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.
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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.

Business Owners - Are you missing out on some serious tax savings???

what is a Corporate Reorganization??

A Corporate Reorganization is a way to reorganize and restructure your company so that you can reap the rewards of the existing tax regulations - often resulting in tens of thousands of dollars of potential tax savings every year into the future.

why do I need a Corporate Reoganization?

As a Business Lawyer, I sometime see situations where businesses are set up with a certain structure to take advantage of particular circumstances that were relevant at the time they were set up, but as we all know, situations change over time.

It is therefore sometimes the case that the favourable conditions existing at the time your corporate structure was put in place are no longer there, and you might end up with a somewhat cumbersome of inefficient structure in today's business climate, particularly from a tax point of view.

On a daily basis, I work with companies in this situation to help them reorganize and restructure so that they can reap the rewards of the existing tax regulations - often resulting in tens of thousands of dollars of potential tax savings every year into the future.

In many situations, for example, I may recommend a corporate reorganization, whether for corporate tax planning, creditor proofing or other organization purposes. I can also assist you in the transfer of assets on a tax-deferred basis from one entity to another, or from one corporation to another. Alternatively, I could recommend amalgamating two corporations or winding up one into the other for tax planning purposes or to rationalize a corporate structure.

Often, I will investigate the options thoroughly and advise you of the best plan to meet with your objectives.

There are many reasons companies may need to be reorganized:

•to establish and implement a family trust in the course of corporate reorganization;
•to create holding companies for creditor-proofing reasons;
•to divide the assets of a corporation among the shareholders;
•to incorporate a business, so that it may be carried on in corporate form;
•to carry out an estate freeze in the most effective manner;
•to transfer a business from a corporation to a partnership to deduct losses, take in a partner, or eliminate capital tax

If you think you are a candidate and would like to know more, I can advise on whether a corporate reorganization is required, the benefits of such a reorganization, and the disadvantages, if any.

Finally, I can also develop a plan to implement the corporate reorganization, and work with your advisors (accountants, financial planners, insurance) to execute the plan.

Please contact me should you wish more information on the above.