible investments of corporations or business trusts registered as investment companies under the Investment Company Act of 1940, as amended (15 U.S.C. § 80a-1 et seq.), and the collection and distribution of the income from such investments or from tangible property physically located outside this State. For purposes of this paragraph, "intangible investments" shall include, without limitation, investments in stocks, bonds, notes and other debt obligations (including debt obligations of affiliated corporations), patents, patent applications, trademarks, trade names and similar types of intangible assets.
Thus a business enterprise may set up a subsidiary corporation in Delaware to which it transfers ownership of intangible assets (especially intellectual property). This “holding company” then licenses the use of those assets back to the parent, which pays the holding company a royalty (typically, some percentage of sales or licensing fees). Those fees, in most states, are deductible expenses which are not taxable in Delaware.
The use of holding companies is controversial for obvious reasons. Indeed, a number of states have sued major multistate or multinational companies (including Home Depot, Victoria’s Secret, and Radio Shack) to recover what they view as improperly lost tax revenue. Accordingly, while the use of holding companies can result in significant savings, they also may result in audit or other legal action by the state that is “losing” tax revenue (i.e., the state where the company has its principal business or earns its revenue). The focus of these audits is normally to prove that the holding company is a mere mechanism for tax avoidance by attacking the holding company’s separate existence and organization.
For this reason, it is critical for those forming Delaware holding companies follow all corporate formalities to ensure that the holding company is not disregarded (leading to the royalties being disallowed as expenses and significant tax assessments being made against the parent).
The following are some steps that are critical for the holding company to maintain its separate identity and status:
- not engage in any business unrelated to maintenance and management of its intangible investments;
- not have or acquire any assets other than the personal property necessary or incidental to its maintenance and management of its intangible investments;
- at all times remain solvent and pay its debts and liabilities from its assets, and maintain adequate capital for the normal obligations reasonably foreseeable in a business of its size and character and in light of its purpose and operations;
- hold itself out as a legal entity, separate and apart from any other person or entity, correct any known misunderstanding regarding its separate identity and not identify itself as a division of any other entity;
- maintain its bank accounts and business records separate from those of any other entity and, to the extent that it is required to file tax returns under applicable law, file its own tax returns;
- maintain its own records, books, resolutions and agreements;
- hold its assets in its own name and not commingle its funds or assets with those of any other Person and has not participated and shall not participate in any cash management system with any other Person;
- conduct its business in its name;
- hold regular meetings of its board of directors;
- comply with all of the terms and provisions contained in its organizational documents;
- ensure that it is duly formed, validly existing, and in good standing in Delaware; and
- pay all taxes which it owes on time.
To the maximum extent possible, any nexus between the holding company and any non-Delaware jurisdiction is to be avoided, and any step that bolsters a Delaware nexus for the holding company is advisable. For example, some steps which holding companies have taken in order to ensure their qualification as Delaware holding companies:
- purchasing or leasing office space and/or equipment within Delaware;
- maintaining a physical address in Delaware;
- having its contracts governed by Delaware law (i.e., the licensing agreement);
- having directors, officers, and employees who reside and/or work in Delaware;
- paying Delaware payroll taxes for such employees.
- maintaining a checking account in a Delaware bank;
- holding meetings of the directors in Delaware;
- maintaining the company’s corporate and financial records (including copies of material contracts) in a Delaware location; and
- engaging the services of Delaware-based accounting and legal professionals.
The ultimate outcome of any audit is likely to be based on a highly fact-intensive analysis. Businesspeople are strongly advised to engage competent legal and tax counsel when forming, managing or defending a holding company from audit.