Most business owners are well aware of the significant income tax savings that can be achieved from having business profits taxed inside a corporation rather than at the personal level.  The 2008 corporate tax rate on business income earned inside a corporation and eligible for the small business deduction is 18.3% (Federal and Ontario rates combined).  This rate is only one-third of the 44% top bracket tax rate paid at the personal level.  As after-tax business profits are earned and accumulated inside a corporation, shareholders need to consider both the tax and non-tax benefits that can be gained from using holding companies in their corporate structures.

In most situations a “holding company” is placed between the operating company and the individual shareholder.  One of the foremost principles of Canadian taxation is that dividends are allowed to flow on a tax free basis from one corporation to another.  Accordingly, after-tax profits accumulated in the operating company can generally be distributed to the holding company as tax-free dividends.  Funds transferred to the holding company in this manner are better protected from the claims of the operating company’s creditors, as unfortunately, a lifetime of accumulated profits can vanish in one single liability claim.  Use of a holding company to reduce this type of exposure is especially attractive to companies where the risk of law suites or litigation is significant.

The retention of business profits that are not reinvested back into the business generally results in the operating company accumulating significant amounts of investments.  These investments are likely to be considered as not being actively used in the company’s business.  An accumulation of such investments to the point where they represent greater than 10% of the value of the operating company’s assets will cause the company to lose its status as a “small business corporation”.  Only shares in a “small business corporation” are eligible to receive the $750,000 capital gains exemption in the event of their sale.  A dividend payment to the holding company allows the investments to be removed on a tax-free basis and thereby allowing the operating company to maintain its “small business corporation” status.  However, the dividends may be subject to tax if they are paid as part of the same series of transactions as the sale of the operating company shares to an arm’s length purchaser.  The consistent and periodic payment of dividends between companies may avoid this problem.

A holding company can also be used to retain ownership of the real estate assets of a business.  Besides protecting the equity in the real estate from the risks of unforeseen litigation, the isolation of the real estate in the holding company provides more flexibility in determining whether the future sale of a business will be a share sale or an asset sale in situations where it is possible the business assets (other than the real estate) may be sold.  The removal of the real estate also reduces the price of the operating company thereby making the sale of the shares more feasible and more affordable.

In corporate structures that have two or more shareholders, a holding company also adds more flexibility as to the timing of dividend distributions to individuals.  Any shareholder not wanting to be taxes personally on a dividend paid by an operating company can simply leave the dividend in their holding company.

Separate holding companies for each shareholder also allow the shareholder’s family members to participate in the holding company rather than directly in the operating company Arm’s-length business partners are often reluctant to have their partner’s family members participate in the operating company.  As well investment and business decisions can be made in each holding company both privately and independently from the interest of the other operating company shareholders.

Although cost and complexity are somewhat increased in a holding company structure, both the tax and non-tax benefits will usually justify the use of this very important tax planning tool.

If you have any questions on how Holding Companies can benefit you, call Joe Truscott today at 905-528-0234 or email Joe at [email protected].