Use of Investment Hold co Part 1

This memo provides an overview of the key concepts associated with incorporating a holding company (“Holdco”) in Canada. It outlines the principal benefits, common scenarios where a Holdco may be advantageous as well as other important considerations. The analysis is intended to assist business owners and high-net-worth individuals in determining whether a Holdco structure may align with their financial, tax, and estate planning objectives. In Part II of this memo series, we will provide a more detailed analysis of the specific tax treatment of investment income earned by a Canadian Holdco.

Key Concepts

A Holdco is a corporation established primarily to own and manage investments, such as shares of an operating company (“Opco”), marketable securities, real estate, or other assets. Unlike an Opco, a Holdco typically does not carry on an active business. Its main function is to hold and administer assets, often as part of a broader corporate or family wealth structure.

The Canadian tax system is intended to be neutral with respect to investment income earned directly by an individual as opposed to in a Holdco structure. This is the concept of “integration” which means that after a Holdco pays tax on investment income and distributes the after-tax funds as dividends to its shareholder(s), the total corporate and personal tax payable should be approximately the same as if the individual shareholder(s) had earned the investment income directly.

Integration, however, is a theoretical concept and in most situations, it does not operate perfectly. As will be demonstrated in Part II of this memo series, the integrated tax rate for investment income earned through a corporation is almost always slightly higher than the personal tax rate for investment income. However, despite the shortcomings of tax integration, there are several benefits to implementing a Holdco structure.

Benefits of an Investment Holding Company

The use of a Holdco structure may provide numerous benefits, including:

• Asset and Creditor Protection
  By transferring excess earnings or assets from Opco to Holdco (commonly via tax-free intercorporate dividends), those assets are generally insulated from Opco’s creditors.  Accordingly, if Opco faces legal claims or insolvency, assets held in Holdco are typically not exposed. A Holdco can also lend funds back to Opco on a secured basis, further protecting its interests.

• Tax Deferral and Tax-Efficient Investing
  Profits from an active business earned in Opco are taxed at the corporate rate, which is generally lower than personal tax rates in Canada. Accordingly, after-tax Opco profits transferred to Holdco allow for greater capital accumulation and can be reinvested, deferring personal tax until funds are withdrawn from Holdco. This may also allow for greater flexibility in the timing of personal withdrawals, which may optimize the overall tax outcome.

• Managing Level of Personal Income
  Holding a large investment portfolio personally provides limited control over an individual’s personal income level. Where the investment income earned exceeds one’s personal cashflow needs, the individual’s income may result in a clawback to Old Age Security benefits. Holding investments in a Holdco allows the individual to manage his or her personal income by drawing dividends from the Holdco only to the level needed for personal use, thereby maintaining personal income at a lower level unless necessary.

• Opco Purification for Lifetime Capital Gains Exemption (LCGE)
  Owners planning to sell the shares of their business may want to maximize their access to the Lifetime Capital Gains Exemption (“LCGE”), which is currently $1,275,000 per individual in respect of the sale of shares of a Canadian-controlled private corporation (“CCPC”) that meet certain tests. In order to qualify for the LCGE on the sale of Opco shares, Opco must meet certain asset tests (i.e., at least 90% of assets used in an active business at the time of sale and greater than 50% of assets used in an active business throughout the 24-month period preceding the sale). Accordingly, a Holdco structure can be used to “purify” Opco by allowing the tax-free transfer of passive or excess assets from Opco to Holdco in order for Opco shares to qualify for the LCGE.

• Estate Planning and Intergenerational Wealth Transfer
  A Holdco structure can facilitate an estate freeze which can allow the current shareholder(s) to “freeze” the value of their shares and pass future growth in the value of the corporation to the next generation. This can be effected by issuing new shares directly to the next generation or alternatively, through the use of a family trust (for more information with respect to the use of family trusts, please refer to our memo “The Use of Trusts in Tax & Estate Planning”).

An estate freeze strategy can also help manage the tax liability on death as the value of the “freeze” shares will be fixed, thus providing some certainty as to the maximum eventual tax liability. A strategy to redeem the “freeze” shares over time may also be implemented, thereby reducing the terminal tax liability of the shareholder. This concept is commonly known as a “wasting” freeze.

Finally, the use of Holdco may provide for a reduction of probate fees in some provinces, as the shares of Holdco may be dealt with by a “Secondary” Will which allows the transfer of assets that do not require probate to the Estate/beneficiaries, such as shares of and balances receivable from private corporations.

• Income Splitting (Limited benefit)
  As a Holdco can issue shares to adult family members, there may be potential for income splitting among the family. However, the Tax on Split Income (“TOSI”) rules and “corporate attribution” rules significantly restrict this strategy, particularly for minors and family members who are not actively involved in the underlying business.

• U.S. Estate Tax Planning

Canadian residents holding U.S. situs assets (such as securities of U.S. corporations) may reduce U.S. estate tax exposure by holding those assets in a Canadian Holdco, as U.S. estate tax generally applies to individuals and not to corporations. For more information on this topic, please contact a Welch LLP US tax advisor.

Other Considerations

• Tax Cost of Passive Investment Income
  As discussed, the Canadian tax system aims for integration between earning investment income personally and through a corporation, however, in practice, there is often a slight tax cost to earning passive investment income in a Holdco, especially when funds are to be distributed to the individual shareholders.

However, to the extent that funds are not needed personally, having investment income earned in a corporation still provides the opportunity for a tax deferral as will be illustrated in Part II of this memo series. Depending on the timing of personal tax needs, this deferral benefit may outweigh the potential tax “cost.”

• Small Business Deduction (“SBD”) Limitations
  If a Holdco is “associated” with an Opco, the passive investment income earned by Holdco can reduce or eliminate Opco’s access to the SBD, thereby increasing the corporate tax rate on Opco’s active business income. This concept will also be further discussed in Part II of this memo series.
  
  
• Complexity and Compliance Costs
  Incorporation of a Holdco will add administrative complexity, requiring additional legal, accounting and tax compliance work (i.e., legal fees for incorporation and annual corporate resolutions, accounting, and corporate tax return filing fees).

• Post-mortem tax issues
  Upon the death of the shareholder, there is a potential for “double tax” as there may be both a capital gain on the deemed disposition of Holdco shares to the deceased shareholder, as well as a dividend on the distribution of assets from Holdco to the estate or beneficiaries. Accordingly, additional post-mortem tax planning is often required to avoid double-taxation.

• LCGE Not Available to Holding Companies
  As discussed, the use of a Holdco can be a valuable tool to assist with the purification of an Opco in order to maintain access to the LCGE. However, it is important to remember that only individuals can claim the LCGE. If Holdco sells Opco shares, it cannot claim the LCGE. Accordingly, careful planning and corporate structuring are required to achieve the goal of accessing the LCGE for the individual shareholder(s).

Conclusion

Holdcos are powerful tools for wealth and business planning and can provide significant benefits in terms of asset protection, tax deferral, estate planning and flexibility for business owners and investors. However, these benefits must be weighed against increased complexity, potential tax costs, and compliance requirements. Their use must be carefully structured and monitored, considering the specific circumstances and objectives of the individual(s) and/or business.

Contact your Welch LLP advisor if you would like to discuss whether a holding company is appropriate for your situation or if you require assistance with a review of your corporate structure.