Do I Need a Holding Company?

Tax deferral and income splitting opportunities

One of the most significant benefits of a holding company is the potential tax savings they may offer in the form of tax deferral and income splitting opportunities. A holding company may offer this benefit where this can’t be accomplished within the operating company itself (e.g., where there may be multiple arm’s length shareholders of the operating company).

To illustrate, profits from an active business earned inside an operating company are subject to a low corporate tax rate. These after-corporate tax earnings can then be distributed to the shareholders in the form of dividends. If the dividends are received by an individual shareholder, they are subject immediately to personal income taxes — albeit at a preferential rate (i.e., reduced by the corporate income tax already paid).

However, the dividends will flow tax-free between the operating company and the holding company if the dividends are received by a holding company and certain tests are met (generally, where the holding company owns more than 10 percent of the voting and value shares of the operating company).

This allows the entire amount of the dividend to be reinvested on a pre-personal tax basis. In most cases, this will result in an additional 30 to 45 percent of capital available for reinvestment within the holding company. Personal tax liability will be deferred until the funds are needed for personal use — possibly as far off as during retirement.

The timing of the withdrawal of the funds from the holding company, again in the form of dividends, can be controlled by the individual shareholder. These funds can be taken out years into the future on a gradual basis to benefit from both the tax deferral and potential tax savings if they (or other family member / shareholders) are in a lower tax bracket at that time.[1]

Holding companies can also invest in anything that an individual can — so you are not limited in your investment strategy. Holding companies can own real estate, securities, private investments, life insurance policies, etc. Additionally, the annual investment income earned inside the holding company will be subject to a similar tax rate as you would pay personally in most cases. This means there is no significant disincentive to earning investment income inside a corporation. However, earning corporate passive income greater than $50,000 in a year can impact the corporate group’s ability to access the small business deduction.

As illustrated above, holding companies can be beneficial where you have a number of shareholders owning one or more operating companies. Having operating company shares owned through holding companies allows each individual shareholder to decide whether they want to flow the dividends paid out of the operating company through the holding company and out to themselves. Alternatively, they could decide to leave some or all of the operating company dividends in the holding company to be reinvested without immediately triggering the personal tax liability.

In this case, holding companies offer the flexibility for each of the individual shareholders of the operating company to independently decide on their draw down / reinvestment strategy. They may also allow other family members to share in the operating company profits — perhaps by holding non-voting shares of the holding company. This causes no impact on the operation or control of the operating company or on any of its other shareholders.

Creditor protection

It may still be advisable to use a holding company even in the case where the operating company shares would otherwise be owned by one shareholder or family unit. This allows the accumulation and reinvestment of the excess earnings for creditor protection purposes.

Having the excess earnings from the operating company paid up as a tax-free inter-corporate dividend and reinvested in the holding company puts these assets out of the reach of potential creditors. It also puts them out of reach from potential liability claims arising within the operating company.

Preserving access to the lifetime capital gains exemption

Having the excess cash and investments in the holding company as opposed to the operating company will also help keep the operating company purified such that at least 90 percent of its assets are used in an active business. Its shares may therefore qualify for the lifetime capital gains exemption ($1,016,836 for 2024).

The capital gains exemption is only available to individuals and not holding companies, and therefore proper structuring of the shareholdings of the operating company is essential. This allows for ongoing purification on a tax-deferred basis using the holding company. It also still provides the individual shareholders potential access to the capital gains exemption on a sale of the operating company shares. In many cases, family trusts may be utilized in the corporate structure to facilitate this.

Making the business more saleable

Keeping excess cash and investments out of the operating company is beneficial on a number of fronts, as mentioned above. Additionally, it may also be advantageous in many cases to hold the real estate used in the business in a separate holding company.

This provides creditor protection from the operating company’s activities. It may also make the shares of the operating company more saleable where the potential purchasers are only interested in acquiring the true business assets and are fine with leasing the premises. This limits the capital required to purchase the business — which is often significant when selling to key employees or family members who may have limited borrowing capacity. Often, the buyers will secure the operating company shares and lease the premises with an option to purchase later, once they are in a better financial position.

Having real estate assets in a separate holding company can still facilitate sales where the buyer does want to purchase the operating company and the real estate initially. This often takes the form of a share purchase of the operating company and an asset purchase of the real estate.

It should be noted that moving excess cash, investments, and real estate out of an operating company just prior to the sale of its shares can be accomplished. However, when done in contemplation of the sale of the shares of the operating company, complicated tax rules will likely result in some or all of this purification occurring on a taxable basis.

Acquisition and divestiture planning

Holding companies also play a key role in business acquisitions and divestitures. They are often used as a vehicle to acquire shares of an operating company, followed by an amalgamation with that target company. This allows the interest expense on the purchase loan to be offset against the operating profits going forward.

Holding companies are also beneficial on the purchase of a portion of the shares of an operating company (i.e., key employee buy-in). They allow the employee to pay off the original share purchase loan with operating company profits / dividends that have not been subject to personal income tax. Structuring of this type of partial buy-in is delicate, to ensure that the interest expense is offset against taxable income as opposed to tax-free inter-corporate dividends, which could nullify the immediate tax benefit.

At the other end of the spectrum, holding companies are often used to defer income taxes on the sale of the shares of an operating company. This is accomplished by utilizing previously taxed corporate surplus and/or removing any redundant assets prior to the sale. This may be in lieu of, or in addition to, utilizing the lifetime capital gains exemption.

Take the next steps

Considering the use of a holding company is a complicated area that offers significant potential benefits and few drawbacks. However, it requires careful planning to be positioned and used effectively.

To see if a holding company may be beneficial to your unique situation, contact your local MNP tax professional.

[1] Subject to the tax on split income rules.