Corporate Stubs
Corporate Stubs refers to a class of contingent or residual interests in a company. They come into being because of a merger, acquisition, liquidation or reorganisation. They are also known as minority interests, certificate of beneficial interests, certificate of participation, certificate of contingent interest, receipts, scrips or liquidation certificates.
Corporate Stub Categories
All types of corporate stubs can be classified into the following three categories:-
- Fixed asset stub
- Participating asset stub
- Fluctuating asset stub
Fixed asset stub
It is a residual interest in an fixed asset, which carries a discount against a cash claim upon liquidation of the fixed asset.
Participating asset stub
It is an interest in an asset which provides an opportunity to gain if the asset price increases. Usually, there is a cap on the gain.
Fluctuating asset stub
It is an interest in a specific asset that has the potential to fluctuate in value.
Example of how an asset stub can be created
Let us suppose that we are a "Wheat Trading Company", trading in wheat. The current price of wheat is Rs. 20. Recently, the wheat prices increased to Rs. 30. This is good for us because we can now sell our stock at this higher price and earn a windfall profit. But the problem is that we will have to pay income tax on our profits (one level of taxation - let's say @ 30%) and finally when the profits are distributed, our shareholders then would be taxed too (second level of taxation - let's say it is based on their income slabs, maybe @ 30%). Is there a way we can avoid some of the taxes legally? The answer is: it depends on loop-holes available in the taxation laws. It is possible to exploit the loop-holes and reduce our tax burden legally. The following is one of the ways in which it can be done.
Let us further suppose that the tax law provides for liquiation of a part of the business without being taxed on its gain. This means that the proceeds from sale of shares would be considered as a return on capital employed and taxed at the capital gains tax rates, instead of the income tax rates. The capital gains tax usually tends to be lower than the income tax rates. If so, we can use this provision as follows to create an opportunity to move from income tax to capital gains tax.
We can create a subsidiary, sell a part of our wheat to that subsidiary and later liquidate that subsidiary. However, instead of a normal liquidation it can be arranged as follows: When we sell the wheat to our subsidiary, the parent company will have profits and it would be taxed at the prevailing income tax rates (say @ 30%).
The wheat that we sold to the subsidiary would, normally, be kept at a warehouse (godown). We can create securities from the warehouse receipts.
(This security is a corporate stub). These securities then can be sold in exchange for our company's common stock (instead of cash). That means, if someone has a stock of our company then he/she could exchange the stock in return for warehouse receipts (stubs). But why would someone be interested to do this exchange? Well! if we can structure the warehouse receipts in such a way that each warehouse receipt had more value than the current value of our shares then people would be interested for this exchange. For example, if our current stock price is Rs. 25, we may structure the value of the warehouse receipt to be Rs. 28. In this way, anyone who is willing to do the exchange will earn a profit of Rs. 3. It is not difficult to structure it this way because the value of the subsidiary is nothing but the value of the grain in the warehouse. Instead, the value of the company's stock depends on many other parameters.
But now the question is: what will anyone do with the warehouse receipts?. If there is a market for warehouse receipts then the warehouse receipts can be exchanged for cash. The profit earned by the shareholders in this method attracts capital gains instead of income tax, which allows shareholders to reduce their tax liability legally.
The above may seem to be a difficult task, but it would be worth the effort if promoters and major shareholders wants to gain from this opportunity and reduce their tax burden. The effort and cost involved in structuring this method would be insignificant compared to the possible gain that one can have from this structure.
Let's say we transferred 100,000 tonnes of grain to the subsidiary - 100,000 tonnes equals to 10 crore kgs of wheat. The current value of this would be Rs. 300 crores (@ Rs. 30 per kg). If a promotor had a stake of 55% in the parent company having total outstanding shares of 10 crore, whose share price is Rs. 25, he/she may sell 5% (50,00,000 shares) of his stake for the warehouse receipts. This would give a profit of 50,00,000 (28-25) = Rs. 1,50,00,000. A 10% tax saving on this would be Rs. 15,00,000/-. The cost of structuring this could be around Rs. 2 lakhs (company secretary charges, chartered accountant fees and security registration and filing expenses), thereby making a net profit of Rs. 13 Lakhs. Once the warehouse receipts are converted into cash, the promoter can use the proceeds to buy additional shares in the company to increase the stake to the original level of 55%.
For this method to work, the following conditions are essential;
- There should be a difference between the income tax rates and capital gains tax rates, particularly the short-term capital gains tax rates.
- There should be a ready market for warehouse receipts; and
- The law should allow for creation of corporate stubs.
The above is an example of a "Floating Asset Stub, as the price of wheat can fluctuate and lead to a loss in the strategy if wheat prices falls below Rs. 25, and more windfall profits if it continues to rise. To avoid losses and lock in the profits, we can short wheat on an exchange, which will ensure that our profits are locked but will also prevent us from participating in any profits if the what prices increase. This method has been used by Warren Buffet for exploting arbitrage opportunities.
END OF MY NOTES