Ákos Baráti

Most of Hungary’s family-owned small and medium-sized enterprises are made up of a single business, typically a limited liability company (Kft.), but in the higher echelons of the SME sector they tend to operate as groups comprised of several companies. How are these company groups formed and what is the rationale behind them? When should you start to establish a company group?

A significant number of companies in the Hungarian business sector began as “garage start-ups” in the 1990s. For understandable reasons, the owner-managers (and their family members involved in the business) were not thinking about corporate and tax structures at the time, but about income generation and growth. However, time comes when owners should think about the operating form of their company and whether it’s appropriate for its size – and, no, it’s not just a question of prestige. Company groups are often created for external reasons, for example when one company acquires another, but also when a company launches operations outside its national borders through a separate foreign company. However, the formation of a group is often based on a conscious, internal decision by the owners of the business – a decision that in most cases is driven by considerations of asset protection as well as tax or business efficiency.

Asset protection – never keep all your eggs in one basket

There are risks involved in running any business. The defective performance of a contract or a defective product can result in a warranty claim against the company. The tax authorities may assess a tax deficiency due to a single incorrect accounting entry. In such a case, all the assets of the company may be lost in the blink of an eye – which, if the founders have “reinvested” the profits over the years, could mean a significant portion, or almost all, of their net worth.

A company can protect itself against this risk by an arrangement whereby the risk-bearing, operative (production or service) company spins off the assets that do not necessarily need to be in the company, or more precisely, in its ownership. This way, a real estate or other asset management company can be set up alongside the operating company to hold the more valuable fixed assets of the business. The operating company can then lease back the spun-off assets to use them for its activities as before, but now as a lessee.

It's also worth considering setting up several companies if the original business is engaged in several activities that are entirely separate from each other. Otherwise, a “disease” infecting one line of the business can easily spread to the other lines, as the activities and assets in the same company serve as collateral for each other.

And it’s not all the same when it comes to tax, either

Besides asset protection, tax considerations also tend to play a major role in decisions to establish company groups. Indeed, if the owner wants to withdraw excess cash – in the form of dividends, for example – from his business for asset protection purposes, such dividend-taking is immediately taxable. If, however, the owner creates a so-called holding company between himself and his company (i.e., a company that has no other function than to hold shares in other member companies of the group), dividends can be taken tax-free. In addition, the dividends withdrawn in this way can also be invested tax-free in other members of the group. The role of holding companies is also very important when the owner plans to sell one of his companies: through a holding company, the profits from the sale of a company may be tax exempt. Although a holding company might appear to be a complicated form, it is, in fact, a simple limited liability company (Kft.) which does not require any specialist financial knowledge or any permit to operate.

Tax considerations are also often the motivation for the company to spin off certain assets (such as its intellectual property) into a separate group company set up for this purpose, as both Hungary and some foreign countries have preferential tax treatment for holding intellectual property, increasing its value and exploiting it. Thus, for example, if a business develops in a separate company the intellectual property (e.g., software or patentable inventions) exploited in the group, and grants the right of use to the operating companies in the group, it will only have to pay 4.5% corporate tax on the royalties invoiced (while the operating company can recognise the invoiced royalties as expenses subject to a tax of 9%).

Concentration of organisational functions

Although it is not the first step in creating a company group, it is often helpful for the operation and efficient functioning of an existing company group to organise certain functions – finance, legal, or even the call centre – into a separate company. Similarly, it is common for groups to create a financing entity within the group to provide funding and liquidity for the other companies in the group. Many firms use a solution where an intra-group service company is set up to concentrate the risks and administrative tasks related to personnel and employment. In such cases, the other member companies use the services of this specialised company and pay a market rate for them.

Benefits and drawbacks

Although transformation into a company group (depending on the specific needs involved) can be done quickly and confers greater prestige, such a series of transactions, like with any reorganisation, has its costs and drawbacks. For instance, maintaining several companies may involve slightly more administration, as well as additional costs. Moreover, in principle, care must be taken to ensure that transactions between member companies are correctly priced. However, the immediate benefits of favourable tax treatment and the future benefits of asset protection will in most cases far outweigh these costs.