Holding companies: when they help and when they just add cost

A holding company is worth having when it does one of four jobs: it moves profit you are not spending beyond the reach of the operating company's creditors, it keeps the operating company clean enough to qualify for the lifetime capital gains exemption, it gives you a platform for an estate freeze, or it sits above several operating companies and a building so cash can move between them without tax. If none of those apply, a holdco is a second T2 return, a second minute book and a second set of accounting fees, with no extra small business deduction to show for it.

In a holdco structure you own the holding company and it owns the operating company, or opco. Everything that follows rests on one rule: dividends paid by one Canadian corporation to a connected Canadian corporation are generally received tax-free, so profit can travel upward without a personal tax bill along the way.

Benefit one: surplus cash beyond the creditors' reach

Cash left inside an operating company is exposed to that company's lawsuits, leases, supplier claims and bank covenants. Paid up to a holdco as a tax-free intercorporate dividend, the same cash sits in a company that has no customers, no employees and no contracts, so there is nobody with a reason to sue it. If the opco later needs working capital, the holdco can lend it back and register security behind the bank.

Two cautions apply. The dividend is only tax-free while the corporations are connected, which in practice means the holdco controls the opco or holds more than 10% of its votes and value; otherwise Part IV tax applies. And subsection 55(2) of the Income Tax Act can convert a tax-free dividend into a capital gain where one of its purposes is to reduce a gain on the shares and the dividend exceeds the opco's "safe income", broadly its retained taxable earnings.

Before moving a large balance we calculate safe income on hand so the dividend stays a dividend. Our answer to should I set up a holding company gives the short version of this trade-off.

Benefit two: keeping the opco eligible for the capital gains exemption

The lifetime capital gains exemption, $1.25 million per person at the time of writing, applies only to shares of a corporation whose assets are at least 90% active business assets at the moment of sale and more than 50% throughout the preceding 24 months. Surplus cash, a stock portfolio and a rental condo are not active assets, and left inside the opco they quietly disqualify the shares. Dividending them up to a holdco each year, a process the profession calls purification, keeps the opco onside without a personal tax cost.

The wrinkle is that a corporation cannot claim the exemption; only a person can. If you own the holdco and the holdco owns the opco, the shares you would sell are holdco shares, and they qualify only if the holdco itself is substantially all opco shares and active assets at the time, which years of purified investments will have undone. The two usual fixes are to have the holdco hold a separate class of opco shares while you keep the common shares personally, or to move the portfolio out of the holdco well before a sale. Either way it must be designed at set-up, not discovered at the letter of intent.

Our post on selling a business with the lifetime capital gains exemption covers the 24-month runway, and how to qualify for the exemption sets out the tests.

Benefits three and four: an estate freeze, and several companies or a building

A platform for an estate freeze

An estate freeze caps the value of your shares at today's figure, so the tax on your death is calculated on that amount, and directs future growth to children or a family trust. Mechanically, you exchange your common shares for fixed-value preferred shares under section 85 or section 86, and new common shares are issued for a nominal price to the next generation. A holdco is the natural home for the frozen preferred shares: it receives dividends to fund your retirement and redeems the preferred shares gradually. We cover the family side in handing a family business to the next generation.

Several opcos, or an opco and a building

Once a second operating company exists, a holdco above both lets profit move from one to the other without a personal tax step. Canada has no consolidated group return, so a loss in one company cannot be netted against profit in another on paper, but a holdco can dividend cash out of the profitable company and lend or subscribe it into the struggling one. A building held in the holdco, or in a separate real estate company, and leased to the opco keeps the property away from operating risk, and rent paid by an associated company that deducts it against active income is treated as active business income for the landlord company rather than passive income. Land transfer tax applies whenever property changes hands, so buy in the right entity from the start.

The costs, stated plainly

• A second T2 return every year, with its own financial statements and, if the holdco holds investments, schedules for refundable tax, the capital dividend account and Part IV tax.
• A second corporate record. Articles, a minute book, annual resolutions, an annual return to Ontario or Corporations Canada, and separate bank and brokerage accounts. Dividends from opco to holdco must be declared by resolution and actually paid, or the CRA can treat the transfer as a loan.
• No extra small business deduction. Associated corporations share one $500,000 business limit. The holdco does not get its own, and it earns no active income to use one on anyway.
• The passive income grind is measured across the group. Once the associated group's adjusted aggregate investment income passes $50,000, the opco's business limit shrinks by $5 for every extra dollar and disappears at $150,000. Moving the investments to a holdco does not escape this; the holdco's investment income counts against the opco's limit. Our answer on how passive income reduces the small business deduction works through the numbers, and how RDTOH works explains the refundable tax on that income.
• Cross-border complications. A holdco holding more than $100,000 (at cost) of foreign investments, including US stocks in a Canadian brokerage, files a T1135 of its own. US dividends inside a Canadian corporation are taxed as investment income at roughly 50% in Ontario with only a partial refund on payout, so integration is worse than for Canadian dividends. And if any shareholder is a US citizen or green-card holder, a passive holdco raises controlled foreign corporation and PFIC reporting on the US side that can cost more than the holdco saves.
• Income splitting is not unlocked. Dividends from a holdco to a spouse or adult child fall under the tax on split income unless an exclusion applies, and holdco shares generally fail the "excluded shares" test because the holdco's income comes from a related business. See paying your spouse dividends.

Our decision checklist

We recommend a holdco when at least two of the following are true, and advise against it when none are:

1. The opco retains more profit each year than the owner needs, and the retained balance is now large enough that losing it in a lawsuit would hurt.
2. The opco carries real operating risk: employees, premises, vehicles, product liability, or contracts larger than its insurance.
3. A sale within the next five to ten years is plausible and the exemption is worth protecting.
4. There is more than one operating company, or a building used by the business.
5. The owner is past 50, or the business is worth several million, and an estate freeze is on the horizon.
6. Family members will be shareholders on terms that satisfy the split income rules, such as a spouse over 65 or a child working in the business full time.

When the honest picture is one opco, all profit drawn as salary and dividends, and no plan to sell, the answer is to keep the structure simple and revisit it in two years. A holdco is easy to add later and expensive to unwind.

How a holdco is set up without triggering tax

If the opco already exists and has grown in value, you cannot simply sell your shares to a new holdco; that is a disposition at fair market value. The standard route is a section 85 rollover: you transfer your opco shares to the holdco in exchange for holdco shares, and the two of you jointly elect a transfer price at your adjusted cost base so no gain arises. The election goes on Form T2057, due by the earlier of your filing deadline and the holdco's for the year of the transfer.

Take back only shares, or non-share consideration no greater than the "hard" cost base of your opco shares, because section 84.1 deems a dividend where an individual extracts more than that from a non-arm's-length corporation. Settle the holdco's share classes now, because a later freeze or family shareholder is far simpler when the articles already allow for it. For a brand-new business we often set up both companies together so the holdco subscribes for opco shares on day one and no rollover is needed.

Our incorporation and compliance service handles both companies as one engagement, our tax services for holding company owners cover the recurring T2s, safe income tracking and T1135, and what a section 85 rollover is explains the mechanics.

Illustrative example: when the holdco pays for itself

Illustrative only. A Brampton electrical contractor's corporation earns $400,000 before the owner's $150,000 salary, so after small business tax on the remaining $250,000 roughly $220,000 accumulates each year. Without a holdco that money sits in the opco's account, exposed to every job-site claim the insurance does not fully cover. With one, the same $220,000 moves up annually as a tax-free dividend after a safe income check, and by year five just over $1 million sits in a company with no operations to be sued over.

The owner's accounting fees rise by the cost of a second year-end. The opco stays eligible for the exemption because its balance sheet is trucks, receivables and work in progress rather than a portfolio, and the holdco's investment income still counts toward the $50,000 grind threshold, so the portfolio is weighted to growth rather than interest. For a consultant earning the same $400,000 with no employees, no premises and no sale in mind, we would give the opposite advice: pay the surplus out over time and skip the second company.

Sources: CRA — Form T2057 · CRA — Form T1135.