Clients who own a business or hold investments might wonder if they should do so using a holding company. Several factors must be considered, says Jamie Golombek, managing director of tax and estate planning at CIBC Financial Planning and Advice.

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For starters, a holding company can be a company that doesn’t produce goods or services but holds shares of an operating company.

“The holding company is simply interposed between the business owner and the active business,” Golombek said in a Nov. 7 interview. “That allows profits to be flowed up and retained in the holding company.”

Alternatively, a holding company could hold marketable securities or rental property instead of the client holding those investments personally.

Using a holding company­–operating company structure

One reason for a business owner to use a holding company is for asset protection. “If a creditor of the operating company decides to sue that opco, [the creditor] could have access, theoretically, to all of its assets,” Golombek said.

Assets can be protected by removing excess cash or investments not needed for business operations to a holding company.

Another reason to use an opco-holdco structure is for tax planning. The opco may be able to pay tax-free inter-corporate dividends to the holdco, which the holdco can retain.

“That income can be held inside that holdco until, perhaps, a later year when you, the business owner, actually need the money,” Golombek said. “You have more control over the timing of receiving that income personally when using the holdco.”

This flexibility is also beneficial where multiple shareholders hold shares in the opco through their individual holdcos.

Where tax-free inter-corporate dividends can be paid to each holdco, the shareholders can each decide when to extract funds from their personal holdcos, at which time they’ll pay personal tax, said a report co-authored by Golombek.

In contrast, “there is no way to prevent current income taxation when dividends are paid directly out of an operating company to an individual,” Golombek said when interviewed.

The report offered a warning, however, about inter-corporate dividends: new anti-avoidance rules may treat inter-corporate dividends paid in excess of retained earnings as a capital gain. Expert tax advice may thus be required to ascertain the amount of dividends that may be safely paid, it said.

Other reasons to use a holdco include protecting U.S. investments from U.S. estate tax, acquiring a corporation in a tax-advantaged way, or implementing an estate freeze, the report said.

Transferring an investment portfolio to a holding company

Clients also commonly ask whether investments already owned personally should be transferred to a holding company for tax purposes, Golombek said. The answer is generally no, because of negative tax integration.

“In all provinces in Canada, there’s actually a tax cost from earning investment income inside a private company compared to earning that same investment income personally,” Golombek said.

To calculate the tax cost, the report compared the combined tax rate on investment income (interest) earned in a holdco and on dividends when after-tax income is paid to the shareholder, versus the tax rate on investment income earned personally (based on 2019 combined federal and provincial/territorial tax rates and assuming the client pays tax at the top marginal rate).

The tax cost from investment income earned in the holdco ranges from about 2% in Nunavut to nearly 8% in Nova Scotia, and half those percentages for capital gains. (The tax cost of Canadian dividends is neutral if they’re paid out of a holdco in the same year they’re earned, the report noted.)

As a result, “it’s always disadvantageous (or neutral, in the case of Canadian dividends) to have investment income taxed in a holdco,” the report said.

It also noted that it generally makes no sense for tax purposes to incorporate an existing investment portfolio when after-tax funds from the holdco will be retained and reinvested, because there’s generally no tax-deferral benefit versus earning the investment income personally.

If, on the other hand, a client already has investments or cash in a holding company, they might want to keep them there to avoid the tax on split income.

Specifically, where a holdco received dividends from an opco, “the cost of taking that money out could be substantial, whether it’s paid out as an eligible or non-eligible dividend,” Golombek said. “It may make sense to keep the money inside of the holdco, even though there is a negative cost of integration, because the cost of taking the money out is so dear.”

Note that tax on split income shouldn’t apply to dividends paid from a holdco to related parties where the holdco is a “pure investment company” and carries on no business, the report said. However, determining whether a holdco carries on a business may require professional advice, it said.

Read: What is a ‘related business’ for TOSI purposes?

Another thing to consider before incorporating an existing investment portfolio is potential loss of the small business deduction (SBD).

“New rules for 2019 say that, if you have passive income of more than $50,000, you could lose the federal and, in most provinces, provincial small business rate at a ratio of five to one,” Golombek said.

The SBD is reduced to zero at $150,000 of investment income. Further, the SBD dollar limit must be shared among associated corporations.

As a result, investments in a holdco affect an associated operating company’s ability to claim the small business rate, Golombek said.

For more details about holding companies, read the CIBC report.

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