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Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.

When you understand the rules of the game, you can make them work to your advantage.

I think of Roger Neilson, former National Hockey League coach, who also coached the Peterborough Petes when my brother-in-law played for the team years ago. Mr. Neilson knew the rules of the game better than anyone. On one occasion, when the opposition was awarded a penalty shot, he pulled his goalie and put a defenceman in net. When the opposing player picked up the puck at centre ice, the defenceman came rushing out of the net and hit the confused shooter. No goal. Hey, there was nothing in the rules to stop this type of tactic. Well, not at that time. The rulebook has since been changed. Mr. Neilson was probably responsible for more changes to the rulebook than any single coach.

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Things are no different in tax planning. If you know the rules, you can use them to your advantage. For those who are business owners, taking advantage of tax law will mean setting up a holding company in most cases. Today, I want to talk about the benefits of a holding company.

The story

Gord is a business owner who established a holding company (Holdco) several years ago. Holdco, in turn, owns all the shares of Gord's operating company (Opco), which carries on an active business - he distributes light fixtures.

Gord pays part of the earnings of Opco to Holdco as a dividend each year. This is generally a tax-free, intercorporate dividend. Gord then uses that money to invest in other things, such as real estate, marketable securities, and other private businesses. If Opco needs more cash for any reason, Gord can arrange for Holdco to lend the money to Opco.

Gord also pays income out of Holdco to himself, and other family members, each year.

The benefits

Gord enjoys a number of benefits:

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Tax-free dividends. Dividends paid by an operating subsidiary (Opco) to the parent holding company (Holdco) in Canada are generally tax-free dividends to Holdco. Tax free is always good.

Creditor protection. Because Gord has excess earnings in Opco each year, he pays the excess to Holdco as a tax-free dividend, which protects those earnings from creditors of Opco. If necessary, he can lend that money back to Opco on a secured basis to retain that protection from creditors.

Efficient reinvestment. Gord has been reinvesting some of Opco's excess earnings in other assets to diversify his holdings. He does this by paying tax-free dividends from Opco to Holdco and then having Holdco make those other investments. If he paid the excess earnings from Opco to himself, personally, to make those investments, he would pay tax first, leaving less to reinvest. As it stands, Holdco filters out that layer of tax, making reinvestment tax efficient.

Income splitting. Gord is able to pay income to his wife and children each year so that some of the earnings are taxed in their hands, not his. The income can be in the form of salary (if the relative is doing work of some kind), or dividends, among other things. Because Gord's children have very little other income, they'll pay no tax at all on the income he pays to them. You do have to be aware that dividends paid to minors (perhaps through a trust) will be taxed at the highest marginal tax rate. But once the kids reach age 18, they can receive up to about $40,000 (it varies by province) each year in Canadian dividends virtually tax free.

Timing income. Think of Holdco as a private pension in many ways. Gord can draw money out of Holdco when he wants it. He chooses to pay himself dividends every second year rather than every year, which allows him to avoid personal tax instalments each quarter, because it's possible to base instalments on either the previous year's tax owing, or the current year's expected liability. If Gord has little or no tax liability every second year, he can base his instalments annually on the year he expects to have little income.

Avoid U.S. estate tax. Canadian residents could be subject to U.S. estate tax if they own "U.S. situs property," which includes shares in U.S. corporations, among other things. If you're otherwise subject to U.S. estate tax on those securities, you can hold those investments in a Canadian holding company to avoid the estate tax.

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A holding company will add complexity to your life, so visit a tax professional to talk about all the pros and cons.

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