Selling subsidiary shares & taxation

This writing is about a case where an entrepreneur had been running down the business because he was about to retire.

This writing is about a case where an entrepreneur had been running down the business because he was about to retire. The accounts of this S&M company had earlier included some shares of a housing company (fixed assets in the books). The parent company sold the shares of the housing company. In a tax audit report, the shares in question were regarded to be included in the “source of personal income” – not business income – and the selling profit was regarded to be taxable income. The company owned 100 % of the shares of its subsidiary. Couple of years later the same company hired a consultant firm to arrange the selling of its subsidiary company. The subsidiary shares had been in the accounts of the parent company for over 20 years and treated as fixed assets. The tax auditors had had no comments about the subsidiary shares and their treatment in the bookkeeping.  The entrepreneur believed that selling the subsidiary shares (fixed assets) is tax free. The tax decision was as expected. Almost 5 years later the tax office sent a tax decision to the entrepreneur: the subsidiary shares were not regarded fixed assets, and the selling profit was regarded as taxable income.  

In the mentioned case, the parent company and its subsidiary were active in different sectors of business. The subsidiary owned the office space where the parent company was also located. The parent company used the services of the subsidiary to promote sales, marketing etc. The sole board member of the parent company was also the sole board member of the subsidiary. Nikula took the case and made a tax appeal. The lack of evidence was problematic. The entrepreneur had submitted many documents to the tax authorities who wanted more detailed information. Unfortunately, the bookkeeping and administrative documents had been given to the buyer and the entrepreneur did not want to bother the buyer with this case. Several years after the sale of shares the archive files had been destroyed.  One long-term corporate client was willing to give a written statement about the role of the subsidiary – would that be enough to prove the business connection between the parent company and the subsidiary?  

According to the law, the selling price of fixed-asset-shares of a limited liability company doing other business than investments is not taxable income (Business Tax Act Section 6,1 and Section 6b,1).  Especially, small and medium-sized companies may end up into a situation where the fixed-asset-subsidiary shares are sold and the tax consequences are unexpected. Taxation praxis is inconsistant.  

The term “fixed assets” is defined by the Business Tax Act, Section 12. Eg. such shares meant for sustained use in business (subsidiary shares) are fixed assets. The primary purpose of fixed-asset-share is else than dividends or short-term-increase in value. 

In the government’s bill (HE 176/2008) preceding the above section of law, the term “fixed assets” is characterized as follows: 

  • the company’s business must benefit from the use value of the commodity,
  • the acquisition price of fixed assets is targeted to the actual production of the company’s outcome and is necessary for it,  
  • the company has acquired the fixed asset shares in order to increase or to facilitate the sales of its own products or services or to obtain certain means of production in a cheaper or more secure way.

The Board of Accounting (KILA) has given guide lines 1054/28.8.1989 according to which the shares can constitute a part of fixed assets if  ”the share are meant to yield incomes in more than just one financial year and the both companies are part of the same group of companies or there is a fuctional connection between the companies because of share possession.” Shares acquired for a long-term-investment not serving the actual production or business of the parent company or the group of companies cannot be hold as fixed assets.

In its decision KVL:011/2005, the Central Taxation Board has defined the fixed-asset-shares the selling price of which is tax free: 

  1. The administration, finance and strategy of the group is organized by the parent company. 
  2. The operative functions of subsidiaries are directed by the parent company.
  3. The shares of its subsidiary are largely owned by the parent company and the parent also includes the shares of its subsidiary in the consolidated financial accounts.
  4. The parent company is not just an investment company. 

The S&M business sector meets challenges in situations where larger companies have a more solid standing. The human and financial resources are limited in the S&M companies where the same person takes care of several duties that are divided between several persons in large companies. 

In the S&M company, it is natural that the owner and the chair of the board must take a bigger role in the administration and leadership. In a larger company the director and employees are separate.  This does not mean that a smaller company should be put into a different position with regard to a larger company in the eyes of the laws. The analysis whether the shares are fixed-asset-shares should be done so that it takes into account the prerequisites for business operations and financial aspects.  

The Supreme Administrative Court has created a resolution line concerning the tax exemption of subsidiary-shares and regarded that the subsidiary-shares are fixed-asset-shares when there is a business connection between the parent and the daughter company as following circumstances: 

  1. The parent company used the business space owned by the subsidiary (KHO 2014:36),
  2. The parent company had owned the subsidiary-shares for several years and received over 200 000 euro royalty payments because of the shareholders’ agreement. The parent had acquired the business space and organized the operations of the daughter, eg. by renting the business space and arsenal. The parent’s board member was also a board member of the daughter (KHO 2012:73). 
  3. The parent – an investment company – had rented arsenal and equipment to the daughter for its production (KHO 2010:50). 

A different view was taken in the case KHO 2012:74 where the court considered that the parent and the daughter had no business connection solely because of a joint board and because the incomes of the parent were from the stock market and the consultation fees paid by the daughter. 

It is recommended to seek for a preliminary tax ruling from the tax authorities before selling the subsidiary-shares. However, an appeal against the preliminary ruling may prolong the process. 

What happened to the entrepreneur? The administrative court did not give any protection of faith on account of the preceded tax audit and considered that the submitted evidence was not enough. The turnover of both companies was quite small, and the sale of subsidiary-shares was regarded taxable. The Supreme Administrative Court did not grant leave for appeal – without any reasoning.   It is regrettable that the taxpayer could not rely on the guidelines given by the tax authorities.  Is it so that when you can pay you may pay. 

It would be important to be able to rely on that the wane of business activities does not mean that the tax exemption of fixed-asset-shares is lost when the entrepreneur gets to the age of retirement and there is no one to continue the business. The status once achieved should be retained even though the turnover gets smaller. 

As far as I understand, if the acquisition price of subsidiary shares has not been reduced by making write-downs, depreciations, allocations or by received subventions and the shares have not been transferred within the group of companies by doing unprofitable or under-priced sales contract, the tax payer must have the right to trust that the subsidiary-shares owned for a long time are treated as fixed-asset-shares if there has been a business connection between the parent and the daughter.  

This article is based partially on a judicial text written by Anne Nikula and published in on 6 October 2015 and an unpublished judgement given by the Finnish Supreme Administrative Court. 

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