There are numerous tax planning strategies through which shareholders of privately-held Canadian companies can defer, minimize, or even eliminate tax liability. Here we discuss the concept of holding company and how it can help achieve these goals.
What is a holding company?
A holding company (holdco) is incorporated for the sole purpose of holding investments (passive assets) - i.e. stocks, bonds, real estate. Holdco is not used to operate a business of any kind.
Tax planning strategies
Inter-corporate tax-free dividends
An individual shareholder who receives a dividend from a corporation pays personal tax on that dividend in the year it is received. Regardless of whether one shareholder wants a dividend distribution in the current year, the amount will be paid to all shareholders at specified dividend payment date. This can unnecessarily put a shareholder(s) in a higher marginal tax bracket, and potentially create discord between them.
To minimize negative tax implications for shareholders and preserve harmony amongst all, each shareholder can setup their own holdco. Doing so would provide autonomy to all shareholders as to when they want to receive the dividend personally.
How it works?
Each shareholder would setup their own holdcos which would own their respective percentages of shares of the operating company (opco). The dividend payment from opco would then be transferred to each shareholder’s respective holdcos; this would be a tax-free intercompany dividend transfer. Thereafter, each shareholder has the option to defer the dividend payment to a future year (leave dividend in the holdco or invest the funds through the holdco) or take it out from their holdco right away. It is only when dividend is taken from the holdco, is when the shareholder would pay tax on it at their personal tax rate.
Lifetime Capital gains exemption (LCGE)
LCGE can possibly allow shareholders of most privately-held companies to pay no tax on capital gain (up to an amount of $883,384 for 2020) upon the sale of their business. However, to qualify for the LCGE the following three criteria must be met.
- At the time of sale, 90 percent of the FMV of the company’s assets must be used in an active business carried on primarily in Canada.
- In the 24 months preceding the sale of business, more than 50 percent of the FMV of the company’s assets must have been used in an active business carried on primarily in Canada.
- The shareholder of the company (or their spouse or child) must have owned the shares for at least 24 months prior to the date of sale.
Although the concept of holdco is irrelevant to the third criteria, setting up a holdco can help in “purification” of the assets and satisfy first and second criteria.
How it works?
A holdco is setup 24 months prior to the anticipated sale of the business. Over the course of these 24 months, it should be ensured the assets actively being used in opco are not less than 50 percent of the total assets. If for some reason active assets decline below the 50 percent threshold (for example, appreciation in value of passive assets in proportion to total assets), the excess assets should be transferred to holdco. This would “purify” the assets and allow the operating company to be compliant with the 50 percent threshold. Same procedure can be used to satisfy the 90 percent threshold at the time of sale.
Estate freezes
A holdco can be used to implement an estate freeze. Estate freeze is used to “freeze” a company’s share value and pass on the future growth of the company to future generations or another beneficiary.
For professional advice, contact Alpha Accountzy, Accounting & Tax Solutions.
