There are a number of benefits of using a holding company in conjunction with an operating company including tax savings, to added creditor protection, to making a business more saleable.
The disadvantages of having a holding company include legal and accounting costs and the complexity associated with incorporating and maintaining the holding company.
In deciding on whether or not to use a holding company in an existing corporate structure, the shareholders must decide whether or not the various benefits outweigh the added costs and complexity involved. A full understanding of the potential benefits is key to making this decision as there will be some cases where a holding company may be quite beneficial and some cases where they may offer minimal benefit.
Tax Deferral and Income Splitting Opportunities
One of the more significant advantages of a holding company is the potential tax savings they may offer in the form of tax deferral and income splitting opportunities where this cannot be accomplished within the operating company itself. This can be the case where you have other shareholders who may not want your family members involved as shareholders and also because the other shareholders may have different goals on the distribution of surplus corporate funds. Having operating company shares owned through holding companies allows each individual shareholder to decide whether they want to flow the dividends paid out of the operating company through the holding company and out to themselves and possibly other family member/shareholders for income splitting purposes. Alternatively, they may want to leave some or all of the operating company dividends in the holding company to be reinvested without immediately triggering the personal tax liability. This allows flexibility with no impact on the operation or control of the operating company.
Profits from an active business earned inside an operating company are subject to a low corporate tax rate. These after corporate tax earnings can then be distributed to the shareholders in the form of dividends. If the dividends are received by an individual shareholder they are subject immediately to personal income taxes although such tax is reduced because of the corporate income tax already paid.
If, instead, the dividends are received by a holding company, and assuming the “connected test” is met, i.e., the holding company owns more than 10% of the voting shares and more than 10% of the value of the operating company shares, the dividends will flow tax-free between the operating company and the holding company allowing the entire amount of the dividend to be reinvested on a pre-personal tax basis. In Saskatchewan, this will result in up to an additional 33.3% of funds available for reinvestment within the holding company, with the personal tax liability deferred until the funds are actually needed for personal use. The timing of the withdrawal of the funds from the holding company, again in the form of dividends, can be controlled by the individual shareholder and taken out years into the future on a gradual basis to benefit from both the tax deferral and potential tax savings if they or other family member/shareholders are in a lower tax bracket at that time.
The holding companies can usually invest in anything that an individual can. The corporate taxation rate on investment income is however significantly higher than on active business income.
Asset Protection and Easier Sale of the Business
Even in the case where the operating company shares may be owned by one shareholder or family unit, it may still be advisable to use a holding company, as opposed to the operating company, to accumulate and reinvest the excess earnings. One of the significant advantages in this case is asset protection. By having the excess earnings from the operating company paid up as a tax-free inter-corporate dividend and reinvested in the holding company, these assets are out of the reach of potential creditors and liability claims arising within the operating company.
In many cases it may also be advantageous to hold the real estate used in the business in a separate holding company. Aside from the asset protection this provides from the operating company’s activities, it may also make the shares of the operating company more saleable where the potential purchasers are only interested in acquiring the true business assets and are fine with leasing the premises. This reduces the funds required to purchase the business, which is often significant when selling to key employees or family members who may have limited borrowing capacity. Oftentimes, the buyers will secure the operating company shares and lease the premises with an option to purchase after say, five years, once they are in a better financial position. If the buyer does want the operating company and the real estate initially, that is easy to facilitate and often takes the form of a share purchase of the operating company and an asset purchase of the real estate.
The Lifetime Capital Gains Deduction and Farm Corporations
Having the excess cash and investments in the holding company as opposed to the operating company, will also keep the operating company “purified” such that at least 90% of its assets are used in an active business and its shares may therefore qualify for the lifetime capital gains deduction.
Since the capital gains deduction is only available to individuals and not holding companies, if the holding company will be used to build up investments and if a sale of the shares with the use of the offsetting capital gain deduction is contemplated, the operating company shares should be owned either by individual shareholders or a family trust.
Farm corporations also have to meet a 90% test for certain purposes where at least 90% of the value of all assets are in the form of assets used in the business of farming. A holding company can be used to keep the farm company “purified” so that the shares can be transferred on a tax free basis to children or grandchildren with the inter-generation farm transfer rules.
If the shareholders are individuals, the purification can be done periodically however this involves a corporate reorganization for each purification and is most tax efficient where the parties are related so section 55 does not cause some immediate income tax.
A family trust can be used as the shareholder of the operating company or farm company and the holding corporation can be a beneficiary of the trust. This allows family members to also be beneficiaries and is very flexible for income splitting with dividends and can also be used to multiply the number of individuals that can use their capital gain deduction on a sale of the operating company shares. Excess cash in the operating or farm corporation can be flowed through the trust into the holding corporation so that the corporation is onside the capital gain deduction or intergeneration farm transfer rules.
Acquisitions including “bumping up” the tax cost of assets and Sale Planning
Holding companies also play a key role in business acquisitions and sales. They are often used as a vehicle to acquire shares of an operating company, followed by an amalgamation with that target company in order to allow the interest expense on the purchase loan to be offset against the operating profits going forward.
A holding corporation can also be used where the vendor wishes to sell shares of a corporation which has assets with high value but lower tax costs. If the majority of those assets are non-depreciable capital property, such as farm land, the tax cost of such assets can be bumped up on the merger of the two corporations. This causes a similar result for the purchaser as if the vendor had sold shares. The vendor may be able to access the capital gain deduction on the sale of the shares and the corporation doesn’t incur any income tax as it would if the assets were sold.
Holding companies are often used to defer income taxes on the sale of the shares of an operating company by taking advantage of the previously taxed corporate surplus and/or stripping out the redundant assets prior to the sale. This may be in lieu of, or in addition to, taking advantage of the lifetime capital gains deduction.
Old Age Security and other Income Tested Benefits
A holding corporation can be used to keep enough income at a corporate level such that taxpayers can avoid the claw back of old age security for high income earners. Other income tested benefits may also be increased.
Considering the use of a holding company is a complicated area that offers significant potential benefits and a few drawbacks, but requires careful planning to be positioned and used effectively.
Should you require additional information please contact your Chartered Professional Accountant.