Holding company pros and cons for Ontario business owners

What a holding company is

A holdco is a corporation whose main job is to own shares, investments or property rather than to run a business. In the common arrangement, you or your family own the holdco, and the holdco owns the shares of the operating company, often called the opco.

The opco earns the business income and can pay dividends up to the holdco. The holdco then keeps, invests or passes on that money. Our encyclopedia entry on holding companies gives the short definition. This article focuses on whether you should set one up.

The benefits people usually point to

The most common reason is flexibility. Cash that the opco does not need can move to the holdco without being paid to you personally, which can postpone personal tax on it until you actually need the funds. Whether that postponement is worth anything depends on the tax each company and you would pay, so ask for the numbers.

A holdco can also separate valuable assets, such as investments or real estate, from the risks of the business. That is mainly a legal question rather than a tax one, so discuss it with a lawyer.

Other reasons include more flexible family share structures and preparing for a future sale, since the way shares are held can affect what a buyer sees and which tax rules apply. These are planning goals that a structure supports, not benefits you get automatically. Ask your advisers to name which of them applies to you, and how much each is worth in dollars over the next five years.

Moving money up: dividends between companies

Taxable dividends that one Canadian corporation receives from another are generally deductible when the receiving company works out its taxable income, which is why money can move between companies without the usual personal tax. The catch is Part IV tax. If the paying company is not connected to the receiver, the dividend attracts Part IV tax at 38 1/3%.

If the payer is connected, such as an opco the holdco controls, Part IV tax generally arises only when the dividend gives the opco a dividend refund of its own. Part IV tax is refundable when the holdco later pays taxable dividends out, but it can tie up cash in the meantime. Dividends received and Part IV tax are reported on Schedule 3 of the T2, so the schedule has to be filed correctly each year.

The costs that are easy to underestimate

A holdco is a separate legal entity. It has its own T2 return, its own books, its own year-end and its own accounting and filing fees, every year, whether or not it earns much. Share structure and legal costs can add to the setup, and you will need to keep clean records of every transfer between the companies.

Intercompany loans and dividends need to be documented so that you can show later what each payment was. Our article on shareholder loans covers the balance-owing problem that can arise when funds move without a paper trail. If the holdco is small and inactive, those fixed costs may exceed any benefit.

The passive income and association trap

A holdco does not escape the rules on investment income. The small business limit of $500,000 reduces once adjusted aggregate investment income reaches $50,000, and is gone at $150,000. The test adds together the income of every associated corporation. A holdco and an opco are usually associated, so the holdco’s investment income can reduce the opco’s limit.

The CRA also has an anti-avoidance rule aimed at transfers meant to reduce this measure: a corporation that lends or transfers property to a related corporation partly for that reason can be deemed associated with it. Our article on passive investments inside a corporation explains the mechanics. The point here is that a holdco is not a way to take investments out of the test.

Situations where a holdco often makes sense, and where it does not

A holdco is more likely to be worth discussing when the opco regularly has cash beyond the owner’s needs, when you expect to sell or restructure, or when you want to separate assets from operating risk and have professional help to manage it. It is less likely to help when profits are modest, when you take most of the profit out each year, or when the main reason is a general belief that it saves tax.

Existing businesses can also be reorganized into a holdco structure, and that step has its own tax rules and timing. Do not move shares or assets without advice, because a poorly documented transfer can create a tax cost or a record that does not match the facts.

Questions to ask before you decide

Start with the problem to be solved: how much surplus cash is there, what will it be used for, and when might you sell? Then ask for a comparison of tax and fees with and without a holdco, using your own figures. Ask how the passive income threshold and association would apply, and what annual cost the structure adds.

Bring the opco’s recent financial statements and T2, your share structure, a list of corporations you or your family control and any sale or succession plans. Our should I incorporate guide covers the earlier step, and the tax advisory page explains how Sora can help you weigh options. Decide on the structure only after the numbers and the legal advice are in front of you.