When a corporation is set up for an active business, it is typically referred to as an operating company. Once our clients have retired from the active business, the operating company is often sold, closed, or converted to a holding company. A holding company is a corporation that has no active business operations but instead holds shares of another corporation or a portfolio of investments. In some situations, we may have a client that opens a holding company as a stand-alone company.
Most of our professional and business clients we assist are shareholders of both an operating company and a holding company while they are working. When they are retired, all that is normally left is the holding company. Depending on the circumstances, there can be substantial tax benefits in using a holding company (HoldCo). Below we have outlined some of the benefits of a corporate structure, as well as the limitations to consider.
Benefits of holding companies
As a business owner, there are a couple of main reasons for incorporation: corporate structure and asset protection.
Many business owners may hold shares of their active business corporation (“OpCo”) directly. Income earned from the active business can be distributed to the individual shareholders in the form of dividends. If the after-tax corporate earnings are not needed to fund the individual shareholders’ personal expenses, they may choose to retain these earnings in the company and take advantage of the tax-deferral opportunity as the active business income is generally taxed at a more favourable rate than the tax at an individual level on dividend income.
We have written an article that includes further information on the taxation of active business income, compared to personal income. The value of an opportunity to defer tax can be significant; each dollar that is not lost to income tax can be invested and potentially grow over time.
As part of the corporate structure, a HoldCo may be introduced in-between the active business corporation and individual shareholders. Individual shareholders would then own shares of the HoldCo, and the Holdco would own shares of the OpCo. Excess funds that are not needed in the business can flow to HoldCo in the form of dividends from the OpCo. If the HoldCo owns shares in the capital of the OpCo with more than ten per cent of “value” and voting rights, dividends can generally flow tax-free between the two corporations.
The HoldCo can invest these dividends to accumulate earnings with potential tax savings.
HoldCos may also exist in isolation, without an underlying investment in a corporation operating an active business.
For example, this could be the case where a corporation has sold its business assets (and not the shares of the company) and is left with cash to invest. Where a corporation earns only passive income, the opportunity to defer tax is all but lost, since the tax rate on investment income within a corporation is roughly equal to the rate paid by an individual earning the same income and paying tax at a top marginal rate.
That being said, there may be other reasons to keep investments within a HoldCo, such as planning for US estate tax and tax planning to “purify” a corporation prior to the sale of the shares, such that the corporation would qualify as a small business corporation and it’s shareholders can gain access to the lifetime capital gain exemption (LCGE).
Lifetime Capital Gains Exemption
The LCGE is very attractive for business clients if they are able to sell the shares of the business. The lifetime capital gains exemption has been increasing over time; currently it is $892,218 for 2021. For couples that own a business, this exemption can each be claimed for a total of $1,784,436. For our clients that are within a few years of wanting to sell their active corporation we will work closely with them, and their tax professional, to ensure all the extra cash and passive income is moved out of the OpCo and into a HoldCo.
There are three tests that must be met for a share of a corporation to be considered Qualified Small Busies Corporation (QSBC) share for claiming the LCGE:
1) Shareholder, their spouse, or a related individual must own the shares at least 24 months prior to the sale;
2) Throughout the 24 months prior to sale, the corporation must be a Canadian-Controlled Private Corporation (CCPC) and more than 50 per cent of the fair market value of assets were used in an active business carried on primarily in Canada; and
3) All, or substantially all (i.e. 90 per cent or more), of the corporation’s fair market value of assets must be used mainly in active business in Canada at the time of the sale.
U.S. Estate Tax
Canadian resident individuals who own U.S. “situs” property, such as U.S. securities or real property situated in the United States may be subject to a tax upon death based on the fair market value of those assets, even if the Canadian resident is not a citizen or domiciliary of the United States. Where the total value of the Canadian resident individual’s estate is less than $11.7 million (2021), the U.S. estate tax should be effectively exempted, although there may still be an obligation to file a U.S. Estate Tax Return in the United States.
For a Canadian resident who is not a US person, their U.S. estate tax may be exempted by holding US situs property through a Canadian HoldCo, since Canadian corporations are not subject to the estate tax and the individual owns shares of a Canadian company (HoldCo). However, one needs to be cautious when the Canadian corporation holds personally used properties.
This may lead to a shareholder benefit issue, which is a taxable benefit to the individual shareholder, unless the shareholder pays fair market value for the usage of the asset to the corporation. Hence, it is important to consult a tax professional to determine if a HoldCo for US estate tax planning is appropriate.
Transfers from OpCo to HoldCo
The majority of the corporate accounts that we manage are HoldCo’s versus OpCo’s. Once an OpCo has excess funds beyond what the shareholders’ cash flow needs are, it is often advised to set up a Holdco. When sufficient funds accumulate in the Opco from the active business, they are then subsequently transferred to the HoldCo through a tax-free intercompany dividend. The main benefits are focused on protection and saving taxes over time. Transfers from OpCo to Holdco are relatively straight forward. Our corporate clients can simply transfer the funds online, write a cheque, or fill out a form that enables us to debit the corporate account at the bank once confirmed verbally.
Types of Investments
One of the items we discuss with our corporate clients is the best structure for investments within the HoldCo to reduce taxes. Other foreign income, interest income, and foreign dividend income are all considered passive income. These forms of passive income have a higher level of tax and the initial tax is at 50.67 per cent (comprised of the federal 38.67 per cent plus 12 per cent B.C.). A portion of the 50.67 per cent tax from these forms of passive income (foreign income, interest income and foreign dividend income) is added to the Refundable Dividend Tax On Hand (RDTOH) account.
Dividends from taxable Canadian corporations are subject to a refundable tax. This tax is added to the RDTOH account.
Capital gains is my favourite form of income within a corporation. The main reason for this is that if a stock has increased in value, and you have not realized the gain, then you have deferral and no immediate tax. Even when an investment is sold and the capital gain is “realized,” only half of the gain is taxed at the passive income rate, and a portion of that tax is added to the RDTOH account.
The other 50 per cent of the capital gain is added to the capital dividend account (CDA). We have written an article on tax-free capital dividends, which can be found here for more information: Understanding tax-free capital dividends.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email email@example.com or visit greenardgroup.com/secondopinion.