Canada: Holding Companies Demystified

As tax professionals, we are often asked by clients to explain the concept and appropriate uses of holding companies. The answer generally is not straightforward; a variety of tax and commercial factors are relevant in any particular case. Though it is beyond the scope of this article to provide a complete list of potential benefits and drawbacks, an introduction to several key issues will be examined.

Creditor proofing and asset protection

For many businesses experiencing growth and increased profitability, it is not uncommon for excess cash and/or investment assets to accumulate. Shareholders often overlook the fact that these assets are now subject to claims from existing or future creditors. This should be a significant concern for those operating in historically litigious environments. One solution is to transfer any non-essential assets on a tax-free basis to a holding company, thereby providing a degree of protection from creditors. There are several structuring options available to transfer these assets that can be customized to specific client situations.

One typical concern is that the operating corporation may need to access these assets in the future (i.e. in the event of a cash shortfall). Should the need arise, funds can be loaned back to the operating entity on a secured basis, thus maintaining priority over unsecured creditors and still affording a degree of asset protection.

Capital gains exemption planning

When shares of a corporation meet certain criteria, individuals resident in Canada throughout the year may be able to shelter $800,000 of capital gains from taxation. This can result in pure savings of up to $200,000 in income tax. If a business is marketable and a share sale is a possibility, maintaining access to this exemption is an important consideration within the overall tax plan. 

Should a corporation hold excess cash or other assets not used in the active business of the company, it might not meet the criteria noted above and thus would not qualify for the exemption. If a holding company is introduced into the structure, it may be possible to transfer these assets on a tax-free basis and maintain eligibility for the exemption. 

Compensation flexibility

It is not uncommon for companies with multiple shareholders (e.g. siblings, arm's-length parties) to face challenges with owner-manager remuneration. Whatever ultimate compensation structure is established, equitable tax consequences are often overlooked. For example, assume Mr. A and Mr. B are each 50 per cent shareholders of a company. They have agreed to total annual compensation of $250,000 each. Now assume Mr. A is married and has four children, all attending university. Their education expenses are to be financed by Mr. A. As a result, it is anticipated that Mr. A requires the majority of his $250,000 (after tax) to satisfy these and other living expenses. Mr. B is married and has no children. His wife is employed at an annual salary of $100,000. It is anticipated that Mr. B requires only $50,000 to maintain his desired lifestyle. If both Mr. A and Mr. B were Ontario residents and received a $250,000 salary (without considering personal tax credits, individual specific deductions, etc.), each would be liable for approximately $95,000 in personal tax.

In the above fact pattern, it does not seem equitable to subject Mr. B to such a high effective rate of tax given he does not require the funds for personal purposes. By establishing holding companies for each of the shareholders and adjusting the compensation structure to some form of dividend/salary mix, it may be possible to defer indefinitely a large portion of Mr. B's $95,000 personal tax liability.

Income splitting

A holding company can be an effective tool for income splitting with adult children. Generally speaking and in combination with other planning steps, it may be possible for the children to subscribe for shares of the newly incorporated holding company for nominal consideration. Dividends can then be paid from the operating entity to the holding company on a tax-free basis and ultimately paid out to some or all of the adult children at the discretion of the directors. An individual resident in Ontario with no other sources of income in 2014 can receive approximately $35,000 of non-eligible dividends and $49,000 of eligible dividends free of tax. Bear in mind certain anti-avoidance and attribution rules require analysis prior to proceeding with this plan to ensure negative tax consequences do not result.

Conclusion

Holding companies continue to be effective tools for achieving tax and commercial objectives in Canada. The discussion above provides an introduction to several significant benefits that can be realized. These benefits should be weighed against the ongoing administrative and professional costs involved. As with any corporate restructuring, technical analysis is required to ensure the proper plan is implemented and potential risks identified and mitigated as appropriate.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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