When a company is set up for an active business, it is usually referred to as an operating company. After our customers leave active business, the operating company is often sold, closed or converted into a holding company. A holding company is a corporation that does not engage in active business activity, but instead holds shares in another corporation or an investment portfolio. In some situations we may have a client opening a holding company as a standalone business.
Most of our professional and business clients that we serve are working shareholders in an operating company and a holding company. As a rule, only the holding company remains in retirement. Depending on the circumstances, the use of a holding company (HoldCo) can bring significant tax advantages. Below we’ve outlined some of the benefits of having a corporate structure and the limitations to consider.
Advantages of holding companies
As an entrepreneur, there are two main reasons for setting up a business: corporate structure and asset protection.
Many business owners can directly hold shares in their active corporate company (“OpCo”). Income from active business can be distributed to individual shareholders in the form of dividends. If the company’s after-tax profits are not needed to fund the personal expenses of individual shareholders, they can withhold those profits in the company and take advantage of the tax deferral option, as active company income is usually taxed more cheaply than the tax at the individual level on dividend income . We have written an article that provides more information on the taxation of active corporate income versus personal income: Businesses Help High Income Workers. The value of a chance to defer taxes can be substantial; Any dollar not lost to income tax can be invested and potentially grow over time.
As part of the corporate structure, a HoldCo can be introduced between the active trading company and individual shareholders. Individual shareholders would then own shares in Holdco and Holdco would own shares in OpCo. Excess funds that are not needed in the business can flow to the HoldCo in the form of dividends from the OpCo. If HoldCo owns shares in the capital of OpCo with more than ten percent of the “value” and voting rights, dividends can in principle flow tax-free between the two companies.
HoldCo can invest these dividends to accumulate profits with potential tax savings.
HoldCos can also exist in isolation without an underlying investment in a company that does an active business. This could be the case, for example, if a company has sold its business assets (rather than the company’s shares) and only has cash left for investments. If a corporation only generates passive income, the possibility of tax deferral is practically lost, since the tax rate on investment income within a corporation roughly corresponds to the tax rate that is paid by a natural person who earns the same income and pays a top tax rate. Aside from that, there may be other reasons to keep investments within a HoldCo, such as: For example, planning for US inheritance tax and tax planning to “clean up” a corporation before selling its shares so that the corporation is classified as a small business. Corporations and their shareholders can gain access to the Lifetime Capital Gains Exemption (LCGE).
Lifelong Capital Gains Exemption
For business customers, the LCGE is very attractive if they can sell the shares. The exemption from lifelong capital gains has increased over time; it is currently $ 892,218 in 2021. Couples who own a business can claim this exemption for a total of $ 1,784,436 each. For our clients looking to sell their active business within a few years, we will work closely with them and their tax advisor to ensure that any additional cash and passive income from the OpCo is transferred to a HoldCo.
There are three tests that must be met in order for a Company’s share to qualify as Qualified Small Busies Corporation (QSBC) share for eligibility for the LCGE:
1) The shareholder, his spouse or a related natural person must own the shares at least 24 months before the sale;
2) During the 24 months prior to the sale, the company must be a Canadian-Controlled Private Corporation (CCPC) and more than 50 percent of the fair market value of the assets has been used in an active business conducted primarily in Canada; and
3) All or substantially all (ie 90 percent or more) of the fair value of the company’s assets at the time of sale must be used primarily for active business in Canada.
US inheritance tax
Canada residents who own US situation property, such as US securities or real estate in the United States, may be subject to death tax based on the market value of those assets even if the Canadian resident is not a citizen or resident of the United States. If the total estate value of a Canadian resident is less than $ 11.7 million (2021), US inheritance tax should be effectively exempted, although there may still be an obligation to file a US inheritance tax return in the United States are.
For a Canadian resident who is not a US person, their US inheritance tax can be exempted by holding US situation property through a Canadian HoldCo since Canadian companies are not subject to inheritance tax and the individual owns shares in a Canadian company (HoldCo). . However, caution should be exercised when the Canadian corporation owns real estate for personal use. This may result in an issue of shareholder benefits which is a taxable benefit to the individual shareholder unless the shareholder pays the company a fair market value for the use of the asset. Therefore, it is important to consult a tax advisor to determine whether a HoldCo is suitable for U.S. inheritance tax planning.
Transfers from OpCo to HoldCo
The majority of the corporate accounts we manage are HoldCos compared to OpCos. Once an OpCo has excess funds that exceed the cash flow needs of the shareholders, it is often recommended that a Holdco be formed. If there are enough funds in Opco from active business, these are then transferred to HoldCo by means of a tax-free interim dividend. The main benefits focus on protecting and saving taxes over time. Transfers from OpCo to Holdco are relatively straightforward. Our corporate customers can simply transfer the money online, write a check or fill out a form that we use to debit the company account at the bank after verbal confirmation.
Types of investments
One of the points we discuss with our corporate clients is the best structure for investing within HoldCo to lower taxes. Other foreign income, interest income and foreign dividend income are all considered passive income. These forms of passive income are taxed higher and the exit tax is 50.67 percent (consisting of 38.67 percent federal plus 12 percent BC). A portion of the 50.67 percent tax on this passive income (foreign income, interest income and foreign dividend income) is credited to the refundable dividend tax (RDTOH) account.
Dividends from taxable Canadian corporations are subject to recoverable tax. This tax is added to the RDTOH account.
Capital gains are my favorite form of income within a company. The main reason for this is that when a stock has increased in value and you haven’t realized the gain, you have a grace period and no immediate tax. Even if an investment is sold and the capital gain “realized”, only half of the gain is taxed at the passive income rate and a portion of that tax is credited to the RDTOH account. The other 50 percent of capital gains are added to the Capital Dividend Account (CDA). We wrote an article on Tax Free Capital Dividends, which you can find here for more information: Understanding Tax Free Capital Dividends.
Kevin Greenard CPA CA FMA CFP CIM is Portfolio Manager and Director, Wealth Management at The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC. Call 250.389.2138, email email@example.com or visit greenardgroup.com/secondopinion