Holding Companies – Issues to Consider

I have written several blog posts dealing with utilizing a holding company (“Holdco”) either directly as a parent company to your operating company (“Opco”) or indirectly as a beneficiary of a trust. These posts include:

Creditor Proofing Corporate Funds - This post discusses how a Holdco can protect surplus corporate funds and how for income tax purposes, the transfer of funds via a dividend from your Opco to the Holdco is in many cases tax-free (connected corporations).

Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company? - This blog examines some “fancier” tax planning to not only creditor proof funds, but allow for possible income splitting and multiplication of the capital gains exemption.

Corporate Small Business Owners: Beware; the Capital Gains Exemption is not a Gimme - This post explores the potential issues you may have in accessing the Capital Gains Exemption (“CGE”) including where your Holdco over time has accumulated too much cash and investment assets.

Because the concepts discussed in the blogs above are very complex (even for accountants), these posts have led to numerous questions by readers. In reading these questions, people are typically confused by the interaction of creditor proofing, income splitting and accessing the CGE, especially where they already have a Holdco in place with significant excess cash and/or investment assets. Thus, I thought today I would try and provide a bit of a road map for using a Holdco.

Working Backwards

Creditor Protection

The main reason small businesses owners typically consider using a Holdco in the first place is to creditor protect excess funds earned in their operating company. Most people find the concept of creditor protection (transferring cash and other assets from your Opco to remove the risk of someone suing Opco and making a claim on those assets) simple to grasp and in almost all cases; it makes business and income tax sense. Thus, I am assuming creditor protection is a given when considering using a Holdco.

Capital Gains Exemption

Where you do not think you can sell your business (the value of your business is just personal goodwill such as in a consulting business) a standard holding company often makes sense.

Where Holdco planning gets more complicated is when you want to ensure you have access to your CGE (while alive or when you pass away) and/or want to multiply the exemption and/or want to use your Holdco for income splitting purposes. The key concept to understand here is that; to access your CGE you or a family member must personally sell the shares of your Holdco (since you own the shares of your Holdco which in turn owns your Opco) and Holdco must meet various criteria to qualify for the CGE. If you have your Holdco sell the shares of your OPCO, there is no CGE, since it is a corporation selling, not an individual.

Situations Where you do not Currently have a Holdco in Place

If you currently own 100% of your Opco or own your Opco together with your spouse, you have a couple decisions to make before incorporating a Holdco.

Again, assuming creditor protection is a given, you need to determine if you think you will be able to access the CGE in the future. If the answer is no, you will probably be fine with a garden variety Holdco (Holdco owns 100% of Opco) especially if you already own Opco with your spouse.

Where you own Opco 100% personally and do not think you can access the CGE, you may want to give consideration to freezing (value of Opco is “frozen” at the current fair market value and you get special shares worth the frozen value) Opco and bringing your spouse in as a shareholder in Holdco. Again, in this situation, you would probably just use the typical Holdco/Opco structure with Holdco owning Opco 100%; however, you would have to concern yourself with ensuring you are not subject to punitive income tax rules, for which you would need income tax advice.

No Holdco in Place, but You may be able to Sell your Company in the Future to Access the CGE

Where you think your corporation is saleable to an arm’s length person in the future, the standard Holdco/Opco structure may not be appropriate, as damming cash in your Holdco may put your ability to claim the CGE in jeopardy.

In these cases, subject to your specific circumstances and only after consulting with your tax advisor, you may use either taxable dividends, stock dividends, an estate freeze or some kind of butterfly (a reorganization in which non-qualifying assets are transferred on a tax-free basis to a newly formed corporation, provided that no sale to an arm's length party of the shares of the small business corporation is contemplated at the time of the reorganization) to provide a structure that will allow Opco/Holdco to either constantly remain onside the criteria for the CGE or at least provide a mechanism to stay onside. Based on the recent Federal budget, your advisor may have to concern themselves with your company's safe income, in addition to the punitive rules I noted above.

As discussed in the “Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company?”, where you have children (especially teenage children or older), it will often make sense to “freeze” the current value of your operating company to you and/or your spouse (if they have original ownership in the Opco) and have a family trust (with a holding company as a beneficiary of the family trust) as the parent of Opco.

Excluding the cost of undertaking this transaction, this structure can provide for multiplication of the capital gains exemption, income splitting (many parents use this structure to tax effectively pay for University) and creditor protection. The nuance here is that the Holdco is not the parent of Opco, but a beneficiary of the trust and therefore is not an impediment to accessing the CGE in the future. Once again, there are punitive tax rules to be wary of and tax advice is essential.

What if I Have a Holdco already in Place?

In situations where you already have a Holdco in place with significant assets, your planning is very complicated and fact specific and beyond the scope of this post. However, typically, subject to your specific fact situation, your advisor will likely suggest either a butterfly, freeze transaction, payment of a taxable dividend or use of a stock dividend that will allow for potential access to the CGE in the future. In cases of a freeze, this may mean you will be required hold the shares at least two years to qualify for the CGE.

I have attempted in this post to provide a bit of a road map for using a Holdco or a variation of a Holdco. However, this topic is extremely complex and fact specific and as such, I have not even got into the various punitive income tax provisions such as the corporate attribution rules amongst the various other punitive rules.

Thus, I cannot stress enough, that this entire blog is simplified and that you should not even consider undertaking any kind of Holdco planning without receiving tax advice from your accountant or tax lawyer.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Corporate Small Business Owners: Beware; the Capital Gains Exemption is not a Gimme

One of the biggest misconceptions small business owners have is that they have automatic access to the $800,000 capital gains exemption (“CGE”) upon the sale of the shares of their corporations (Note: beginning in 2015, the $800,000 will be indexed for inflation). Nothing can be further from the truth. There are three complex tests that must be met in order to qualify for the exemption and something as innocuous as imposing a holding company (with significant cash and investment assets) between you and your operating company may disqualify the shares.

Warning!!! Before I move forward, please note that I am “dumbing down this post”. You may think it complex, but I am leaving out significant issues, definitions and details to make it somewhat readable. Do not rely upon this blog for your capital gains planning, use it only to gain an understanding of the issues and please contact your tax advisor before undertaking any planning discussed in this post. In fact, to emphasize the complexity of this issue and how intricate and fact related the planning is, I will not answer questions and respond to comments on this post. Sorry about that.

The Capital Gains Exemption

In order to access the CGE, the shares you sell must meet the definition of a "qualified small business corporation share” (“QSBC shares”). Sounds simple, but this provision and the related provisions often prove to be a tax quagmire for many practitioners.

The shares must meet three tests to be considered QSBC shares and become eligible for the CGE.

Small Business Corporation Test

At the time you sell your shares, they must be shares of a Small Business Corporation (“SBC”). A SBC, amongst other criteria, must be a Canadian-controlled private corporation whereby all or substantially all (meaning 90% or greater) of the fair market value (“FMV”) of the assets of which at that time is attributable to assets that are used principally in an active business carried on primarily in Canada.

In plain English: at the time of the sale, the company must be using a minimum of 90% of its assets in carrying on an active business in Canada. In other words, if you have more than 10% of the FMV of your corporation in passive assets such as cash, stocks, rental real estate, you may be offside the rule.

It is important to note that the Goodwill (which is often the largest asset) of a business will count as an asset used in an active business. However, generally cash, portfolio investments and intercompany loans will not qualify as active assets.

Holding Period Ownership Test

This test requires that the shares cannot have been owned by anyone other than the individual or a person or partnership related to the individual, throughout the 24 months immediately preceding the disposition time. The two year test is very confusing. It is a rule that at its core is intended to prevent anyone not related to you from holding the shares within the last two years. However, on one hand the 24 month rule provides for exceptions such as if you transfer a proprietorship or partnership to a corporation, yet if you incorporate a new company and hold the shares less than 24 months, you will be disqualified.

In plain English: in most cases you will be required to have held the shares two years prior to the sale.

Holding Period Asset Test

If you thought the above rules were complicated, this test makes the other rules seem simple.

This test requires that throughout the 24 months immediately preceding the sale, more than 50% of the FMV of the corporation's assets must have been attributable to assets used in an active business. For this purpose, assets considered to be used in an active business consist of:

1) Assets used principally in an active business carried on primarily in Canada by the corporation or a related corporation;

2) Certain shares or debt of connected corporations; and

3) A combination of active business assets or certain shares or debt of connected corporations

In plain English: at least 50% of the company’s assets must have been used in an active business throughout the two-year period prior to sale.

Where you have a holding company ("Holdco") or stacked companies (Holdcos owning Holdcos) ultimately owning the shares of an operating company, the threshold percentage for meeting the Holding Period Asset Test may become 90% instead of 50%. These rules are far too complicated to discuss, suffice to say, if you have a chain of companies, at least one of the companies in the chain must meet the 90% threshold percentage over the two-year period.

As you can see, the CGE is no gimme. You need to ensure you hold the shares 24 months, at the time of sale 90% of the assets are used in an active business and over the prior 24 months, 50% (in some case 90%) of the FMV of the assets were used in an active business.

Traps and Obstacles

Holding Companies

Many small business owners utilize a Holdco for creditor proofing, which is often recommended. However, over years the Holdco may end up owning substantial investment assets. These assets may be problematic for the following reasons:

1. Since Holdco owns your operating company ("Opco"), you have to sell your holding company shares to a buyer to qualify for the CGE and if you have substantial assets, you need to remove them prior to a sale. This may trigger a substantial tax liability and/or cause the shares to fall offside the QSBC rules.

2. Many people use their Holdco to hold the shares of other corporations. This is very problematic when you want to sell your shares of Company A, but your Holdco not only owns Company A, but also owns shares of Company B and Company C. How do you get the shares of Company B and C out of your Holdco prior to the sale? The answer is - not easily.

As I have written in prior blogs, I often suggest rather than automatically interposing a Holdco between you and your Opco, you may wish to consider using a family trust with a corporate beneficiary (a Holdco typically owned by you). Thus, instead of the cash being plugged up in your Holdco and potentially putting you offside the QSBC rules, your Opco pays a dividend of the excess cash to your family trust which in turn allocates a tax-free dividend (in most cases) to the holding company beneficiary of the family trust.

This is a very subtle point, but now instead of having the dual problem of your Holdco company potentially having too many investment assets and/or you needing to sell your Holdco shares to access the capital gains exemption, you can now just sell the Opco shares, as the operating company is owned by the trust. The Holdco company even if it has accumulated substantial assets, is not part of the three CGE tests as it has no direct interest in the company being sold.

Safe Income

I have no desire to get into this complicated issue. However, where a Holdco or Opco has other assets such as excess cash, shares in other corporations or real estate that a purchaser does not require, it is often necessary to transfer these assets out of Opco or Holdco (known as purification). This is often done by cross share redemptions that result in dividends. All you need to know for purposes of this post is that if an operating company pays a dividend to another corporation in contemplation of a sale and the dividend exceeds the recipient’s proportionate share of safe income (in very simple terms, retained earnings of the dividend payer) the excess portion becomes a taxable capital gain. This can be very problematic when you are trying to purify your corporation of excess assets prior to the sale to qualify for the CGE and you definitely require your tax advisor's assistance.

Cumulative Net Investment Loss

The Cumulative Net Investment Loss (“CNIL”) account tracks an individual’s net historical investment income. Essentially it is the sum of your investment income, such as interest and dividends, less investment expenses such as interest expense, carrying charges, losses from limited partnerships and resource deductions from flow-through shares. If the cumulative balance is negative, this balance restricts access to the CGE. The negative balance can in many circumstances be eliminated by having your company pay you a dividend prior to any sale, subject to the safe income rules noted above.

Allowable Business Investment Losses

An Allowable Business Investment Loss (“ABIL”) typically results from capital losses on shares and debt in private Canadian corporations. If an individual has realized an ABIL in a prior year, it will reduce his or her CGE available to claim. Thus, you need to confirm if you have ever made such a claim prior to utilizing your CGE.

Insufficient Dividends

This issue is way beyond the scope of this article, however, where it is reasonable to conclude that a significant portion of the gain is attributable to the fact that a minimum amount of dividends has not been paid annually on any class of shares in the corporation, other than classes of "prescribed shares”, the CGE can also be restricted. Ask your accountant if this is an issue for you.

Planning

Prudent planning would suggest that you and your advisor consider these rules far in advance of any potential sale, so you can monitor whether your corporation is onside the rules. Where the corporation falls offside you can “purify” the corporation of any offending assets. Purification should be ongoing, because if you have to purify at the last minute, there is a good chance you will not meet the various criteria to qualify for the exemption.

If you are still with me, I am sure you will agree that you should never assume your corporation’s shares will qualify for the CGE. The morass of rules requires you and your advisors to carefully navigate the rules to ensure your shares will qualify when you decide to sell your corporation.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Using a Corporation to Hold Your Investments

In December 2011, I wrote a post titled “Should your Investment Income be Earned in a Corporation”. Notwithstanding this post, I continue to receive questions and emails on two related topics:

1. Readers who are earning substantial personal investment income ask; should they transfer their investments into a corporation?

2. Small business owners with excess investable assets inquire if they should incorporate a holding company to hold the shares of their existing active corporation’s? An active corporation is a corporation that carries on a real business (manufacturing, providing services, etc.) that does not earn rental income (see exception below), royalties, interest, dividends or capital gains.

Based on these questions and the fact that my clients who have corporations that earn investment income, either ask me to “explain this again” each year or just roll their eyes, when I discuss the taxation of investment income, I figured I would give this topic one more try.

Please note that all tax rates noted below ignore (figuratively and literally) the May 1st Ontario Budget.

Reasons to Incorporate Investment Income

For income tax purposes (as I detail below), there are essentially no reasons to incorporate investment income. However, there are several non-income tax related reasons for which it may make sense to incorporate your investment income.

1. Creditor Proofing - If you have an active corporation (“Opco”), you can protect your cash and retained earnings from creditors (assuming this is not a fraudulent conveyance) by paying any excess cash or retained earnings as a dividend to a newly formed Investment Holding Company (“Holdco”). As long as the Holdco is connected to the Opco for income tax purposes (simplistically, owns greater than 10% of Opco), any dividends can be paid tax-free to Holdco.

This allows you to use tax-deferred funds to invest (i.e.: in Ontario, the small business rate is only 15.5%, so potentially you may defer and have 31% more funds to invest [46.46% high non-super tax rate if you earn income personally-15.5% corporate rate]). Once the excess funds have been transferred and your Holdco earns investment income on these funds, the tax is essentially the exact same amount you would have paid if you earned the income personally. Thus you have no significant tax savings by using a Holdco to earn investment income, the main benefit is creditor proofing. [Note: For fancier planning, you may be able to use a family trust to own Opco and have a holding company as a beneficiary of the family trust].

2. U.S. Estate Tax - if you own U.S. securities, you can avoid U.S. estate tax by moving these securities into a Holdco. However, again there are no actual Canadian income tax savings.

3. Rental Properties- Many people incorporate their rental properties. However, unless you are a large rental operation with more than five employees, the only reason to do this is for creditor proofing in case a tenant or visitor to the building sues you.

There may be a couple other reasons, but these are the three main reasons people use a Holdco for their investment income.

Double Taxation

The utilization of a Holdco is potentially problematic when you pass away. The reason for this is that upon death, you are deemed to dispose of your Holdco shares on your final terminal tax return for their fair market value (unless they are left to your spouse). So you pay tax upon your death on the value of these shares. However, when your estate starts selling the individual securities in Holdco, the Holdco has to pay tax on the same securities you paid tax upon on your final return, a double tax. In order to avoid this result, fancy tax planning is typically undertaken, which can be costly and cumbersome.

Why There are no Tax savings

If you read my December, 2011 post, you will realize that the reason there is no benefit to incorporating your investment income, is because of the extra layer of tax imposed by a refundable tax known as RDTOH (“Refundable Dividend Tax on Hand”).

As I mentioned above, I have been unsuccessful in trying to explain this RDTOH mechanism to my clients, and have now taken a new simpler approach which I will use below.

My examples will use a high-rate Ontario taxpayer (not super-rate) who pays tax at the rate of 46.41% on any interest income earned, 29.54% on eligible dividends and 23.2% on capital gains.

Interest

If you use a Holdco and earn $1,000 in interest income, you would pay the following corporate income tax:

Non-refundable corporate tax $195

Refundable tax $267

Total Tax $462 (46.2%)

As I note above, a high-rate Ontario taxpayer would pay 46.41% on interest income. Thus, for all intents and purposes, there is no benefit to incorporating investment income to earn interest income as the corporate tax rate is almost exactly the same as the personal rate. Further the administrative costs (especially the costs paid to your accountant) of maintaining a corporation would also impact negatively on the use of  a corporation.

Eligible Dividends

If you use a Holdco and earn $1,000 in public company dividends, you would pay corporate tax as follows:

Non-refundable corporate tax $0

Refundable tax $333

Total Tax $333 (33.3%)

As I note above, a high-rate Ontario taxpayer would pay 29.54% tax on an eligible dividend. Thus, the corporation pays more tax initially and there is no benefit to incorporating eligible dividend income (or non-eligible dividend income). However, when a dividend is paid by Holdco, the refundable tax is refunded by the CRA and the taxpayer ends up with an actual tax cost of 29.54%, so there is not an extra tax cost, just an initial disincentive to incorporate dividend income.

Capital Gains

If you use a Holdco and earn $1,000 in capital gains, you would pay corporate tax as follows:

Non-refundable corporate tax $98

Refundable tax $133

Total Tax $231 (23.1%)

As I note above, a high-rate Ontario taxpayer would pay 23.21% on a capital gain. Thus, again, for all intents and purposes there is no benefit to incorporating capital gain income, as the corporate tax rate is almost exactly the same as the personal rate.

I hope I have done a better job simplifying this complicated issue so I don’t have to revisit this issue again in the future; if not, I cry uncle anyways.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.