Why you MUST have an Holding Company (a.k.a. HoldCo)

Today, I would like to share an excellent article written by Tim Cesnick, clearly explaining the advantages of Holding Companies.  At HazloLaw, we advise clients on a daily basis about the necessity of putting in place this type of structure and we also suggest to add a Family Trust to your current structure.  Read our related blog on Family Trust.

HOLDING COMPANY 
This summer when you're standing around the barbecue with your business-owner neighbours, impress them with your knowledge of tax planning.

I can tell you from experience that you'll bore them to tears with the conversation, but they'll thank you later when the tax savings start rolling in. Specifically, share with them that holding companies can help them to defer tax. Here are the highlights.

THE RULES

If you happen to own a corporation that carries on an active business, give some thought to setting up your affairs to allow for a deferral of tax.

How? By establishing a holding company to own the shares of your active business corporation (ABC).

You see, if you own the shares of your ABC directly, then any payment of dividends from that corporation to you will be taxable in your hands personally in the year you receive those dividends.

If, on the other hand, you have a personal holding company that owns your shares in your ABC, you can pay a dividend to your holding company that will, in most cases, be tax free to your holding company.

It's subsection 112(1) of our tax law that allows, in most cases, your holding company to claim a deduction for taxable dividends received from your ABC. And, as long as your holding company and ABC are "connected" under our tax law (which will be the case in the vast majority of situations), you'll avoid another tax called the Part Four tax.

By passing some of those earnings from your ABC to your holding company, you'll defer tax, which is essentially the difference between the tax paid by your ABC on its profits, and the amount of tax you would have paid had the profits been paid out immediately to you as a bonus.

The tax deferred is approximately 30 per cent of the taxable income in most provinces for someone in the highest tax bracket.

THE STRATEGIES

What strategies should you be thinking about?

Multiple shareholders: If you're one of multiple shareholders in your ABC, setting up a personal holding company for each shareholder can provide flexibility to each of you.

Think of each holding company as a tap to control the payment of dividends to each of you personally.

Your ABC can pay dividends to each of the holding companies on a tax-free basis, and then each holding company can pay dividends to its shareholders based on his or her personal cash requirements.

Splitting income: Your holding company can be owned by more than one person in the family.

Your spouse, for example, could own some shares. This will allow you to sprinkle dividends to your spouse or others in the family so that the tax burden on those dividends can be shared.

It's not always advisable to issue shares in the holding company directly to your children (and if they're minors, this isn't possible), and so a family trust can be utilized, which brings me to the next strategy.

Establish a trust: I really like this structure. The shares of your ABC can be held by a family trust.

The beneficiaries of the trust will include you, your spouse, your children (regardless of their age), and your holding company.

Now, any dividends paid by your ABC to the trust can be distributed out to your holding company as a beneficiary of the trust, and you'll achieve the same tax-free payment to the holding company as you would achieve if the holding company owned the shares in the ABC directly, provided the two companies are "connected."

The advantages, however, include: The ability to sprinkle dividends to family members or the holding company as beneficiaries of the trust, at your discretion; the ability to multiply the lifetime capital gains exemption on a sale of the shares of your ABC (assuming the shares qualify for the exemption); creditor protection over the property of the trust, including the shares of the ABC, among other benefits.

Protection from creditors: Any excess profits of your ABC can be paid to your holding company as dividends, and can be lent back to your operating business on a secured basis, if the cash is needed for the business. This will protect those excess profits from other creditors of the business.

Retirement nest egg: The accumulation of assets inside your holding company can become the type of retirement nest egg or "pension" that you will need to look after yourself during retirement

For more information on the above, call/email our Founder & CEO + Business Lawyer, Hugues Boisvert at hboisvert@hazlolaw.com or +1.613.747.2459 x 304

Business Owners: Why do you need a Holding Company (Holdco)??

Here is a great article written by Rolland Vaive, CA, TEP, CPA - an excellent accountant based in Ottawa and specializing in complicated tax matters.
_______________________________________________________

Speak to any tax accountant for more than a minute and they'll surely be talking about holding companies, or HoldCo's for short.

A holding company is not a term which is defined in the Income Tax Act. It is a term which is used to define a corporation which holds assets, most often income generating investment assets. It does not typically carry on any active business operations.

A HoldCo can arise for a variety of reasons. In the early 1990's, the personal marginal tax rate in Ontario was slightly higher than 53%, while the corporate rate of tax was considerably lower than that. High income individuals who had significant investment assets could realize a tax deferral by transferring their investment assets to a HoldCo, particularly in situations where they did not need the income which was being generated by the investments. This breakdown between the corporate rate of tax and the personal rate of tax lead to many HoldCo's being formed.

HoldCo's may also come about as an effective means of creditor proofing profitable operating companies, as a result of Canadian estate planning, or as a means of avoiding U.S. estate tax and Ontario probate fees.

Regardless of their origins, the investment income generating HoldCo is taxed in an unusual manner, which I will attempt to explain.

The underlying concept of HoldCo taxation is called "integration". In general terms, integration means that an individual should pay the same amount of tax on investment income if they earned it personally or if they earned it through a corporation and withdrew the after-tax income in the form of dividends. When we look at some real numbers, you will see that this in fact generally holds true. However, it is possible to exploit some breakdowns in integration, at which time it may become quite beneficial to earn your investment income through a HoldCo.

Let's look at the theory. We often hear about how corporations are taxed at low tax rates. In situations where a private company is earning income from active business operations carried on in Canada, that is quite true. In these situations, the rate of tax would be a flat tax rate of 18.620% if the company was resident in Ontario. The other provinces have similarly low rates of tax on "active business income". The low rate of tax does not apply to investment income, which is what the HoldCo would be generating.

For an Ontario resident private company generating investment income, the combined Federal and Provincial rate of tax would be a flat 49.7867% on all forms of investment income, other than dividends from other Canadian corporations. Bear in mind that only 1/2 of capital gains are included in income, so the effective corporate rate of tax on capital gains would be 24.8934%.

A portion of the tax that HoldCo pays each year on its' investment income goes into a notional pool called the RDTOH pool. This is an acronym for "refundable dividend tax on hand". Of the 49% rate of tax that is paid by the corporation, 26.67% will go into the RDTOH pool each year and is tracked on the corporation's Federal tax return. If HoldCo pays a taxable dividend to its' shareholders in a particular year, it gets back part of its RDTOH pool. More specifically, the company will get back $1 for every $3 of dividends that it pays. This RDTOH recovery is called a dividend refund, and would be a direct reduction of the corporation's tax liability for the year. If the corporation pays a large dividend to a shareholder, the dividend refund would also be large and may result in the company actually getting money back from the Canada Revenue Agency. In short, the HoldCo will pay a large tax liability on its investment income up front, but it can get a large portion of it back at a later date if it pays out dividends. The dividend refund is an attempt to compensate for the fact that the dividend will attract tax in the hands of the shareholder. Without this mechanism, the 48% rate of tax on investment income combined with the tax paid by the shareholder on the dividend that they receive would result in an onerous rate of tax.

It is possible that a second notional tax pool may arise in HoldCo if it is generating capital gains on its' investment assets. You will recall that only 1/2 of capital gains are included in income. The other 1/2 portion of the capital gain which is not included in income will get added to the capital dividend account, or "CDA", of HoldCo. The CDA balance is something which needs to get tracked by the company on a regular basis, since it does not appear anywhere on the company's financial statements or tax returns. The CDA is important because it is possible for HoldCo to pay a dividend to a shareholder and elect to pay it out of the CDA balance, making the dividend tax-free to the shareholder. If a company realizes a capital gain of $10,000 , only $5,000 will be included in taxable income, with the remaining $5,000 being added to the company's CDA balance. The company could then pay a $5,000 dividend to the shareholder. By electing to do so out of the CDA balance, the shareholder would not be taxed on the dividend.

Lets look at this in conjunction with the RDTOH balance. If the company pas a dividend to a shareholder out of the CDA balance, it is tax free to the shareholder, but it is not going to generate a dividend refund to HoldCo. HoldCo only gets a dividend refund if the dividend is a taxable dividend to the shareholder.

Armed with this theory, we can look at a live example of how this would work. Lets consider the example of an Ontario resident individual who is holding shares that have an adjusted cost base (i.e. tax cost) of $1,000. These shares have experienced a dramatic increase in value, and are now worth $100,000. The individual is going to sell these shares and would like to know if there is any advantage to doing so through a HoldCo. The individual is in the highest marginal tax rate (currently 31.310 % on Canadian source dividends and 46.410 % on everything else). The individual wants the after tax money, so they would withdraw everything from the HoldCo once the shares are sold. If they were to go the HoldCo route, they would elect to transfer their shares to HoldCo at their $1,000 tax cost prior to the sale (to transfer them at fair market value would defeat the purpose), and would have the capital gain realized within HoldCo. In the process of transferring the shares to HoldCo, they could arrange to have HoldCo issue a note payable to them equal to their original $1,000 tax cost.

Integration tells us that selling the shares through a HoldCo should give us the same result as selling the shares personally. If the individual wants to get the money out of the HoldCo following the sale of the shares, they would elect to take part of the proceeds from the share sale out of HoldCo as a non-taxable repayment of their $1,000 note and as a non-taxable payment our of the CDA balance. The remaining cash would be withdrawn from the company as a taxable dividend, leading to a dividend refund in HoldCo.

As this example illustrates, there is no advantage to using the HoldCo to sell the shares even without considering the professional fees associated with the HoldCo. So why do it?

Well, there may be some good reasons for doing it. Firstly, the example assumes that the individual withdraws all of the cash from HoldCo in the year of the share sale, and at a time when they are in the highest marginal tax rate. If the cash from the sale was left in the corporation and withdrawn as a dividend a year or two later when the individual was not in the highest marginal tax rate, then the results may be quite good. The HoldCo would get the dividend refund at a rate of $1 for every $3 of dividends in that later year when the dividend is paid, and the shareholder may not incur a significant tax liability on the dividend that he or she receives.

Alternatively, it may be possible to transfer the shares to HoldCo well before a sale is to happen. In this way, future growth in the value of the shares could be shifted to other family members. When the shares are sold, the growth in value since the time of the transfer could be paid as a dividend to these other family members. If these family members are in a low marginal tax rate, they would not incur much tax on the dividend, and the results could be quite good when compared to the alternative where the shares continue to be held by the individual and sold by him or her personally.

There are a host of issues to be considered before embarking on such an exercise, including the corporate attribution rules and the tax on split income to name but a few.

As always, seek professional advice before undertaking any steps.

Business Owners: Why you MUST have a Holding Company (Holdco)

Today, I would like to share an excellent article written by Tim Cesnick, clearly explaining the advantages of Holding Companies.  At HazloLaw, we advise clients on a daily basis about the necessity of putting in place this type of structure and we also suggest to add a Family Trust to your current structure.  Please email us at info@hazlolaw.com is you have any questions.
HOLDING COMPANY
This summer when you're standing around the barbecue with your business-owner neighbours, impress them with your knowledge of tax planning.

I can tell you from experience that you'll bore them to tears with the conversation, but they'll thank you later when the tax savings start rolling in. Specifically, share with them that holding companies can help them to defer tax. Here are the highlights.

THE RULES

If you happen to own a corporation that carries on an active business, give some thought to setting up your affairs to allow for a deferral of tax.

How? By establishing a holding company to own the shares of your active business corporation (ABC).

You see, if you own the shares of your ABC directly, then any payment of dividends from that corporation to you will be taxable in your hands personally in the year you receive those dividends.

If, on the other hand, you have a personal holding company that owns your shares in your ABC, you can pay a dividend to your holding company that will, in most cases, be tax free to your holding company.

It's subsection 112(1) of our tax law that allows, in most cases, your holding company to claim a deduction for taxable dividends received from your ABC. And, as long as your holding company and ABC are "connected" under our tax law (which will be the case in the vast majority of situations), you'll avoid another tax called the Part Four tax.

By passing some of those earnings from your ABC to your holding company, you'll defer tax, which is essentially the difference between the tax paid by your ABC on its profits, and the amount of tax you would have paid had the profits been paid out immediately to you as a bonus.

The tax deferred is approximately 30 per cent of the taxable income in most provinces for someone in the highest tax bracket.

THE STRATEGIES

What strategies should you be thinking about?

Multiple shareholders: If you're one of multiple shareholders in your ABC, setting up a personal holding company for each shareholder can provide flexibility to each of you.

Think of each holding company as a tap to control the payment of dividends to each of you personally.

Your ABC can pay dividends to each of the holding companies on a tax-free basis, and then each holding company can pay dividends to its shareholders based on his or her personal cash requirements.

Splitting income: Your holding company can be owned by more than one person in the family.

Your spouse, for example, could own some shares. This will allow you to sprinkle dividends to your spouse or others in the family so that the tax burden on those dividends can be shared.

It's not always advisable to issue shares in the holding company directly to your children (and if they're minors, this isn't possible), and so a family trust can be utilized, which brings me to the next strategy.

Establish a trust: I really like this structure. The shares of your ABC can be held by a family trust.

The beneficiaries of the trust will include you, your spouse, your children (regardless of their age), and your holding company.

Now, any dividends paid by your ABC to the trust can be distributed out to your holding company as a beneficiary of the trust, and you'll achieve the same tax-free payment to the holding company as you would achieve if the holding company owned the shares in the ABC directly, provided the two companies are "connected."

The advantages, however, include: The ability to sprinkle dividends to family members or the holding company as beneficiaries of the trust, at your discretion; the ability to multiply the lifetime capital gains exemption on a sale of the shares of your ABC (assuming the shares qualify for the exemption); creditor protection over the property of the trust, including the shares of the ABC, among other benefits.

Protection from creditors: Any excess profits of your ABC can be paid to your holding company as dividends, and can be lent back to your operating business on a secured basis, if the cash is needed for the business. This will protect those excess profits from other creditors of the business.

Retirement nest egg: The accumulation of assets inside your holding company can become the type of retirement nest egg or "pension" that you will need to look after yourself during retirement.

Business Owners: The cold hard logic behind freezing your assets or Estate Freeze 101

The cold hard logic behind freezing your assets - written by Tim Cesnick and published in the Globe and Mail.

Paul is a close friend of mine. We don’t see each other often enough, but we got together for lunch this week. “Tim, I’m freezing my assets,” Paul said. For a minute, I was wondering if Paul was making a commentary on the sub-zero temperatures we’ve been experiencing. But that wasn’t it. Paul was actually freezing his assets. And I’m not talking about the fact that he left his lawn furniture and lawn mower out in the backyard this year to face the elements rather than putting those things away for the winter (he says he got busy and forgot).

 

No. Paul has decided to implement a tax manoeuvre called an “estate freeze.” Although it’s possible to “freeze” most assets, this is most commonly done by those who own shares in a private company and want to accomplish a few things. Let me explain.

The concept
Completing an estate freeze involves identifying certain assets – perhaps private company shares – and freezing those assets at their current value. When this is done, the future growth in value of those assets won’t accrue to you (the person completing the freeze), but will belong to others who you have chosen to receive that future growth. There are a number of benefits to this idea, but most notably you’ll pass the tax bill on that future growth to others. That is, you will have “capped” your tax liability on the assets frozen at today’s value.

The example

Paul owns the shares of a corporation that holds rental properties that he’s been accumulating over the years. The value of these properties is about $5-million today (net of any mortgages). He expects these properties to continue to grow in value in the future. Paul doesn’t need the income from these properties to support his lifestyle.

When Paul passes away, there’s going to be a tax bill owing on the shares of his corporation. After all, the shares are worth $5-million today (since the properties owned by the corporation are worth $5-million), but his adjusted cost base of his shares is nominal, at $100. In this case, Paul will owe about $1,160,227 in taxes upon death (he lives in Ontario and is in the highest tax bracket).
As the value of the properties grows, so will Paul’s expected tax bill on death. Paul decided to cap this tax liability by completing an estate freeze. How? Paul is going to exchange his common shares that he owns in his corporation for new preferred shares that are fixed, or frozen, in value (this exchange can take place without tax at the time of the exchange). These shares won’t appreciate in value as the properties grow in the future. Paul is going to issue new common shares in the corporation to his children. The future growth of the company will accrue to these common shares.
In actual fact, Paul isn’t going to issue the new common shares to his kids directly (although he could), but has decided to issue those shares to a family trust of which the kids are beneficiaries. This will allow Paul to continue to control those shares (as trustee of the trust) for the time being. He can distribute those shares out of the trust to the kids in the future if he chooses (this distribution can generally be done on a tax-free basis). But there are real benefits to having the trust in place to hold the shares today, including the ability to split income with the beneficiaries of the trust.

The nuances

Now, there’s more than one way to accomplish an estate freeze. Exchanging shares in an existing corporation for new frozen shares, as Paul is planning, is one method. It’s also possible in most cases to take assets that are currently outside of a corporation and transfer those assets to a corporation and take back, in exchange, shares in the corporation that are frozen in value. It may also be possible to place assets directly in a trust (without use of a corporation) so that the future growth will accrue to the beneficiaries, but this method may trigger a tax bill when transferring the assets to the trust if those assets have appreciated in value (in which case a corporation is likely the better route).
Freezing your assets won’t eliminate the tax bill that has accrued to date on those assets, but will stop the bleeding by passing the future growth to others who will likely pay the tax on that growth at a much later date than you. More on this topic next week.

Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.

Holding Company (Holdco): What Is It and How Does it Work?

Below is a great article written by Rolland Vaive, CA, TEP, CPA www.taxadvice.ca - An excellent accountant based in Ottawa and specializing in complicated tax matters.

______________

Speak to any tax accountant for more than a minute and they'll surely be talking about holding companies, or HoldCo's for short.

A holding company is not a term which is defined in the Income Tax Act. It is a term which is used to define a corporation which holds assets, most often income generating investment assets. It does not typically carry on any active business operations.

A HoldCo can arise for a variety of reasons. In the early 1990's, the personal marginal tax rate in Ontario was slightly higher than 53%, while the corporate rate of tax was considerably lower than that. High income individuals who had significant investment assets could realize a tax deferral by transferring their investment assets to a HoldCo, particularly in situations where they did not need the income which was being generated by the investments. This breakdown between the corporate rate of tax and the personal rate of tax lead to many HoldCo's being formed.

HoldCo's may also come about as an effective means of creditor proofing profitable operating companies, as a result of Canadian estate planning, or as a means of avoiding U.S. estate tax and Ontario probate fees.

Regardless of their origins, the investment income generating HoldCo is taxed in an unusual manner, which I will attempt to explain.

The underlying concept of HoldCo taxation is called "integration". In general terms, integration means that an individual should pay the same amount of tax on investment income if they earned it personally or if they earned it through a corporation and withdrew the after-tax income in the form of dividends. When we look at some real numbers, you will see that this in fact generally holds true. However, it is possible to exploit some breakdowns in integration, at which time it may become quite beneficial to earn your investment income through a HoldCo.

Let's look at the theory. We often hear about how corporations are taxed at low tax rates. In situations where a private company is earning income from active business operations carried on in Canada, that is quite true. In these situations, the rate of tax would be a flat tax rate of 18.620% if the company was resident in Ontario. The other provinces have similarly low rates of tax on "active business income". The low rate of tax does not apply to investment income, which is what the HoldCo would be generating.

For an Ontario resident private company generating investment income, the combined Federal and Provincial rate of tax would be a flat 49.7867% on all forms of investment income, other than dividends from other Canadian corporations. Bear in mind that only 1/2 of capital gains are included in income, so the effective corporate rate of tax on capital gains would be 24.8934%.

A portion of the tax that HoldCo pays each year on its' investment income goes into a notional pool called the RDTOH pool. This is an acronym for "refundable dividend tax on hand". Of the 49% rate of tax that is paid by the corporation, 26.67% will go into the RDTOH pool each year and is tracked on the corporation's Federal tax return. If HoldCo pays a taxable dividend to its' shareholders in a particular year, it gets back part of its RDTOH pool. More specifically, the company will get back $1 for every $3 of dividends that it pays. This RDTOH recovery is called a dividend refund, and would be a direct reduction of the corporation's tax liability for the year. If the corporation pays a large dividend to a shareholder, the dividend refund would also be large and may result in the company actually getting money back from the Canada Revenue Agency. In short, the HoldCo will pay a large tax liability on its investment income up front, but it can get a large portion of it back at a later date if it pays out dividends. The dividend refund is an attempt to compensate for the fact that the dividend will attract tax in the hands of the shareholder. Without this mechanism, the 48% rate of tax on investment income combined with the tax paid by the shareholder on the dividend that they receive would result in an onerous rate of tax.

It is possible that a second notional tax pool may arise in HoldCo if it is generating capital gains on its' investment assets. You will recall that only 1/2 of capital gains are included in income. The other 1/2 portion of the capital gain which is not included in income will get added to the capital dividend account, or "CDA", of HoldCo. The CDA balance is something which needs to get tracked by the company on a regular basis, since it does not appear anywhere on the company's financial statements or tax returns. The CDA is important because it is possible for HoldCo to pay a dividend to a shareholder and elect to pay it out of the CDA balance, making the dividend tax-free to the shareholder. If a company realizes a capital gain of $10,000 , only $5,000 will be included in taxable income, with the remaining $5,000 being added to the company's CDA balance. The company could then pay a $5,000 dividend to the shareholder. By electing to do so out of the CDA balance, the shareholder would not be taxed on the dividend.

Lets look at this in conjunction with the RDTOH balance. If the company pas a dividend to a shareholder out of the CDA balance, it is tax free to the shareholder, but it is not going to generate a dividend refund to HoldCo. HoldCo only gets a dividend refund if the dividend is a taxable dividend to the shareholder.

Armed with this theory, we can look at a live example of how this would work. Lets consider the example of an Ontario resident individual who is holding shares that have an adjusted cost base (i.e. tax cost) of $1,000. These shares have experienced a dramatic increase in value, and are now worth $100,000. The individual is going to sell these shares and would like to know if there is any advantage to doing so through a HoldCo. The individual is in the highest marginal tax rate (currently 31.310 % on Canadian source dividends and 46.410 % on everything else). The individual wants the after tax money, so they would withdraw everything from the HoldCo once the shares are sold. If they were to go the HoldCo route, they would elect to transfer their shares to HoldCo at their $1,000 tax cost prior to the sale (to transfer them at fair market value would defeat the purpose), and would have the capital gain realized within HoldCo. In the process of transferring the shares to HoldCo, they could arrange to have HoldCo issue a note payable to them equal to their original $1,000 tax cost.

Integration tells us that selling the shares through a HoldCo should give us the same result as selling the shares personally. If the individual wants to get the money out of the HoldCo following the sale of the shares, they would elect to take part of the proceeds from the share sale out of HoldCo as a non-taxable repayment of their $1,000 note and as a non-taxable payment our of the CDA balance. The remaining cash would be withdrawn from the company as a taxable dividend, leading to a dividend refund in HoldCo.

As this example illustrates, there is no advantage to using the HoldCo to sell the shares even without considering the professional fees associated with the HoldCo. So why do it?

Well, there may be some good reasons for doing it. Firstly, the example assumes that the individual withdraws all of the cash from HoldCo in the year of the share sale, and at a time when they are in the highest marginal tax rate. If the cash from the sale was left in the corporation and withdrawn as a dividend a year or two later when the individual was not in the highest marginal tax rate, then the results may be quite good. The HoldCo would get the dividend refund at a rate of $1 for every $3 of dividends in that later year when the dividend is paid, and the shareholder may not incur a significant tax liability on the dividend that he or she receives.

Alternatively, it may be possible to transfer the shares to HoldCo well before a sale is to happen. In this way, future growth in the value of the shares could be shifted to other family members. When the shares are sold, the growth in value since the time of the transfer could be paid as a dividend to these other family members. If these family members are in a low marginal tax rate, they would not incur much tax on the dividend, and the results could be quite good when compared to the alternative where the shares continue to be held by the individual and sold by him or her personally.

There are a host of issues to be considered before embarking on such an exercise, including the corporate attribution rules and the tax on split income to name but a few.

As always, seek professional advice before undertaking any steps and do not hesitate to contact me should you have any questions.

The 21-Year Rule is Taxing on Family Trusts

Family trusts are popular estate and succession planning vehicles for good reason: they can be versatile and effective tools to help manage family wealth and taxes.

But many Canadian family trusts are now well into their second decade and need attention to avoid significant—even devastating—tax bills triggered by the Income Tax Act’s “21-year rule.” “This rule,” says Angela Ross, associate partner, tax services, PwC, “states in general that any family trust, whether it is created during someone’s lifetime or on the death of a person, has to treat itself as having disposed of its property every 21 years.”

In Canada, when someone dies, they are seen as having disposed of their property (except property left to their spouse) at fair market value and their estate pays taxes on any gains realized on that property. Any property then acquired by their child will again be deemed disposed on the death of that child. Were it not for the “21-year rule,” a family trust could hold property for multiple generations without ever incurring tax on the death of a generation.

So every 21 years in a family trust’s “life,” the CRA looks at the property in a trust as if it were the property of someone who had just died. “When the 21 years are up, if the trust holds property on that date, it is deemed to have disposed of the property at its current market value and has to pay taxes on it. Say the trust owns property that had an original cost of $10 but its value on the 21-year anniversary is $100. That trust will be deemed to have realized a $90 capital gain.” As we enter 2011, many Canadian family trusts are approaching the 21st anniversary of their creation and families need to be aware that in most cases, with proper, advanced planning, steps can be taken to defer the tax.

“A trust can generally transfer its assets to Canadian resident beneficiaries on a tax-deferred basis prior to the 21-year anniversary, meaning it can transfer its assets to beneficiaries without triggering the tax on the gain,” says Ross. “So if the trust owns property with a cost of $10, and at 20 years, its fair market value is $100, the trust can transfer the entire asset to its Canadian resident beneficiaries at its $10 price. The trust disposition would reflect $10 of proceeds and not the $90 gain. The taxes on the $90 capital gain can be deferred until that beneficiary sells or dies.” Ross advises family trusts to begin planning for the transfer at least a year in advance of the 21-year anniversary—although in more complex cases two or more years will be needed.

Some important points to keep in mind include: With the exception of Canadian real estate held in a trust, the general rule is you can’t transfer the trust’s assets at cost to beneficiaries who are not Canadian residents. But even if you have non-Canadian resident beneficiaries, depending on the terms of the trust and situation, it may be possible to do some planning to get the assets out for the benefit of that non-resident. It can be very complicated, so start early.

If timed properly and you have the right tax scenario, you can transfer the trust’s assets to grandchildren rather than your children and thus defer the taxes for another generation. In the case of a family trust owning a business that is transferring shares to children or grandchildren, it’s prudent to have a shareholders’ agreement in place before the children or grandchildren receive the shares.

Even if your family trust is nowhere near 21 years old, having it reviewed carefully by an expert now can be a smart move. “There are a few provisions in the Tax Act that could prevent you from doing the rollout before 21 years,” says Ross.

“Most important is 75(2)—the revocable trust provision. It applies if the trust received property from any person who is a capital beneficiary of the trust or is a person who decides when the trust property is disposed of or to whom it eventually goes. It’s a brutal provision that may prevent the rollout of any assets to beneficiaries before 21 years and it’s one people need to be aware of.” Although there’s nothing that can be done to change it, with enough time, it’s possible to develop strategies to fund the eventual tax liability. “The sooner you know you have this issue, the better,” says Ross. “Alternative planning may be possible.

You could implement a reorganization at say 10 years to stop the growth in a bad trust and potentially start the growth in a good trust and minimize the tax hit that’s going to happen at 21 years.”

written and published by Ms. Angela M. Ross from PriceWaterHouseCooper(PWC)

Holding Company 101: What is it and Why do you need one?

Here is a great article written by Rolland Vaive, CA, TEP, CPA - an excellent accountant based in Ottawa (Orleans) and specializing in complicated tax matters.

&&&&&&&

Speak to any tax accountant for more than a minute and they'll surely be talking about holding companies, or HoldCo's for short.

A holding company is not a term which is defined in the Income Tax Act. It is a term which is used to define a corporation which holds assets, most often income generating investment assets. It does not typically carry on any active business operations.

A HoldCo can arise for a variety of reasons. In the early 1990's, the personal marginal tax rate in Ontario was slightly higher than 53%, while the corporate rate of tax was considerably lower than that. High income individuals who had significant investment assets could realize a tax deferral by transferring their investment assets to a HoldCo, particularly in situations where they did not need the income which was being generated by the investments. This breakdown between the corporate rate of tax and the personal rate of tax lead to many HoldCo's being formed.

HoldCo's may also come about as an effective means of creditor proofing profitable operating companies, as a result of Canadian estate planning, or as a means of avoiding U.S. estate tax and Ontario probate fees.

Regardless of their origins, the investment income generating HoldCo is taxed in an unusual manner, which I will attempt to explain.

The underlying concept of HoldCo taxation is called "integration". In general terms, integration means that an individual should pay the same amount of tax on investment income if they earned it personally or if they earned it through a corporation and withdrew the after-tax income in the form of dividends. When we look at some real numbers, you will see that this in fact generally holds true. However, it is possible to exploit some breakdowns in integration, at which time it may become quite beneficial to earn your investment income through a HoldCo.

Let's look at the theory. We often hear about how corporations are taxed at low tax rates. In situations where a private company is earning income from active business operations carried on in Canada, that is quite true. In these situations, the rate of tax would be a flat tax rate of 18.620% if the company was resident in Ontario. The other provinces have similarly low rates of tax on "active business income". The low rate of tax does not apply to investment income, which is what the HoldCo would be generating.

For an Ontario resident private company generating investment income, the combined Federal and Provincial rate of tax would be a flat 49.7867% on all forms of investment income, other than dividends from other Canadian corporations. Bear in mind that only 1/2 of capital gains are included in income, so the effective corporate rate of tax on capital gains would be 24.8934%.

A portion of the tax that HoldCo pays each year on its' investment income goes into a notional pool called the RDTOH pool. This is an acronym for "refundable dividend tax on hand". Of the 49% rate of tax that is paid by the corporation, 26.67% will go into the RDTOH pool each year and is tracked on the corporation's Federal tax return. If HoldCo pays a taxable dividend to its' shareholders in a particular year, it gets back part of its RDTOH pool. More specifically, the company will get back $1 for every $3 of dividends that it pays. This RDTOH recovery is called a dividend refund, and would be a direct reduction of the corporation's tax liability for the year. If the corporation pays a large dividend to a shareholder, the dividend refund would also be large and may result in the company actually getting money back from the Canada Revenue Agency. In short, the HoldCo will pay a large tax liability on its investment income up front, but it can get a large portion of it back at a later date if it pays out dividends. The dividend refund is an attempt to compensate for the fact that the dividend will attract tax in the hands of the shareholder. Without this mechanism, the 48% rate of tax on investment income combined with the tax paid by the shareholder on the dividend that they receive would result in an onerous rate of tax.

It is possible that a second notional tax pool may arise in HoldCo if it is generating capital gains on its' investment assets. You will recall that only 1/2 of capital gains are included in income. The other 1/2 portion of the capital gain which is not included in income will get added to the capital dividend account, or "CDA", of HoldCo. The CDA balance is something which needs to get tracked by the company on a regular basis, since it does not appear anywhere on the company's financial statements or tax returns. The CDA is important because it is possible for HoldCo to pay a dividend to a shareholder and elect to pay it out of the CDA balance, making the dividend tax-free to the shareholder. If a company realizes a capital gain of $10,000 , only $5,000 will be included in taxable income, with the remaining $5,000 being added to the company's CDA balance. The company could then pay a $5,000 dividend to the shareholder. By electing to do so out of the CDA balance, the shareholder would not be taxed on the dividend.

Lets look at this in conjunction with the RDTOH balance. If the company pas a dividend to a shareholder out of the CDA balance, it is tax free to the shareholder, but it is not going to generate a dividend refund to HoldCo. HoldCo only gets a dividend refund if the dividend is a taxable dividend to the shareholder.

Armed with this theory, we can look at a live example of how this would work. Lets consider the example of an Ontario resident individual who is holding shares that have an adjusted cost base (i.e. tax cost) of $1,000. These shares have experienced a dramatic increase in value, and are now worth $100,000. The individual is going to sell these shares and would like to know if there is any advantage to doing so through a HoldCo. The individual is in the highest marginal tax rate (currently 31.310 % on Canadian source dividends and 46.410 % on everything else). The individual wants the after tax money, so they would withdraw everything from the HoldCo once the shares are sold. If they were to go the HoldCo route, they would elect to transfer their shares to HoldCo at their $1,000 tax cost prior to the sale (to transfer them at fair market value would defeat the purpose), and would have the capital gain realized within HoldCo. In the process of transferring the shares to HoldCo, they could arrange to have HoldCo issue a note payable to them equal to their original $1,000 tax cost.

Integration tells us that selling the shares through a HoldCo should give us the same result as selling the shares personally. If the individual wants to get the money out of the HoldCo following the sale of the shares, they would elect to take part of the proceeds from the share sale out of HoldCo as a non-taxable repayment of their $1,000 note and as a non-taxable payment our of the CDA balance. The remaining cash would be withdrawn from the company as a taxable dividend, leading to a dividend refund in HoldCo.

As this example illustrates, there is no advantage to using the HoldCo to sell the shares even without considering the professional fees associated with the HoldCo. So why do it?

Well, there may be some good reasons for doing it. Firstly, the example assumes that the individual withdraws all of the cash from HoldCo in the year of the share sale, and at a time when they are in the highest marginal tax rate. If the cash from the sale was left in the corporation and withdrawn as a dividend a year or two later when the individual was not in the highest marginal tax rate, then the results may be quite good. The HoldCo would get the dividend refund at a rate of $1 for every $3 of dividends in that later year when the dividend is paid, and the shareholder may not incur a significant tax liability on the dividend that he or she receives.

Alternatively, it may be possible to transfer the shares to HoldCo well before a sale is to happen. In this way, future growth in the value of the shares could be shifted to other family members. When the shares are sold, the growth in value since the time of the transfer could be paid as a dividend to these other family members. If these family members are in a low marginal tax rate, they would not incur much tax on the dividend, and the results could be quite good when compared to the alternative where the shares continue to be held by the individual and sold by him or her personally.

There are a host of issues to be considered before embarking on such an exercise, including the corporate attribution rules and the tax on split income to name but a few.

As always, seek professional advice before undertaking any steps.

Business owners: why you MUST use separate corporations.

USE OF SEPARATE CORPORATIONS

The use of separate corporations to carry on different businesses is a basic creditor proofing technique that should always be considered when starting a new business. Separate corporations generally have limited liability, which will help insulate the assets associated with one business from any risks associated with another business. The use of separate corporations is also recommended where a business has used accumulated earnings to acquire significant liquid and/or investment assets or perhaps real estate. For example, it is desirable for real estate and/or equipment which is used in the business to be owned by a separate company(Holding Company), rather than be owned by the operating company. In this manner, the real estate can be protected from direct creditors of the operating business.

If the operating company already owns real estate, it may be possible to separate the real estate by means of a tax deferred corporate reorganization. Where the real estate is owned separate from the operating company, the company owning the real estate would generally charge the operating company a fair market value
rent.

This type of arrangement may also provide ancillary tax benefits with regard to the potential for a more rapid deduction of the leasehold improvements incurred by the operating company.

In addition to real estate assets, other liquid assets(such as cash) accumulating in an operating company should be separated from the company to the extent there are accumulated earnings. For example, term deposits owned by an operating company could be separated and transferred to a holding company by having the operating company pay a tax-deferred dividend to the holding company. In the future, if the
operating company requires the funds, the holding company could then loan the funds back by way of a registered debenture, so that, in the event of a business failure, the holding company’s right to realize on the loan would precede the rights of any general unsecured creditors of the operating company.

If a holding company does not currently exist, a relatively simple re-organization6 could take place to establish a holding company and protect the investment assets of the operating company.

As usual, you should seek professional advice before implementing your new structure - call me or email me if you have any questions.

Holding Company - what is it?

Here is a great article written by Rolland Vaive, CA, TEP, CPA - an excellent accountant based in Ottawa (Orleans) and specializing in complicated tax matters.

Speak to any tax accountant for more than a minute and they'll surely be talking about holding companies, or HoldCo's for short. A holding company is not a term which is defined in the Income Tax Act. It is a term which is used to define a corporation which holds assets, most often income generating investment assets. It does not typically carry on any active business operations.

A HoldCo can arise for a variety of reasons. In the early 1990's, the personal marginal tax rate in Ontario was slightly higher than 53%, while the corporate rate of tax was considerably lower than that. High income individuals who had significant investment assets could realize a tax deferral by transferring their investment assets to a HoldCo, particularly in situations where they did not need the income which was being generated by the investments. This breakdown between the corporate rate of tax and the personal rate of tax lead to many HoldCo's being formed.

HoldCo's may also come about as an effective means of creditor proofing profitable operating companies, as a result of Canadian estate planning, or as a means of avoiding U.S. estate tax and Ontario probate fees. Regardless of their origins, the investment income generating HoldCo is taxed in an unusual manner, which I will attempt to explain. The underlying concept of HoldCo taxation is called "integration". In general terms, integration means that an individual should pay the same amount of tax on investment income if they earned it personally or if they earned it through a corporation and withdrew the after-tax income in the form of dividends. When we look at some real numbers, you will see that this in fact generally holds true. However, it is possible to exploit some breakdowns in integration, at which time it may become quite beneficial to earn your investment income through a HoldCo.

Let's look at the theory. We often hear about how corporations are taxed at low tax rates. In situations where a private company is earning income from active business operations carried on in Canada, that is quite true. In these situations, the rate of tax would be a flat tax rate of 18.620% if the company was resident in Ontario. The other provinces have similarly low rates of tax on "active business income". The low rate of tax does not apply to investment income, which is what the HoldCo would be generating.

For an Ontario resident private company generating investment income, the combined Federal and Provincial rate of tax would be a flat 49.7867% on all forms of investment income, other than dividends from other Canadian corporations. Bear in mind that only 1/2 of capital gains are included in income, so the effective corporate rate of tax on capital gains would be 24.8934%. A portion of the tax that HoldCo pays each year on its' investment income goes into a notional pool called the RDTOH pool. This is an acronym for "refundable dividend tax on hand". Of the 49% rate of tax that is paid by the corporation, 26.67% will go into the RDTOH pool each year and is tracked on the corporation's Federal tax return.

If HoldCo pays a taxable dividend to its' shareholders in a particular year, it gets back part of its RDTOH pool. More specifically, the company will get back $1 for every $3 of dividends that it pays. This RDTOH recovery is called a dividend refund, and would be a direct reduction of the corporation's tax liability for the year. If the corporation pays a large dividend to a shareholder, the dividend refund would also be large and may result in the company actually getting money back from the Canada Revenue Agency. In short, the HoldCo will pay a large tax liability on its investment income up front, but it can get a large portion of it back at a later date if it pays out dividends. The dividend refund is an attempt to compensate for the fact that the dividend will attract tax in the hands of the shareholder. Without this mechanism, the 48% rate of tax on investment income combined with the tax paid by the shareholder on the dividend that they receive would result in an onerous rate of tax. It is possible that a second notional tax pool may arise in HoldCo if it is generating capital gains on its' investment assets. You will recall that only 1/2 of capital gains are included in income. The other 1/2 portion of the capital gain which is not included in income will get added to the capital dividend account, or "CDA", of HoldCo. The CDA balance is something which needs to get tracked by the company on a regular basis, since it does not appear anywhere on the company's financial statements or tax returns. The CDA is important because it is possible for HoldCo to pay a dividend to a shareholder and elect to pay it out of the CDA balance, making the dividend tax-free to the shareholder.

If a company realizes a capital gain of $10,000 , only $5,000 will be included in taxable income, with the remaining $5,000 being added to the company's CDA balance. The company could then pay a $5,000 dividend to the shareholder. By electing to do so out of the CDA balance, the shareholder would not be taxed on the dividend. Lets look at this in conjunction with the RDTOH balance. If the company pas a dividend to a shareholder out of the CDA balance, it is tax free to the shareholder, but it is not going to generate a dividend refund to HoldCo. HoldCo only gets a dividend refund if the dividend is a taxable dividend to the shareholder. Armed with this theory, we can look at a live example of how this would work.

Lets consider the example of an Ontario resident individual who is holding shares that have an adjusted cost base (i.e. tax cost) of $1,000. These shares have experienced a dramatic increase in value, and are now worth $100,000. The individual is going to sell these shares and would like to know if there is any advantage to doing so through a HoldCo. The individual is in the highest marginal tax rate (currently 31.310 % on Canadian source dividends and 46.410 % on everything else).

The individual wants the after tax money, so they would withdraw everything from the HoldCo once the shares are sold. If they were to go the HoldCo route, they would elect to transfer their shares to HoldCo at their $1,000 tax cost prior to the sale (to transfer them at fair market value would defeat the purpose), and would have the capital gain realized within HoldCo. In the process of transferring the shares to HoldCo, they could arrange to have HoldCo issue a note payable to them equal to their original $1,000 tax cost. Integration tells us that selling the shares through a HoldCo should give us the same result as selling the shares personally.

If the individual wants to get the money out of the HoldCo following the sale of the shares, they would elect to take part of the proceeds from the share sale out of HoldCo as a non-taxable repayment of their $1,000 note and as a non-taxable payment our of the CDA balance. The remaining cash would be withdrawn from the company as a taxable dividend, leading to a dividend refund in HoldCo. As this example illustrates, there is no advantage to using the HoldCo to sell the shares even without considering the professional fees associated with the HoldCo. So why do it? Well, there may be some good reasons for doing it.

Firstly, the example assumes that the individual withdraws all of the cash from HoldCo in the year of the share sale, and at a time when they are in the highest marginal tax rate. If the cash from the sale was left in the corporation and withdrawn as a dividend a year or two later when the individual was not in the highest marginal tax rate, then the results may be quite good. The HoldCo would get the dividend refund at a rate of $1 for every $3 of dividends in that later year when the dividend is paid, and the shareholder may not incur a significant tax liability on the dividend that he or she receives. Alternatively, it may be possible to transfer the shares to HoldCo well before a sale is to happen.

In this way, future growth in the value of the shares could be shifted to other family members. When the shares are sold, the growth in value since the time of the transfer could be paid as a dividend to these other family members. If these family members are in a low marginal tax rate, they would not incur much tax on the dividend, and the results could be quite good when compared to the alternative where the shares continue to be held by the individual and sold by him or her personally.

There are a host of issues to be considered before embarking on such an exercise, including the corporate attribution rules and the tax on split income to name but a few. As always, seek professional advice before undertaking any steps.