If you are a business owner, you have probably heard peers, accountants, lawyers, and bankers talk about this thing called a holding company. Lots of them have probably told you “hey – you NEED to setup a holding company! It’s way better.”
We get this question from our clients all the time, “should I use a holding company?” In this article, we’re going to break down this question in understandable terms to help you decide if you should use a holding company in Canada. Here’s what we’re going to talk about:
- Basic things you need to know about a corporation
- What is a holding company?
- What is a subsidiary?
- Why do people use holding companies?
- Credit Protection
- Lifetime Capital Gains Exemption
- Income Splitting
Let’s get to it.
Basic things you need to know about a corporation
Odds are that you will already know everything in this section, but we’re going to cover some basics about corporations. We love point form and we know you do too, so here is our list of basic things to know before we get started:
- A corporation is a company or group of people authorized to act as a single entity
- This entity can be thought of as a person that is separate from the owners of the corporation
- The corporation is owned by shareholders, who hold shares in the corporation
- Each share in a corporation entitles the shareholder to vote on policy and management decisions
- Most of the time, if a shareholder owns more than 50% of the shares, they have control of the corporation
- A corporation can be a shareholder of another corporation
With this refresher out of the way, we’re ready to get into the good stuff.
What is a holding company?
A holding company is a corporation that owns one or more other corporations, which are called subsidiaries. Most of the time, the holding company has control over the subsidiary companies. Sometimes, a holding company is called a parent company or an umbrella company, reflecting the fact that it has control over the subsidiary’s policies and management decisions.
A holding company does not operate a business. It may hold real estate or other assets, but in a normal scenario it does not have active business income. Active business income includes pretty much everything, so it’s easier to lay out what isn’t active business income. The most common types of non-active business income are:
- Investment income
- Rental income
- Leasing income
- Personal service businesses
In other words, a holding company exists to do exactly what it sounds like; to passively hold assets that generate passive income.
What is a subsidiary?
A subsidiary is a corporation that is owned by a holding company. Most of the time, a subsidiary is controlled by a holding company, but there may be other shareholders that also own a portion of it. Unlike the holding company, a subsidiary will operate a business and have active business income. Sometimes we call a subsidiary an operating company, or Opco, because it is operating a business.
The Opco will typically hold wonderful things like bank debt, supplier debt, receivables from customers, inventories, or other things that expose it to credit, business, or legal risk. In other words, the Opco is made liable for all the headaches that can arise from running a business.
Why do people use holding companies?
There are three main reasons that people use holding companies in their corporate structures. These are:
- Credit protection
- Crystallizing the Lifetime Capital Gains Exemption
- Income Splitting
We’re going to talk about each of these issues in the next sections.
A corporation is a separate legal entity. This means that a corporation can make commitments to creditors to pay debts. A common example everyone is familiar with would be a bank loan.
What happens when you do not pay your debts? Well – creditors will look to collect their cash in other ways. This can include taking buildings, vehicles, inventories, or any other assets within the corporation that can be sold and converted into cash to pay debts. In December 2019, there were 214 businesses that filed for bankruptcy.
A business going bankrupt is a reality. Sometimes it only takes one bad year or a single negative event to take a healthy business into bankruptcy. Reasons can include lawsuits, bad contracts, or recessions.
A holding company has the effect of protecting assets from creditors. By putting things such as real estate or investment accounts into a holding company and separating it from the operation, it protects the assets from being seized by creditors to pay off debts.
Crystallizing the Lifetime Capital Gains Exemption
One of the most valuable tax benefits available to a business owner is the Lifetime Capital Gains Exemption (LCGE). In summary, the LCGE gives an individual taxpayer an exemption on the disposition of qualified property of up to $866,912 as of 2019. So – what does this mean? Let’s walk through an example.
Let’s say you hold 1,000 shares in a company you founded with a par value of $10 per share, worth a total of $10,000. You’ve been successful, and now your shares are worth $500 per share, making them worth $500,000. If you try to sell your shares for $500,000, you will trigger a capital gain of $490,000 which you will be taxed on. With the LCGE, assuming the shares meet the criteria for qualified property, you would be able to sell the shares without being taxed on the capital gain.
How does this relate to holding companies? Well – it comes down to the criteria for qualified property. There are many criteria, but the one that is applicable in this example is that “50% of the fair market value of the assets of the corporation were used active business activity.” It is completely possible that if a business has many years of operating successfully, it will accumulate a significant amount of cash held in investment accounts. If this grows to be too large, you would no longer qualify for the LCGE.
If you find yourself getting close to this limit, it’s time to setup a holding company and “crystalize the LCGE.” This is a very technical topic. But, at a high level, it works like this:
- Transfer the shares to a holding company at fair value
- Trigger a capital gain on that transfer
- Use the LCGE to make the capital gain on transfer tax-free
- Your “cost” of those shares then becomes the fair value (ie: the exemption is locked-in/crystallized)
In summary, crystalizing the LCGE has the effect of triggering the capital gain now while you qualify so that it won’t be triggered later when you don’t qualify.
Holding companies were once used to execute income splitting strategies. You’ll find content all over the internet talking about how you can use a holding company to split income and reduce your taxes. This was true for a long time, but now it’s become a lot riskier and more convoluted due to the CRA introducing tax on split income rules.
If you’re reading this hoping to save by income splitting, then a holding company probably isn’t for you. Long story short, income splitting should not be your main reason for setting up a holding company in Canada.
In conclusion, there are reasons why you should use a holding company, and they are primarily credit protection and crystalizing the lifetime capital gains exemption. There are ways to achieve income splitting with holding companies, but this is a high-risk and new area with the introduction of tax on split income rules and shouldn’t be your main reason for setting up a holding company.
If you’re looking for credit protection or to begin planning to sell-off your business, our online tax planning and business taxes services can help you get a holding company set up that meets your needs.