Risks and Rewards of Setting Up a Holding Company

Most business owners think a holding company structure only benefits big businesses, which is incorrect. In fact, holding companies can offer various advantages and tax planning opportunities to businesses of all kinds and sizes. But it is crucial having a clear understanding of what a holding company is and whether it is right for you?

What is a Holding Company?

A holding company (many times referred to as “Holdco” or “Hold Co”) is an incorporated company primarily used to hold assets such as shares of other companies (many times referred to as “Opco”), investments, rental properties, shares of public companies, GICs or other assets. This arrangement offers a range of benefits, including minimizing risk to tax planning opportunities.

Holding Company vs. Operating Company

Holdco and Opco are two different legal entities in Canada. As discussed above holding companies are used to own investments and assets including shares of Opco, normally classified as passive or investment income under the tax law. This way you indirectly own and control Opco. While the Operating Company or Opco. is used to engage in day-to-day business, classified as active business income as per the tax law.

A major advantage of keeping the Opco (with active business income) is qualifying for preferential tax treatment i.e., small business deduction on the taxable profit earned, which substantially reduces the tax rate.

Advantages of a Holding Company

Asset Protection

If you run into financial difficulty or your company (Opco) is facing a lawsuit, the holding company provides an extra layer of protection by holding assets in the name of the holding company. In such cases, creditors or claimants will have access to assets only under the name of the operating company.

Similarly, if you are an investor, it makes a lot of sense to hold each investment (say real estate) separately in a holding corporation.

Assets or excess cash from Opco need to be transferred to Holdco, which can be done in a tax-efficient manner with proper planning involving a lawyer and an accountant.

Tax Savings & Deferral

Tax deferral is a strategy businesses and individuals use to reduce the taxes they pay in any given year. Under the Income Tax Act of Canada, intercompany dividends are considered tax-free. A holding company is used to protect assets by transferring extra cash by paying out a tax-free dividend to the Holdco.

In Holdco, you have the flexibility to determine the optimal timing for distributing dividends to shareholders based on their individual tax situation. And while the funds held in holding company can also be used for additional income-generating activities.

Ideal When You Own a Business with Someone Else

Holding a company is also ideal for the situation when an operating company is controlled by two individuals (or groups) and one shareholder desires immediate dividends, while the other wishes to avoid them due to being in a higher tax bracket. 

The operating company can declare dividends for both shareholders (or both groups), however, the person who does not want the dividend immediately, can receive a tax-free dividend through a holding co instead of taking the dividend in their own name. When the individual requires the money, the holding company can declare the dividend for the shareholder. This way this individual can independently control when the dividend will actually be included in his personal income regardless of when issued by the operating company.

Lifetime Capital Gains Exemption (LCGE)

Another major incentive for a Canadian Controlled Corporation (CCPC) is that the sale of shares of a qualified small business corporation (QSBC) qualifies for a lifetime capital gain exemption (LCGE). Simply put, any gain on the share of such a corporation is exempted from the tax up to $971,190 (the limit for 2023).

To qualify for this exemption a corporation needs to meet certain conditions including the following two:-

• 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 the sale.
• More than 50% of the fair market value of those assets must have been used in an active Canadian business during the 24 months immediately preceding their sale.

The use of a holding company helps in the qualification process by using a technique called the “purification” strategy. Using the purification technique, shareholders transfer assets not engaged in active business to the holding company. This often involves restructuring, setting up a new holding company, and transferring excess assets such as cash, investment, and rental properties to the holding company.

Claiming the LCGE can be more complicated with the involvement of a holding company and non-compliance with the rules may disqualify a shareholder from claiming the LCGE. This could lead to a significant unexpected tax bill from the CRA later. Therefore, it is recommended to take professional advice.

Investment Income

Generally, the income tax act does not treat investment income (passive income) favorably inside a corporation, there are still some tax planning and tax saving opportunities when holding investments through a corporation instead of personally.

The extent of these savings will depend on various factors, including the shareholder’s province of residence, age, corporate and personal income levels, etc.

Estate Planning or Estate Freeze

Another key benefit of a holding company is the ease of estate planning or estate freeze. Simply put, in the “estate freeze” process the original shareholders (typically parents) “freeze” their interest in the company (by exchanging the common shares of Opco with the fixed value preferred shares in Holdco) and new shareholders (typically children) come into ownership (by subscribing to new common share on a nominal value). As a result, any future earnings will be attributed to the ‘new’ shareholders.

This is one of the very important estate planning tools for business owners in Canada and is called an “estate freeze”.

Disadvantages of a Holding Company

Costs for a Holding Company

As for any type of corporation, a holding company comes with some cost which includes incorporation costs, annual filing (annual information return), annual corporate tax filing, and bookkeeping cost.

Administrative Challenges

Like an operating company, for Holdco, you need to maintain administrative discipline to stay in good standing with authorities for example timely filing of tax returns and annual information returns etc. This requires timely action and shareholders’ attention.

The Complexity of a Holding Company

Using a holding company is beneficial when worked out with a clear plan, but its use also adds a level of complexity. Surprisingly, business owners can lose track of how their assets are held or establish a holding company without knowing what they are going to achieve.

Potential for Higher Taxes

Having clear and well-thought-out objectives and purposes for utilizing holding companies is crucial; otherwise, it is possible to end up paying more taxes by holding investments in a corporation than by owning them personally.”

Conclusion

In Canada, a holding company provides various tax benefits and tax planning flexibility such as asset protection, tax planning, and business expansion. These benefits far out weight the cost of managing it.

However, establishing and managing a holding company requires careful consideration of legal and tax implications. Seeking professional advice from legal and financial experts is highly recommended to ensure compliance with regulations and to optimize the benefits of a holding company structure.

If you want to register a holding company or need assistance in evaluating whether a holding company is the right for you, please book a consultation session with our CPA for professional guidance. 

Source Accounting Professional Corporation (CPA) is a full-service accounting firm in Mississauga, helping business owners, investor, trading company, immigration consultants by providing tax preparation, corporate tax filing, accounting, bookkeeping services, payroll solutions, etc. If you are a business owner, trading company, or investor interested in leveraging tax laws through the establishment of a holding company, we invite you to give us a call at 647-930-8130.

Disclaimer: The above contents are provided for general guidance only, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. It does not provide legal advice, nor can it or should it be relied upon. Please contact/consult a qualified tax professional specific to your case.