As a business owner, you strive to make your business profitable. Unfortunately, when it begins to generate excess cash, the Canada Revenue Agency (CRA) lays its tax claws on your profits. But there are many ways to reduce the tax paid on these profits, and one of them is a holding company. As the name goes, a holding company is commonly used to hold assets, real estate, shares, and any other investment or income on your behalf in a tax-free manner.
This article will talk about how a holding company works and how it can help you save on taxes under certain circumstances.
How a Holding Company Works
In Canada, the individual tax rate is higher than the corporate rate. So, if your marginal tax rate is high, it makes sense to find a way to have excess funds charged at the corporate rate instead of the personal. This is when a holding company may be an effective solution.
Your primary business, the one generating the profit by doing business, is referred to as your “operating company.” In contrast, you can establish a holding company to “hold” shares and other assets of the operating company to earn passive income like dividends, rent, leasing, and management consulting services. A holding company has no active operations or income, but it is the parent of the operating company as it holds voting shares.
Since a holding company is a separate entity, it will be free from any credit risk faced by your operating company or you as an individual. This holding company structure brings potential benefits like tax deferral and savings, asset protection and can also help make estate planning easier.
How to Defer Tax Using Holding Company
An operating company pays dividends to its shareholders at regular intervals. As a business owner, it is taxable when you withdraw the profit through dividends. But the Canada Revenue Agency (CRA) applies no tax on a transaction between two companies until you withdraw that money in your personal capacity.
Hence, if your business is generating excess cash, you can withdraw those earnings in the form of dividends and pay them to the holding company. You won’t be taxed until you personally withdraw the income from the holding company. This transaction serves two purposes:
- It gives you the flexibility to determine when to withdraw the funds, and pay tax, in your personal capacity. You can opt to withdraw the money at a later date when your marginal tax rate is low (probably retirement), thereby allowing you to defer income tax.
- It leaves you with the complete dividend amount (before tax) at your disposal for reinvestment in other assets. For instance, the holding company can invest the funds or purchase income-generating real estate with the funds.
How to Save Capital Gains Tax Using a Holding Company
A holding company also enables you to take advantage of the Lifetime Capital Gains Tax Exemption (LCGE) by “crystalizing” the value of shares at a time when they still qualify for the exemption. Capital gain refers to the profit generated by the sale of capital property, including real estate or company shares. The CRA levies capital gain tax on 50% of the capital gain, but the LCGE provides an exemption from the tax on up to $892,218 (as of 2021). This is a lifetime amount available to those who meet the necessary eligibility requirements. As demonstrated below, a holding company can allow you to trigger the LCGE at a financially beneficial time, which can offer considerable tax savings.
Let’s say you hold 10,000 shares of a Canadian-controlled private corporation (CPCC), and each share is valued at $10.00. Over the years, the corporation flourishes, and the price of the shares rises to $1,000, increasing your holding to $1 million. You choose to sell your shares to a third party for a profit of $990,000. The CRA would ordinarily calculate your capital gains tax on $495,000 (50% of the gain). But the LCGE provides an exemption from tax on $892,218 (assuming you have not used any part of your lifetime exemption to date). Therefore, the CRA will only tax $97,782, presenting significant tax savings on the transaction.
This is where the holding company comes into the picture. If you find that the value of shares is inching close to the LCGE limit, you can trigger the exemption by transferring the shares to the holding company and using the exemption to reduce or eliminate taxes on the transfer. This will ‘lock in’ the value of those shares at that price, so you will not need to pay tax on a transfer later.
Things to Consider Before Setting up a Holding Company
Setting up a holding company can effectively save tax if you have excess cash and assets that might attract a high tax rate. It also provides non-tax-related advantages like credit protection and estate planning.
But setting up a holding company entails significant costs, such as incorporation fees, the cost of preparing financial statements, and legal and compliance expenses. Some amendments may be required if the operating company’s share structure does not support a holding company. You must ensure that the company’s tax benefits will outweigh, or justify, the related expenses.
Contact Glenn Graydon Wright LLP for Experienced Advice on Personal and Business Financing and the Related Tax Implications
When deciding whether a holding company could benefit you from a tax or financial perspective, it is best to consult with a qualified tax professional. The tax and business advisors at Glenn Graydon Wright LLP can help you identify the most tax-efficient way of borrowing money. Contact us today by phone at 905-845-6633 or reach out online.