The 3:12 rules – taxation of active partners with qualified shares in closely held companies
Much of the work with which we, here at Advice, provide assistance concerns taxation issues for closely held companies and their partners.
A closely held company is a limited company or cooperative economic association, or corresponding foreign legal person, in which a maximum of four natural persons hold more than half of the votes. Family members are counted as one person in this respect. The companies usually have a limited ownership base in which all or many of the partners are active.
The special rules governing partners in closely held companies whereby dividends and capital gains can be taxed both as earned income and as capital are also referred to as the “3:12 rules” and apply solely to “qualified shares”.
The aim of the 3:12 rules is to ensure that the income that a partner receives from a company is distributed and taxed both as earned income and as returns on the capital invested in the company. The provisions are also designed to ensure that it is impossible to convert earned income, which attracts a high rate of taxation, to investment income, which attracts a lower rate.
Shares in closely held companies are either “qualified” or “unqualified”. A partner with a “qualified” shareholding is often referred to as an active partner. An “unqualified” shareholding means that the partner is passive in the company. Holdings of “qualified” shares are reported in tax returns using form K10, while holdings of “unqualified” shares are reported using form K12.
Shares in a company are “qualified” if the owner or a family member of the owner has been active in the company to a significant extent (see below) during the year in question or the previous five years. The shares may also be “qualified” if the work performed by the owner or their family member has been carried out within another company that engages in the same or similar operations (see below).
The term, “active to a significant extent”, refers to work carried out by the owner or an owner’s family member and which has had a significant effect on profit generation within the company. The work does not have to have been carried out on a full-time basis: rather, it must be viewed in relation to the company as a whole.
The CEO and senior executives are usually classified as members of this group of qualified active persons. Employees in non-executive positions can also be regarded as having been active to a significant extent if their work is of considerable significance in terms of the company’s profits, which may, for example, be the case in a firm of consultants.
The term, “companies engaged in the same or similar operations”, refers to cases where all or part of the operations in a closely held company have been transferred to another company and the operations of this latter company lie within the framework of the operations previously conducted.
The aim of this provision is to prevent circumvention of the rules by dividing up the operations into different companies or transferring the operations to a new company and then selling the first company. The provision is also designed to make it impossible to conduct similar operations during the so-called idle or withholding period. This refers to the five-year period that follows from the point when an active partner’s ceases to be active within a company until the point when this partner’s shares are regarded as “unqualified”.
The transfer of capital between separate companies usually gives rise to a so-called capital contagion whereby the companies are deemed to engage in the same or similar operations. The transfer of know-how and business contacts between companies with the same owner is also deemed to constitute engaging in the same or similar operations.
Dividends and capital gains on “qualified” shares in closely held companies are taxed either as investment income or as earned income. The percentage taxed in each category depends on the size of the threshold amount.
The threshold amount is calculated in accordance with either the simplification rule or the major rule. When the simplification rule is applied, the threshold limit is calculated annually on the basis of a standard amount, whereas when the major rule is applied, the amount is calculated on the basis of the cost amount for the shares in the company and a salary-based margin. The salary based margin comprises 50% of the total salary base which is calculated on the basis of salaries disbursed to employees of the company and its subsidiaries. The major rule may be used by partners who own at least 4% of the shares in the company (the equity share requirement) and who draw a given salary, known as the salary withdrawal requirement.
Dividends or capital gains below the threshold amount are taxed at 20%. If a dividend or capital gain exceeds the threshold amount, the excess portion is taxed as earned income (with certain exceptions for very large amounts, known as the ceiling rule or ceiling amount).
If the entire threshold amount is not utilised in a single year, the remaining margin is saved and can be utilised in subsequent years. The dividend margin saved is appreciated every year by a given percentage.
Under the so-called outsider rule, an active partner’s shares are not “qualified” if passive owners own a large part of a company.
The outsider rule constitutes an exception to the rules governing “qualified” shares and means that a share in a company in which outsiders own a significant share of the company and are entitled to receive dividends is only deemed to be “qualified” under special circumstances. The circumstances during the tax year and the five preceding tax years shall be taken into account.
The term, “significant share”, refers to circumstances where an outsider owns at least 30% of the shares in the company and is consequently entitled to at least 30% of the dividends.
In simple terms, a company is deemed to be owned by outsiders to the extent that these persons are not active in the company or other companies engaged in comparable operations, i.e. the term, outsider, refers to passive investors in the company.
What the rule means, in other words, is that shares in a company in which passive outsider owners own at least 30% of the shares are not normally classified as “qualified”, despite meeting other criteria for classification as such. The rule exists because it is not regarded as profitable to take dividends rather than a salary if the company needs to pay dividends to passive owners who are entitled to at least 30% of such payments. The outsider rule applies in connection with the taxation of both dividends and capital gains.