Understanding Holding Companies in Canada

If you own small, medium or large business, you may have heard of holding companies and wondering if it makes sense to incorporate a holding company for your business. Let's understand what a holding company is and when you should consider putting one into place.

What is a Holding Company?

As a small business owner, you are carrying on daily business activities through an operating company that is used for running primary business such as restaurant or a law firm. On the other side, a holding company is an incorporated company that does not provide goods or services, but primarily used to hold investment in an operating company.

What are the benefits of a Holding Company?

As a small business owner, there are number of reasons for you to consider using a holding company to own shares of your operating company. Some of these benefits include:

Asset Protection

As a business owner, you need to ensure that your company assets are protected in the event that something happens to your operating business. Even if a business is very successful, events such as lawsuit, bad contracts or recession can take a healthy business into downward spiral or even bankruptcy.

In case there is a lawsuit against your business or you are not able to pay business debts, creditors will look at other ways to settle their receivables. Generally, creditors will file a lawsuit again your operating business and will demand to take your assets, including taking away land, building, equipment, vehicles or any other assets within the business that can be sold to pay off the debts.

Every business is exposed to certain level of risk through daily business activities, therefore, the legal structure by which you hold your assets and operate your business can be an important planning consideration. By putting operating company assets in a holding company, you are adding a layer of protection to those asses in case creditors come after your business.

Tax Savings

Everybody wants to save more of their hard earned money and pay less in tax. If you are holding investments that earn interest income, you should consider doing so using holding company rather than personally. This tax strategy can have significate tax savings because the corporate tax on the investment income is generally lower than the personal tax rate.

Other tax benefits may arise through the use of a holding company in an acquisition. If you are purchasing a new business, you may want to consider acquiring the business using a holding company rather than doing so personally.

Tax Deferral

Tax deferral is a tax planning strategy for individuals who earn high income in current years and want to defer some of the income to later years, either when they retire or in a year with low income, to reduce taxable income and tax payable. A holding company can provide flexibility around the timing of when dividends are distributed to shareholders. Let's walk through an example.

ABC corporation is a law firm in Toronto operated and owned by two individuals: Tom and Jerry. The firm is owned equally by these two individuals. In 2020, the firm has declared and issued dividends of $300,000 to each of the owner. For more on dividends: Read our Salary vs Dividends article.

Both shareholders are in a very high tax bracket for 2020 tax year. Let's assume that Tom does not need the funds in the current year, a tax strategy for him would be to defer receiving the dividends from his business to later years. Unfortunately, the firm has already declared and issued dividends in 2020 and as a result, Tom will have to pay tax at high marginal rate unless he has a holding company in place.

If Tom wants to save on taxes in 2020, he needs to have a holding company that holds his share in ABC Inc. Now, Tom is allowed to transfer some or all of the dividends issued by ABC Inc. to his holding company. Any amount that is transferred from operating company to holding corporation is exempt from paying any taxes on the transfer because there are tax rules allowing for tax-free dividends between Canadian Controlled Private Corporations in Canada.

Tom can keep the dividends in holding company as long he wish and pay himself in the year

with low overall income to reduce tax payable.

Lifetime Capital Gains Exemption (LCGE)

For many Canadian small business owners, LCGE is one of the most valuable tool to help them save for retirement or invest more in another small business. If you are the owner of a Canadian-controlled private corporation (CCPC) that is a qualified small business corporation, LCGE allows you to offset capital gain on the sale of your business. This means when you sell your small business for a profit, the lifetime capital gains exemption (LCGE) can be claimed to offset some or all of the profit you've earned. In 2020, LCGE limit is $883,384. Let's walk through an example.

You own a farm that meets the qualified small business corporation criteria and you end up selling your farm in 2020 and make a $1,000,000 in profit or capital gains (same thing). Without the LCGE, you would have to pay taxes on the profit that you earned from the sale of your business, however, since your farm business meets CCPC and QSBC requirements, LCGE allows you to subtract $883,384 from your profits in 2020. This means that you only pay taxes on ($1,000,000 - $883,384) x 50% = $58,308 rather than on $500,000.

In order to qualify as a small business corporation, your business must meet specific criteria to be able to claim the Lifetime Capital Gains Exemption. To determine if your company meet these criteria there are three tests. First test is called Asset Test and it looks at the timing of the sale of your business and your business should be using at least 90% of the corporation’s assets to carry on active business at the time of the sale. Under the second test, which is called Basic Asset Test, your company should be using at least 50% or more of the it's assets in active business for the entire 24 month period before the sale. For the third test, you as an owner must hold shares of the company for at least 24 months before the date of the sale.

How does LCGE relate to holding companies?

If your business is quite successful and you are investing excess cash to hold certain investment accounts, your business might not satisfy these tests and therefore, you may not qualify for the LCGE upon sale of your business. You should consider incorporating a holding company and own some of the shares of the operating company. This would allow you to transfer the excess cash through a tax-free dividend to the holding company and let holding company invest the cash in investment accounts instead.

In conclusion, you should have high level understanding of what a holding company is and the use of putting once in place. Our firm has many years of experience assisting small business clients with tax planning strategies to maximize tax savings. Get in touch if you require accounting and tax services and we will be happy to help!