A holding company, commonly known as “Holdco,” offers benefits ranging from tax optimization to minimizing risk. It can also be beneficial in situations such as selling a business and succession planning. If you have considered starting a holding company in Canada, it’s important to understand what is involved and whether it will provide the anticipated benefits to help you meet your objective. Here we take a deep dive into a holding company set up in Canada to help you understand precisely what is involved.
A holding company (“Holdco”) is an incorporated company that is used primarily to hold assets, such as shares of other companies and interest-earning investments. Holding companies are not intended for active businesses but exist mainly to own shares of the operating company (“Opco”) or to hold assets. This allows profits from the operating business to be retained in the Holdco and can be beneficial for tax purposes. Holding companies can also be used to own real estate, rental properties, marketable securities such as shares of public companies, and interest-earning investments such as bonds, term deposits, and GICs.
Holding Company vs. Operating Company
Holdco and Opco are two distinct business legal entities in Canada. Holding companies are used to own assets and investments, while operating companies are used to conduct the day-to-day operations of a business. Holding companies can provide advantages such as tax efficiency, asset protection, estate planning, and diversification of investments.
Operating companies are active businesses created for the purpose of running business operations. These can be in any form, from manufacturing and selling products to offering services in various industries. Operating companies have the advantage of being able to generate revenues and profits from their activities, and are eligible for preferential tax treatment via the small business deduction (SBD) on the profits earned. In Canada, both types of corporations must adhere to specific regulations set out by the Federal or provincial governments, depending on where they’re located.
From a liability standpoint, holding companies provide asset protection, making it harder for creditors to seize corporate assets if there is a dispute involving debt repayment obligations or a potential lawsuit relating to the business operation.
Operating companies can also offer limited liability protection for shareholders in some instances, although this isn’t always the case. It is important to understand what legal protections might be available depending on how a particular operating company has been structured upfront.
Advantages of a Holding Company
There are a number of benefits for a holding company, including:
If you own an operating company, creditors can claim assets related to that company should you run into financial difficulties. If your assets are held in a holding company, they are protected under this scenario because an extra layer of protection is added to ensure that assets remain safe even if claims are made against the operating business. You would need to transfer assets or excess cash from Opco to Holdco, which can be done in a tax-efficient manner with proper planning with a lawyer and an accountant.
In addition, the benefit also applies to potential lawsuits where your operating company is being sued for situations such as faulty workmanship, poorly made products, or gross negligence relating to the professional services you offer. While business liability insurance helps mitigate the risks exposed through everyday activities, it may not provide sufficient protection depending on the outcome of these lawsuits. It pays to have protection through your Holdco, since it offers an additional layer of protection that may help shield company assets from the impact of legal action.
Let’s go over an example of how a holding company offers asset protection for a software company.
SaaS Co. is a software company that has decided to invest in an app to support local businesses. The app does surprisingly well, producing a respectable amount of revenue. To protect against potential challenges from creditors and lawsuits related to the app, the SaaS Co. sets up a holding company in Canada and reorganizes the legal business structure in a tax-efficient manner so that the holding company owns 100% of the shares of the operating company. The excess funds are transferred from Holdco to Opco tax-free since the transfer is completed through intercorporate dividends. By transferring excess cash and other assets into a holding company, SaaS Co. can safeguard its investments while maintaining control.
Tax Savings & Deferral
Tax deferral is a strategy businesses and individuals can use to reduce the taxes they have to pay in any given year. By utilizing a holding company, dividends paid out by an operating company (Opco) can be deferred until the shareholders decide when it’s best for them to receive their income personally. This income splitting strategy through tax deferral allows shareholders to take advantage of lower corporate tax rates while investing additional funds within the corporation.
Also, if a dividend payout is planned during a year when you are in a very high tax bracket, tax free dividends can be paid to the holding company instead. Intercorporate payments are considered tax free dividends under the Income Tax Act because the same shareholder owns both companies. You can then have the holding company pay out the dividend when your personal tax rates are in a lower tax bracket, thus achieving tax savings for your personal taxes.
A holding company allows the shareholders to control when they want to receive their dividends and pay tax personally. This is particularly beneficial if one shareholder doesn’t need cash flow right away while another shareholder may require it immediately.
Also, when multiple shareholders are present in an Opco, there may be disagreements regarding when each shareholder should receive their dividends personally. By using a holding company, each individual shareholder can easily decide when they should take out payments from their personal holding company.
Lifetime Capital Gains Exemption
Lifetime capital gains exemption (LCGE) is a valuable tax incentive for individuals who own shares of qualified small business corporations (QSBC). The shares of the corporation in question must be Canadian Controlled Private Corporations and cannot be public companies. Based on 2023 updated figures, LCGE allows you to offset up to $971,190 of capital gains on the sale of eligible shares. To qualify for this exemption, specific criteria must be met, and certain holding company business structure can help facilitate such qualification. Here are the details on how holding companies can help maximize your ability to take advantage of LCGE.
In order to qualify for the LCGE, two tests must be met for the operating company: First, at least 90% of the fair market value of all its assets must be used in an active business carried on primarily in Canada immediately before their sale. In other words, the corporation cannot have more than 10% of its assets being used for non-active business activities such as investments or excess cash.
Secondly, more than 50% of the fair market value of those assets must have been used in such an active Canadian business during the 24 months immediately preceding their sale. The use of a holding company may potentially help to qualify for LCGE, as there are various “purification” strategies which could be used. These tax planning strategies reduce the number of assets held in the operating company that are not being utilized in an active business. One purification method often used is restructuring and setting up a new holding company and transferring excess cash or investments to this holding company.
It should also be noted that using Hodco to own Opco shares before a sale makes claiming the LCGE more complex if it is structured incorrectly. The holding company cannot claim the exemption on the sale of the Opco shares as the LCGE is only available to individuals, not corporations.
Holding companies can help separate assets and investments from those used in an active business, allowing the qualified small business corporation test to be met more easily and maximizing your ability to claim LCGE on the sale of your shares. It should be noted that this is a complex area, and you should always seek professional advice before proceeding. If done correctly, holding companies can be a powerful tool for minimizing taxes when selling shares of a QSBC.
If you are approaching your retirement years, estate planning is integral to ensuring that your business and assets are taken care of after you’re gone. One popular estate planning tool for businesses in Canada is the holding company, which can provide many benefits to the business owner. This is accomplished through a process called an “estate freeze,” where you transfer ownership of the common shares in an operating company (the “Opco”) to the holding company (the “Holdco”). The common shares of Opco will be exchanged for fixed-value preferred shares in the Holdco. Once this exchange occurs, any future appreciation or income generated by Opco will flow to the new common shareholders in Holdco, who is likely the next generation, such as your children or other family members. This allows you to reduce exposure to taxation upon death, as the holding company shares are subject to only one layer of tax. Also, the transfer will enable you to preserve the value of the operating company’s assets while transferring them to your children or other successors on a tax-efficient basis.
When considering an estate freeze strategy using a holding company in Canada, several important tax considerations should be considered. Firstly, when transferring the common shares of Opco to Holdco, any capital gains realized can be tax-free if appropriately structured, or taxed at your marginal tax rate for capital gains. Secondly, consider electing a specified amount on the estate freeze to claim the Lifetime Capital Gains Exemption (LCGE).
To illustrate, let’s assume you are the sole shareholder of Opco, which you originally paid $10 to set up. The Opco is now valued at $3 million, and you could transfer those shares to a holding company (Holdco) you’ve created. In exchange for this transfer, you would receive preferred shares of Holdco that are redeemable for $3 million. Additionally, your adult children can subscribe to common shares in the holding company for a nominal amount, such as $10, since all its value is reflected in your redeemable preferred shares.
If Opco continues increasing in value over time, this increase will flow to the common shares held by your children within the holding company. Additionally, should you decide to transfer your common shares to Holdco at their adjusted cost base (ACB) of $10, you would not realize any capital gain on the transaction. However, if you wish to capitalize on potential capital losses carried forward or take advantage of lifetime capital gains exemption (LCGE), you can elect an amount up to the fair market value of $3 million when transferring your holdings. For example, if you elect a transfer amount of $971,200, you would realize a capital gain totaling $971,190 (the elected amount of $971,200 less her ACB of $10). The lifetime capital gains tax exemption can then be fully applied against realized gain, making it tax free capital gains.
Ultimately, a holding company can provide business owners with an effective tool for estate planning. By transferring ownership of the operating company to a holding company, you can take advantage of transferring the future growth of a corporation to the next generation and reduce exposure to taxation upon death.
Disadvantages of a Holding Company
Before you decide to set up a holding company in Canada, you should also consider the disadvantages. Some cons to holding companies include:
Costs for a Holding Company
When incorporating a holding company in Canada, several costs can add up, including the incorporation costs for a lawyer to draft the incorporation documents, by-laws, shareholder agreements, and other resolution documents. This step is critical to outline the founding directors, the initial share structure, and the rules governing the corporation.
Your holding company would also incur ongoing costs, including:
- Legal annual return filings: To remain in good standing with the governing body where the holding company was incorporated, the annual legal return needs to be filed once a year.
- Corporate tax returns: Since the holding company is a separate legal entity, it must file a corporate tax return annually. This is a mandatory requirement, and the tax return must be filed within six months after the fiscal year-end, with tax payments due two months after the fiscal year-end. Also, if you are using the holding company to optimize the taxation on dividend distribution, filing a T5 information return during the calendar year when dividends are paid would be required.
- Bookkeeping: Managing all your assets and investments requires proper bookkeeping to avoid potential issues when tax time arrives. The bookkeeping records for a holding company must comply with the requirement as stipulated by the Canada Revenue Agency.
Although there are additional costs associated with incorporating a holding company, there are other benefits of incorporating if you have not already incorporated your business.
Although you aren’t running an operating company, a holding company comes with its own set of administrative challenges. Between the legal and tax filings alone, everything you do should be planned carefully to avoid adverse tax consequences. Chances are you may not be equipped with the proper knowledge, meaning you would need to find someone reliable to handle this.
It would help if you felt confident that you or someone you trust could keep track of your assets and understand the tax implications when transferring assets from your operating company to your holding company. The potential for disaster is high if you are unfamiliar with how this should be carried out. Errors and lack of understanding may lead to large sums of money owed to the government for you and your business.
Potential for Higher Taxes
While we’ve sung the praises of tax benefits for the holding company, it could cost you more taxes if it is not managed properly. Tax planning is at the heart of a good tax strategy to minimize the amount of taxes you owe and maximize your investment income. This is especially true if you decide to transfer investments or funds you own personally.
Also, the small business deduction (SBD) most private corporations are entitled to on the first $500,000 of active business income might be impacted by a holding company. The dollar limit is shared among associated corporations, so even if your holding company doesn’t earn any active business income, passive income exceeding $50,000 may impact the SBD claimed for the operating company.
Overall, a Canadian holding company can be an effective tool for business owners in Canada. To make the most of this legal entity and its advantages, careful consideration must be given to all relevant issues before making a decision. Working with both tax and legal professionals with experience dealing with holding companies will ensure you can successfully navigate the complexities of incorporating one in Canada. With the help from our corporate tax accountant, you’ll be well on your way toward finding out if forming a holding company in Canada is suitable for your particular situation. Contact us to discuss if setting up a holding company is right for you.