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.

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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)

How a trust can lighten the burden of raising a family

Today, we would like to share a great article written by Tim Cesnick and published in the Globe & Mail.

At HazloLaw, we often advise clients to consider the implementation of a Family Trust.

How a Trust can lighten the burden of raising a family

My friend Allan gave me a call this week.  “Tim, I just got an e-mail letting me know about my high-school reunion in the fall,” he said. “Sounds like fun, Al,” I replied. “Tim, I graduated 25 years ago, and I feel like I’ve been wasting time. The reunion is coming up fast. I only have four months to make something of myself. Got any ideas?” Then it hit me. “Al, why don’t you set up a family trust?” I suggested. “It really doesn’t matter how successful you’ve actually been – most successful people have a family trust. ” “Tim, I like it! So, when people at the reunion ask what I’m doing today, I can just tell them the truth – I play video games – but mostly I watch over my family trust. Wow, that sounds great. Uh, Tim, what am I going to do with this family trust once it’s set up?” I then shared with Allan a primer on how a trust can save a family significant tax dollars.

Here are the highlights.

A trust is actually a legal relationship between the settlor (the person who transfers the assets to be held in trust), the trustee (the person(s) who holds the assets that were transferred), and the beneficiary (the person(s) for whom the assets are being held). Now, from a tax perspective think of a trust as a vehicle to hold certain assets you choose to place in the trust. The trust is treated as a separate individual for tax purposes, and any income earned by the trust will be subject to tax. The trust can pay the tax, or the trustees may choose to distribute the income to the beneficiaries, in which case the trust claims a deduction for the amount distributed and the beneficiaries face the tax on that income instead (the beneficiaries will receive a T3 slip showing the amount of income they must report). So, it’s possible to sprinkle income to various family members (beneficiaries) who might pay tax at lower rates than you might face.

You should know that there are two types of trusts: An inter vivos trust, which is a trust you might establish during your lifetime, and a testamentary trust, which is established by your will after your death. I’m talking today about inter vivos trusts. These trusts are taxed at the highest possible marginal tax rate – which is not a good thing, obviously.

So, you’ll generally want to distribute the income of the trust to beneficiaries to face tax in their hands at lower rates.

Trust example.

Consider my friend Allan. He has children and regularly pays for many things for them. What if Allan could pay for these things using dollars that have been taxed in the kids hands rather than his own? The tax savings could be huge.

To make this possible, Allan is going to lend money to a family trust that will be established. Now, there’s no hard and fast rule around how much he should advance to the trust. In my view, it should be at least $500,000 over time in order to gain sufficient benefit.

If Allan lent, say, $500,000 to his family trust, the trust could invest those dollars.  Let’s assume the trust earns 5 per cent annually on those funds. This would result in $25,000 of income annually. If this income were taxed in Allan’s hands, he’d pay $11,600 in taxes (in the highest tax bracket in Ontario this year). In this case, however, the trustee of the family trust – Allan in this case – can distribute the $25,000 of income to Allan’s three kids.

The result? Each of his kids reports one-third of the income ($8,333 each) and pays little or no tax since these kids have little or no other income and they each have a basic personal tax credit that will shelter the first $10,527 of income from tax in 2011.

Here’s the problem: Allan doesn’t really want to distribute cash to each of his kids directly. No problem. Allan can simply use the income in the trust to pay for expenses related to the kids. He could, for example, pay for their tuition, sports, travel, and other costs. The taxman will generally consider these amounts to have been distributed to the kids even when paid directly to third parties, provided the costs are clearly for the benefit of the kids.

Small business owners should beware the taxman's test

written by Tim Cesnick and published in the Globe and Mail.

Small business owners should beware the taxman's test

I was at a local hockey arena last weekend when I ran into an old friend who I hadn’t seen in a while. “Jack, I haven’t seen you for a couple of years! I heard that you’ve started a new business. Is that right?” I asked. “That’s right,” Jack replied. “This time it’s a non-profit corporation,” he continued. “I didn’t intend it that way, but it is.” As it turns out, Jack is going to save big tax dollars because of his business losses. Many taxpayers have done the same thing in the past. Self-employment can be a great tax shelter, but you should understand the taxman’s – and the court’s – view of this. A recent court decision serves as a good reminder about the guidelines to follow. The tax shelter If you operate a business as a proprietorship (rather than incorporating the business), any losses you report from the business can be applied to offset other income you might be reporting on your personal tax return. Quite often, the losses stem from costs you’re incurring anyway.

You might, for example, use your car in your business and claim depreciation (known as “capital cost allowance” – or CCA) on your car. You’re paying for a car anyway, so why not make it deductible? It’s not uncommon to experience losses in the early years of a business. The story Brian Sumner is a gentleman who decided to start a business several years ago. Although he had a full-time job as an economist, he owned a vacation property in Victoria Beach, Man. (primarily a summer recreational area), spent weekends and vacations there, and felt there was a demand in that area for excavation services.

So, Mr. Sumner registered a business called Sumner Mechanical. He turned his garage into a maintenance shop and bought a back-hoe, tractor and skid-steer loader. Mr. Sumner reported losses on his tax returns in 2004, 2005 and 2006, and the Canada Revenue Agency disallowed losses amounting to $26,857, $29,648, and $32,710 for those years respectively. Most of the losses were created by claiming CCA on the equipment he had purchased. Mr. Sumner took CRA to court over the issue, and he lost his case. His story serves as a reminder as to what you need to do if you hope to have a small business (full- or part-time) to open the door to tax deductions. The lessons This type of battle with the taxman is nothing new. Yet, in the last few years, the courts have spelled out the principles that should be followed by taxpayers – and the CRA – when determining whether losses from an activity should be allowed.

In particular, it was the Supreme Court of Canada in the Stewart decision (2002 SCC 46) that set out the principles to consider. The Supreme Court recognized that Canadian tax law will allow deductions where a source of business or property income exists. The question in every case, including Mr. Sumner’s case, is whether a source of income existed. Canada’s top court established that if an endeavour is clearly commercial in nature, with no personal element to it, then a source of income exists. This is not to say that the endeavour must produce a profit in any particular year. Where an endeavour is commercial in nature, then there is no room for the CRA to disallow losses on the basis that there is no reasonable expectation of profit. Where the endeavour could be classified as being personal in nature, or having a personal element to it, then it must be determined whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income. If so, then deductions and losses may be allowed.

A problem arises where the endeavour has a personal element to it and is not carried on in a sufficiently commercial manner. In this case, a source of income is not considered to exist, and losses won’t generally be tolerated by the taxman or the courts. When deciding whether an endeavour is sufficiently commercial in nature, the taxman will look at many factors, including: the profit and loss experience in past years, your training in the activity being carried on, your intended course of action, and the capability of the endeavour to show a profit. Mr. Sumner failed the commerciality test. Since he used his equipment more for his own personal property maintenance, advertised his business only seasonally, earned very little revenue, had little experience or training and lacked certain licences to operate some of his equipment on public roads, the courts ruled against him.

Business Owners: Tax savings should be top of your resolution list

Happy New Year 2012 to everyone who is readying this blog. Today, I would like to share an excellent article from Tim Cesnick and published in The Globe & Mail. &&&&&&&&&& Tax savings should be top of your resolution list Once again it’s time for my annual New Year’s resolution. That’s right, a single resolution. This year, I’m getting into shape again. I’m going to start by eating slowly in 2012. It’s not about slowing my metabolism. It’s about my kids. They eat so much that if I slow down my pace of eating, there won’t be anything left by the time I’ve finished my salad. That’ll do it. What about you? If you’re still thinking about your New Year’s resolutions, consider adding tax savings to the list. If you make just one change to your affairs annually to save tax, you’ll do yourself a world of good in a short time. Consider one of these ideas: 1. Create self-employment earnings. Self-employment is still one of the greatest tax shelters available. Why? Deductions. Operating a part-time business from home is all you need to do. This can open the door to deducting a portion of those things you’re paying for anyway, such as mortgage interest, rent, property taxes, home insurance, home repairs, utilities, vehicle repairs, gas, auto insurance, interest on a car loan or lease payments, computer costs and more. 2. Pay family members a salary. If you have self-employment earnings you can move income into the hands of a family member who is in a lower tax bracket by paying wages or a salary for work performed. If you’re an employee, speak to your employer about requiring you to hire your own assistant for your work. Our tax law will allow an employee to deduct salary or wages paid to an assistant provided your employer required you to pay for one. Hiring your spouse or a child who is in a lower tax bracket will keep the money in the family and will save tax dollars. 3. Make your interest deductible. If you’re paying interest costs that are not deductible, and have some cash or investments on hand, consider doing a “debt swap” to create a deduction for your interest. You can do this by taking some of your cash, or selling some investments to create the cash, and using the cash to fully or partially pay down your non-deductible debt. You can then re-borrow to replace those investments or that cash. As long as the new debt is used for an income-producing purpose you should be entitled to deduct your interest costs. 4. Extract cash from your company tax-free. If you own a corporation, consider paying yourself capital dividends, repaying shareholder loans owing to you, and returning “paid up capital” to yourself to access the cash in your company tax-effectively. Also, consider claiming a refund of “refundable dividend tax on hand” (RDTOH) by paying yourself taxable dividends. All of this may sound like a foreign language, but a visit to a tax pro, perhaps your friendly chartered accountant, will help. 5. Consider a leave of absence or sabbatical. You can defer tax by setting aside some money in a deferred salary leave plan (DSLP). You can then take a leave of absence or sabbatical in a later year and collect your deferred salary at that time. Speak to your employer about setting up a DSLP. A DSLP must be in writing and meet certain criteria, such as: No more than one-third of your salary can be set aside for the leave, your leave must be at least six consecutive months, the leave must begin no later than six years after the salary deferral begins, and following the leave you must return to work for a period at least as long as the leave. There are other details that must be looked after as well, so your employer will need to seek advice on this. 6. Create pension income for the credit. If you have eligible pension income you’ll be entitled to claim the pension tax credit. If you and your spouse each claim the credit, this could fully or partially shelter the tax on $4,000 ($2,000 each) of pension income. It’s not going to make you wealthy, but it’s all part of building up tax savings year after year. You can create eligible pension income by, for example, converting part of your registered retirement savings plan to a registered retirement income fund to create $2,000 of RRIF income annually. You can also provide your spouse with eligible pension income by reporting up to half of certain pension income in his or her hands.