In Canada, as other places in the world, the smaller businesses have a low survival rate, more specifically small businesses and medium sized businesses. Industry Canada claims only 51 percent of these sized business are able to survive and last longer than five years. Efficient planning from a tax perspective, by using holding companies, is one of the factors that attribute to the successful endurance and survival of these businesses.
What is a holding company or Holdco? Basically a Holdco is the company that owns the operating company. It is also used as a vehicle to minimize taxation with thorough tax planning. Some of the potential benefits to a Holdco includecreditor protection, tax efficiency,succession or estate planning and income splitting. The operating company carries on with its normal day-to-day active business, which results in earnings. The earnings are paid out as dividends to the shareholders of the operating company. The shares of the operating company are owned by the Holdco, and as shareholder the Holdco receives the dividends from the earnings of the operating company. These funds are then used by the Holdco to safely secure the funds, or to reduce risks by diversifying investments.
One of the benefits to a Holdco is tax efficiency. This advantage is demonstrated by using the example of an owner of a business with a significant portion of net income.An inter-corporation dividend transfer is a methodthat can be used to move earnings, tax free, from the operating company to the Holdco. The passive income of the Holdco’s assets will be taxed according to the relevant rate, but the individual is not taxed until distribution. The owner of the business wants to keep the small business status when the operating company becomes successful. To do this, the business owner needs to take the retained earnings, which has now become excess funds, out of the operating company. The reason being, that of the assets, minimum ninety percent are used in earning active business income. Therefore, he takes out the retained earnings by transferring these funds to the Holdco. In the event that the operating company requires funds at a later stage, the Holdco loans the secured funds to the operating company.
Another advantage is that the Holdco is used for the purpose of deferring tax. For example, XYZ is a small business, situated in Quebec. The income XYZ earns is $500,000, the maximum allowed to keep the reduced rate of “small business deduction”. This active business incomewill be taxed at the rate of 19%, for both provincial and federal levels, which is equal to $95,000. The amount that remains is $405,000, and these funds are transferred to Holdco to be invested. If the business owner, as an individual,receives these funds as bonus, the moneywill attract a tax of minimum 50%, which is far greater than the 19%.The amount of $250,000) that becomes available to invest, after tax, is much less than $405,000.
Another benefit of a Holdco is creditor protection. This means creditors cannot access the funds so easily. By transferring the earnings to a Holdco, these funds have now been transferred to another separate entity that creditors do not have access to. When the funds are moved back into the operating company from the Holdco, the funds have secured status which grants protection to a certain degree.
A Holdco is a beneficial tool when used for succession or estate planning. The possibility of double taxation can be avoided by transferring assets to the heirs by way of trusts. Alternatively, at death the assets are liquidated. Spreading the income among the family members is another possibility. When a member of the family is employed by the company, or does works for them, income is received by paying out dividends or with a salary. This becomes advantageous when family members, are taxed in a lower bracket. However, attribution rules need to be considered.
Certain circumstances deem it possible to freeze an estate. This is another benefit of a Holdco. This allows taxes to be saved through postponement, and the heirs benefit from the company’s future growth. The amount of tax to be paid at death can be significantly reduced. It all depends on how soon the estate is frozen.
There are a number of factors to consider when establishing a Holdco. A Holdco is not always the right choice businesses. Despite the benefits, a business owner should not attempt in using and benefiting from a Holdco without adequate knowledge and sufficient deliberation.