Holding Company in Canada
After reading this article, you’ll understand what a holding company is and when you should consider using one.
We’ll look at some common scenarios to explain why someone would incorporate a holding company in Canada.
We will also discuss the disadvantages of incorporating a holding company in Canada.
↓ Joe’s got the holdco details in this video if you’d rather hear it from him ↓
What is a Holding Company?
A holding company is an incorporated company that is primarily used for holding investments. This is different from an operating company. Operating companies are used for running active businesses like an accounting firm or a hardware store.
Investments owned by a holding company could come in many forms including:
- Shares in public companies like Apple or Facebook
- Interest earning investments such as cash, GICs, term deposits or bonds
- Real estate including residential or commercial rental properties or land
- Shares in private companies such as a local incorporated plumbing business
Holding companies hold investments, unlike operating companies that are used to operate businesses.
What is a Holding Company for?
There are a number of reasons for using a holding company in Canada.
- Asset protection - Hold assets in a holding company instead of an operating company. This helps to keep them safe from creditors in the event that something happens to the operating company.
- Help claim the Lifetime Capital Gains Exemption - There are specific criteria that need to be met to claim the LCGE. A holding company can help business owners meet these criteria.
- Tax savings -In some situations, corporations have a lower tax rate than individuals. Holding investments in a corporation instead of personally can help save taxes.
- Tax deferral -Holding companies can provide flexibility in the timing of income, allowing for tax deferral.
- Estate planning - Holding companies can help facilitate succession planning (transferring assets or the ownership of a business to the next generation).
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Holding Company Examples
We’ll walk through some holding company examples that are based on our list of reasons to incorporate a holding company.
Asset Protection from a Holding Company
Operating companies are exposed to risk through everyday business activities. Transferring some of the assets of the operating company to the holding company can provide a layer of protection in the event that creditors come after those assets.
Holding Company Example - Asset Protection
Let’s look at the example of a local construction company that is sued for installing faulty electrical equipment in an office building.
Bob’s Building Co is a medium sized construction company that specializes in building office buildings. Bob Loblaw, the owner, incorporated the company ten years ago. Since then it has become quite successful, earning $250,000 in profit each of the last four years after paying the owner’s salary. Those profits have stayed in the corporation and Bob has invested the cash in safe, interest-bearing investments.
A year ago, Bob’s Building Co finished building a large office building in Vancouver. It turned out that the electrical equipment that was installed in the building was faulty and the building caught fire and burned to the ground.
Bob’s Building Co is now being sued for damages by the owner of the office complex. The $1,000,000 of investments that Bob’s Building Co owns is now in danger.
Holding company to the rescue!
Now let’s consider the scenario again, but this time Bob Loblaw had also incorporated a holding company ten years ago.
Bob’s Building Co could have transferred the excess cash to the holding company through a tax-free dividend. The investments would then be held within a separate legal entity and the plaintiff would have a much harder time going after the funds. Asset protection.
Help Claim the Lifetime Capital Gains Exemption
The lifetime capital gains exemption provides owners of Canadian Controlled Private Corporations (most small incorporated businesses in Canada) with tax-free capital gains of up to $913,630.
This means that business owners could sell their company at a gain of $914k and pay no tax!
To be able to claim the Lifetime Capital Gains Exemption there are specific criteria that corporations must meet. Here is a simplified version of these criteria:
- Asset test - 90% or more of the company’s assets must be used in active business (aka not holding passive investments) at the time of the sale.
- Basic asset test -50% of the company’s assets must be used in active business (aka not holding passive investments) for the entire 24 month period before the sale.
- Holding period test - The owner of the business must have held the shares for at least 24 months before the date of the sale.
How does a holding company help to meet these criteria?
Holding Company Example - Lifetime Capital Gains Exemption
Aviato Inc. is a Canadian Controlled Private Corporation founded by Erlich Bachman four years ago. The company created a software application that scrapes social media for angry mentions of Air Canada and posts them as short reviews on its web-page. It earns revenue from other Canadian airlines placing ads on the Aviato site.
Aviato earned profits totaling $250,000 over the last four years after Erlich paid himself a salary. The remaining cash was kept in the company and invested in term deposits.
Erlich has been approached by a group of investors who would like to buy his company for $800,000. This means that Erlich will have a gain on the sale of his company of nearly $800,000. If he can qualify for the Lifetime Capital Gains Exemption, he could avoid paying any tax on the gain.
In this example, Aviato Inc. has failed the basic asset test because less than 50% of its assets were used in active business over the previous 24 months. The $250,000 in term deposits made up around 80% of the company’s asset value.
Erlich gets a tax bill of $166k from selling his business.
Holding company to the rescue!
If Erlich had incorporated a holding company 24 months ago, the holding company could own some of the shares of the operating company and he could have transferred the excess cash through a tax-free dividend. The holding company would then invest the cash in term deposits.
Erlich would then be able to sell the shares that he owns in Aviato Inc. and take advantage of the LCGE because it meets both of the asset tests. More than 90% of its assets were used in active business at the time of the sale and throughout the previous 24 months.
Now Erlich gets a tax bill of $0 from selling his business!
Tax Savings From a Holding Company
There are some opportunities for tax savings when investments are held in a corporation instead of personally. Recent rule changes around earning passive investment income in a corporation have added some complexity, but there is still opportunity for savings.
The amount of tax savings depends on a number of factors including the province of residence, the level of corporate and personal income and the type of income earned.
Holding Company Example - Tax Savings
Harvey Spectre is a successful lawyer in Calgary. He earns $350,000 per year as an employee of Spectre Legal. He also has an investment portfolio that earns interest income of $50,000 each year.
Because Harvey’s employment income is so high, he has to pay an additional $24,000 in taxes just from the investment income. That’s half gone because of taxes!
Holding company to the rescue!
Instead of holding the investments personally, Harvey incorporates a holding company and invests his cash within the company. Due to the lower tax rate of the holding company, he only has to pay $19,300 in taxes on the interest income.
He’s just saved nearly $5,000.
Tax Deferral from a Holding Company
Using holding companies can provide flexibility around the timing of when income is earned. This means that income, and therefore taxes owing, can be deferred from one period to the next.
Holding Company Example - Tax Deferral
Sterling Cooper Inc., an advertising agency in Toronto, is operated by three individuals: Don, Bertram and Roger. They each own 1/3 of the common voting shares of the company. In 2019 they had a successful year and the company is going to issue $100,000 dividends to each of the owners.
(Not sure what dividends are? learn the difference between salary and dividends)
In 2019 Don also had a significant amount of income from his side gig as an actor. This means that he is in a very high tax bracket in 2019. Don also knows that he won’t have any acting income in 2020 so he would rather that the dividend is issued in 2020.
Unfortunately for Don, the company issued the dividend in 2019 and he will have to pay tax at his high marginal tax rate.
Holding company to the rescue!
If Don had incorporated a holding company to hold his shares in Sterling Cooper Inc., a dividend could be paid from Sterling Cooper Inc. to his holding company in 2019. Because there are tax rules allowing for tax-free dividends between Canadian Controlled Private Corporations, no taxes are owed in 2019.
Don can then wait until 2020 to pay himself the $100,000 dividend from his holding company. He has deferred the income from one year to the next and has even reduced his overall tax bill because he is in a lower income bracket in 2020.
Estate Planning with a Holding Company
Holding companies can also be used to help smooth out the transition of assets from one generation to the next.
Holding Company Example - Estate Planning
Tom Callahan Sr. owns a brake pad manufacturing company in Manitoba called Callahan Auto Parts Ltd. When he retires, he wants to transfer ownership of the company to his son, Tommy Callahan Jr.
Tom has grown his business from the ground up. It is now worth $3 million according to the latest business valuation report he received. Tom wants to bring Tommy into the business, but he also wants to retain control of the business. Tommy means well, but he has a lot to learn about running an auto parts business before taking the helm.
Holding company to the rescue!
Tom can carry out what is called an estate freeze with help from a holding company. An estate freeze of Tom’s shares in Callahan Auto Parts Ltd. allows him to make Tommy a shareholder and shift all future growth in the business to him. It also allows Tom Sr. to remain in control of his business.
This also has the effect of freezing Tom’s current position in the company. This limits the income tax liability that will arise from the deemed disposition of his shares upon his death. Unfortunate to have to think about, but that’s part of an accountant’s job!
Tommy goes on to be the best salesperson Callahan Auto Parts has ever seen and the company flourishes under his unique brand of leadership.
Disadvantages of Holding Companies
We’ve looked at a lot of advantages of holding companies, but there are also disadvantages. Many of these are the same things to think about when you’re deciding whether to incorporate a business or not.
Incorporation Costs of a Holdco
There are costs involved when starting a holding company. Having a lawyer help draft the documents of incorporation is a good idea but it isn’t free.
It’s important to weigh the costs with the benefits of having a holding company before incorporating one.
Ongoing Costs of a Holding Company
There are also ongoing costs associated with a holding company. For example,
- Annual Legal Filings - There is an annual legal filing that needs to be completed to keep the company in good standing. The cost to have a lawyer file this averages around $350 per year.
- Annual Corporate Tax Return - You will also need to pay an accountant to file the annual corporate tax return. The cost of this averages around $2,500 per year.
- Bookkeeping - You may even need to have bookkeeping completed before the corporate tax return can be filed. Unless you’re doing this yourself, it comes with a cost too.
Administrative Burden of a Holding Company
Just like an operating company, a holdco requires legal and tax filings each year to remain in good stead with the authorities. On top of the financial cost, these require the attention and time commitment of the holding company owner(s).
Complexity of a Holding Company
Using a holding company can be beneficial, but its use also adds a level of complexity. It might be surprising, but people can lose track of how their assets are held.
We have seen many examples of clients that create multiple holding companies across the years and end up with a tangled web of corporations. This means more reliance on expensive professionals.
We’ve also seen it result in the need to pay large sums of money to simplify corporate structure and amalgamate the corporations back into just a single holdco.
Pay More Taxes with a Holdco
Sometimes, using a holding company can actually mean you end up paying more taxes than you otherwise would.
It’s possible that if you hold investments in a corporation, you will end up paying more tax than if you just owned them personally.
Use careful planning to minimize taxes.
Holding Company Frequently Asked Questions
Some quick-fire answers to frequently asked questions about holding companies.
Holding company vs. operating company
A holding company is a company that isn’t active. It holds investments such as company shares, interest earning investments, or real estate. Operating companies directly operate an ongoing business.
For example, Avalon Accounting Inc. is the operating company that operates our accounting firm. A holding company would be something like Paul Sharpe Holdings Inc. that owns shares in the operating company - Avalon Accounting Inc.
What is the purpose of a holding company?
The main purpose of a holding company is to hold investments such as shares of other companies. This is done to either earn investment income, facilitate tax planning or to minimize risk.
What is the benefit of a holding company?
The main benefit of a holding company is that it minimizes risk of asset loss. For example, if a holding company owns valuable assets, it minimizes the chance of the operating company losing those assets due to litigation or becoming insolvent.
Holding companies also provide additional flexibility when it comes to tax and estate planning.
How do I start a holding company?
Can a holding company own real estate in Canada?
A holding company can own many different types of assets including real estate, publicly traded securities, bonds and shares in private companies.
While it is possible to hold real estate in a holding company, it is not always the best option. Consult your tax advisor to determine the best solution for your situation.
Do holding companies file tax returns in Canada?
Yes, holding companies must file a tax return annually just like operating companies. The tax return is due six months after the year-end date, but any taxes owing would be due two months after the year-end.
How are holding companies taxed in Canada?
Holding companies pay tax on taxable income earned. Often holding companies will earn investment income. This means that the tax rate applied can be significantly higher than an operating company.
Check out our article on corporate tax rates in Canada to learn more.