Delaware Investment Holding Companies

Scott E. Waxman

Introduction

Under Delaware law, a corporation whose activities in Delaware are limited to the maintenance and management of intangible investments and the collection and distribution of income from such investments or from tangible property physically located outside of Delaware, is exempt from the Delaware corporate income tax.  For corporations with intangible assets currently taxed by other states, this could represent a significant tax saving opportunity.  Furthermore, because intangible investments include investments in stocks, bonds, notes, other debt obligations, trademarks and trade names, thousands of Delaware corporations have been formed to capitalize on the benefits of the so-called Delaware Investment Holding Company ("DIHC").  This summary will discuss the formation, operation and advantages of the DIHC.  ( Click here to read a general article about Delaware corporations).

Example

The following example clearly illustrates the benefit of a DIHC.  If Corporation X has $1,000,000 of income from interest bearing securities, dividends, intercompany receivables and royalties, and its domiciliary state taxes this income at the rate of 10%, X would pay state income taxes of $100,000 on this income.  If X formed a DIHC and transferred these intangible assets to it, the new DIHC would owe no Delaware corporate income taxes, and if X files a consolidated Federal tax return, this income is offset by the same amount of expense with no net effect.  Moreover, if the DIHC received gains on the sale of its intangible assets,such gains would be exempt from Delaware corporate income taxes.

Formation of a Delaware Investment Holding Company

The costs associated with incorporating in Delaware are nominal.  However, in setting up a DIHC it is important to adopt the proper form.  Failure to adopt the proper form could result in a situation where the DIHC might not be recognized by a parent or holding company's state of origin for tax purposes.  Thus, in order to minimize this possibility, the incorporate or of a DIHC should establish an independent corporation having sufficient contacts with the State of Delaware to substantiate the substantive existence of a separate legal entity based in Delaware.

In the way of requirements under the Delaware General Corporation Law (Title 8, Delaware Code), all corporations are required to have a registered agent as well as a registered office in Delaware.  As far as other non-statutory steps that may be taken, the following list includes recommended steps to help establish a sufficient presence in Delaware that would likely be cognizable in most other states as a separate legal entity:

  1. The DIHC should own or lease office space and/or equipment in Delaware;
  2. The DIHC should have and use a Delaware address;
  3. The DIHC should have all of its contracts become effective in Delaware;
  4. The DIHC should have officers and employees (and, ideally, directors) who reside in Delaware;
  5. The DIHC should pay Delaware payroll taxes;
  6. The DIHC should maintain a checking account in a Delaware bank;
  7. The DIHCs directors should hold a meeting in Delaware at least once a year;
  8. Custody of the DIHCs assets should be within Delaware (generally accomplished by using the trust department of a Delaware bank);
  9. The income from the DIHC's assets should be deposited into its Delaware account; and
  10. The DIHC's corporate and financial records should be maintained in delaware and copies of its material contracts should be kept in Delaware.

Utilizing The DIHC's Cash and Other Assets

If the DIHC was formed as a subsidiary, the DIHC can distribute cash to its parent by declaring and paying a dividend.  Alternatively, the DIHC could lend funds to its parent at prevailing market rates.  Moreover, the DIHC could be used to finance the operations of affiliated companies.  The money loaned by the DIHC to its parent or affiliates could either be raised by liquidating some of the DIHC's intangible assets or by borrowing from third parties.  The interest paid to the DIHC by the parent and/or affiliates creates a tax benefit in that the interest income to the DIHC is not taxable in Delaware, while the interest paid by the parent and/or affiliates is generally a deductible expense for the payor.

Sale of Subsidiary

DIHC's may also be used in some cases to shelter gains arising on the sale of a foreign or domestic subsidiary from state taxation.  This can be accomplished by placing the stock of the existing subsidiary in a DIHC prior to its sale.  The gain on the sale of the subsidiary will be exempt from Delaware corporate income taxes.  To minimize the risk of the sale being subject to tax in the parent's domiciliary state, the stock should be held for a period and not be sold shortly after it is transferred to the DIHC.

Royalty and Other Income

DIHC's are particularly advantageous for corporations with intangible assets such as patents, trade names, copyrights, franchises and secret formulas.  In most cases a parent corporation can successfully shift taxable income from another state to income exempt from corporate income taxes in Delaware, by exchanging its intangible assets for all of the DIHC's stock.  Thereafter, the DIHC may contract with other parties to use the intangible assets in exchange for the payment of royalties.  As long as the DIHC's activities are limited to the maintenance and management of its intangible assets, the royalty income received will be exempt from Delaware corporate income taxes.

Conclusion

With state budgetary shortfalls, the revenue departments of many states are becoming more aggressive in an effort to increase revenues, and vehicles such as DIHCs may receive increased scrutiny.  However, if properly structured, a DIHC can be used to avoid state taxation by Delaware and most other jurisdictions.  This opportunity to shift taxable income in other states to exempt income in Delaware should not be overlooked as a tax saving vehicle.