Dividend stripping

Business structures tend to evolve gradually over time, and many successful commercial operations grow by adding additional companies or trusts on an ad hoc basis, until the resulting structure becomes somewhat unwieldy. There is then a need to streamline the business’s legal structure by inserting a holding company, providing a common point of ownership and simplified management and administration. However, a provision within the Income Tax Act, commonly referred to as ‘dividend stripping’, risks such innocuous restructures being challenged by IRD as a tax avoidance arrangement. A dividend strip occurs when a ‘sale of shares’ occurs in substitution for a dividend, the following is a simple example:  Mr A owns 100% of the shares in OpCo, which has retained earnings of $1m.  Mr A incorporates a new HoldCo, in which he holds 100% of the shares.  Mr A lends $1m to new HoldCo and HoldCo uses the loan to purchase OpCo’s shares off him for $1m.  OpCo pays the retained earnings to Hold Co as a tax free dividend.

 HoldCo repays the $1m loan to Mr A.

The above arrangement has allowed Mr A to receive the retained earnings tax free. The dividend strip provision deems the amount received by Mr A on sale of the shares in OpCo to be a taxable dividend. Inland Revenue released Revenue Alert 18/01 in January which sets out the Commissioners current view on dividend strips, and asserts that the provision can apply in a range of circumstances. Although the dividend strip provisions have been around for some time, the ‘tax avoidance’ landscape has changed in recent years and can arguably apply in wider circumstances than previously thought. For businesses seeking to restructure without gaining a tax advantage there is the option of inserting a holding company by way of ‘share for share’ exchange, which should ensure no dividend strip arises. Under a share for share exchange Mr A would swap shares in OpCo for shares in the HoldCo. No cash changes hands and there is no need for debt. Under the ‘share for share’ exchange provisions, the subscribed share capital in HoldCo mirrors that of OpCo, i.e. a neutral result. However, in practice, if OpCo had capital reserves there is a risk a share for share exchange converts these into taxable revenue reserves due to a disconnect with the ‘capital gain’ provisions in the tax act. Therefore, the share for share provisions can create a significant tax disadvantage. Given the dividend strip risk combined with what appears to be a flaw in the share for share provisions, in some cases it is simply not possible to implement commercial restructures. Given the current landscape, anyone considering a restructure of their business holdings needs to be extremely cautious of the dividend strip provisions, not only to avoid a tax avoidance challenge by IRD but also to avoid any adverse tax consequences caused by seeking to counter these provisions.