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Do I Need a Holding Company?

12/12/2012


I speak more about this in The Globe and Mail article 'U.S. expats in Canada face new Obamacare health care tax'

This is a question clients who already own (or may be looking to buy) one or more operating companies, often ask their MNP tax professional. Unfortunately, like most things in life, there is no clear answer and it really depends on the client’s unique situation and, often, personal preference.

The benefits of using a holding company in conjunction with an operating company can be numerous and span everything from tax savings, to added creditor protection, to making a business more saleable. On the flip side, the disadvantages of having a holding company are for the most part limited to the added legal/accounting costs and complexity associated with incorporating and maintaining one.

In deciding on whether or not to incorporate a holding company into an existing corporate structure it basically comes down to whether or not the various benefits they offer (taking into account the client’s needs/objectives) outweigh the added costs and complexity of having them. A thorough understanding of the potential benefits is key to making this decision as there will be many instances where a holding company may be quite beneficial and many instances where they may offer minimal benefit.

Tax Deferral and Income Splitting Opportunities

One of the most significant advantages of a holding company is the potential tax savings they may ​offer in the form of tax deferral and income splitting opportunities where this can’t be accomplished within the operating company itself (i.e. where there may be multiple arm’s length shareholders of the operating company, for example).

To illustrate, profits from an active business earned inside an operating company are subject to a low corporate tax rate. These after corporate tax earnings can then be distributed to the shareholders in the form of dividends. If the dividends are received by an individual shareholder they are subject immediately to personal income taxes, albeit at a preferential rate (i.e. reduced by the corporate income tax already paid).

If, instead, the dividends are received by a holding company, and assuming certain tests are met (i.e. the holding company owns more than 10% of the voting and value shares of the operating company), the dividends will flow tax-free between the operating company and the holding company allowing the entire amount of the dividend to be reinvested on a pre-personal tax basis. In most cases, this will result in an additional 20% to 30% of capital available for reinvestment within the holding company, with the personal tax liability deferred until the funds are actually needed for personal use - possibly as far off as during retirement. The timing of the withdrawal of the funds from the holding company, again in the form of dividends, can be controlled by the individual shareholder and taken out years into the future on a gradual basis to benefit from both the tax deferral and potential tax savings if they (or other family member/shareholders) are in a lower tax bracket at that time.

More good news is that holding companies can invest in anything that an individual can, so you are not limited in your investment strategy. They can own real estate, securities, private investments, life insurance policies, etc. In addition, in most cases the annual investment income earned inside the holding company will be subject to a similar tax rate as you would pay personally so there is no significant disincentive to earning investment income inside a corporation.

As illustrated above, holding companies are quite beneficial where you have a number of shareholders owning one or more operating companies. Having operating company shares owned through holding companies allows each individual shareholder to decide whether they want to flow the dividends paid out of the operating company through the holding company and out to themselves (and possibly other family member/shareholders for income splitting purposes) or alternatively, whether they want to leave some or all of the operating company dividends in the holding company to be reinvested without immediately triggering the personal tax liability.

Holding companies in this case offer the flexibility for each of the individual shareholders of the operating company to independently decide on their draw down/reinvestment strategy. They also allow other family members to share in the operating company profits, perhaps by holding non-voting shares of the holding company. This way, there is no impact on the operation or control of the operating company, or any of its other shareholders.

Creditor Protection

Even in the case where the operating company shares may be owned by one shareholder or family unit, it may still be advisable to use a holding company, as opposed to the operating company, to accumulate and reinvest the excess earnings. One of the significant advantages in this case is creditor protection. By having the excess earnings from the operating company paid up as a tax-free inter-corporate dividend and reinvested in the holding company, these assets are out of the reach of potential creditors and liability claims arising within the operating company.

Purification and the $750,000 Lifetime Capital Gains Exemption

Having the excess cash and investments in the holding company as opposed to the operating company, will also keep the operating company “purified” such that at least 90% of its assets are used in an active business and its shares may therefore qualify for the $750,000 lifetime capital gains exemption. Since the capital gains exemption is only available to individuals and not holding companies, proper structuring of the shareholdings of the operating company is essential to allow for this ongoing purification on a tax-deferred basis using the holding company, while still providing the individual shareholders potential access to the capital gains exemption on a sale of the operating company shares. In many cases, family trusts may be utilized in the corporate structure to facilitate this.

Making the Business More Saleable

Keeping excess cash and investments out of the operating company is beneficial on a number of fronts as mentioned above, and in many cases it may also be advantageous to hold the real estate used in the business in a separate holding company. Aside from the creditor protection this provides from the operating company’s activities, it may also make the shares of the operating company more saleable where the potential purchasers are only interested in acquiring the true business assets and are fine with leasing the premises. This limits the capital required to purchase the business, which is often significant when selling to key employees or family members who may have limited borrowing capacity. Oftentimes, the buyers will secure the operating company shares and lease the premises with an option to purchase after say, five years, once they are in a better financial position. If the buyer does want the operating company and the real estate initially, that is easy to facilitate and often takes the form of a share purchase of the operating company and an asset purchase of the real estate.

It should be noted that moving excess cash, investments and real estate out of an operating company just prior to the sale of its shares can be done, however when done in contemplation of the sale of the shares of the operating company complicated tax rules will likely result in some or all of this “purification” occurring on a taxable basis.

Acquisition and Divestiture Planning

Holding companies also play a key role in business acquisitions and divestitures. They are often used as a vehicle to acquire shares of an operating company, followed by an amalgamation with that target company in order to allow the interest expense on the purchase loan to be offset against the operating profits going forward. On the purchase of a portion of the shares of an operating company (i.e. key employee buy-in) holding companies are also beneficial as they allow the employee to pay off the original share purchase loan with operating company profits/dividends that have not been subject to personal income tax. Structuring of this type of partial buy-in is delicate, to ensure that the interest expense is offset against taxable income as opposed to tax-free inter-corporate dividends, which could nullify the immediate tax benefit.

At the other end of the spectrum, holding companies are often used to defer income taxes on the sale of the shares of an operating company by taking advantage of the previously taxed corporate surplus and/or stripping out the redundant assets prior to the sale. This may be in lieu of, or in addition to, taking advantage of the $750,000 lifetime capital gains exemption.

Closing Comments

As you can see, considering the use of a holding company is a complicated area that offers significant potential benefits and few drawbacks, but requires careful planning to be positioned and used effectively. To see if they may be beneficial in your situation, talk to your local MNP tax professional.