This summer when you're standing around the barbecue with your business-owner neighbours, impress them with your knowledge of tax planning. I can tell you from experience that you'll bore them to tears with the conversation, but they'll thank you later when the tax savings start rolling in. Specifically, share with them that holding companies can help them to defer tax. Here are the highlights.
If you happen to own a corporation that carries on an active business, give some thought to setting up your affairs to allow for a deferral of tax. How? By establishing a holding company to own the shares of your active business corporation (ABC). You see, if you own the shares of your ABC directly, then any payment of dividends from that corporation to you will be taxable in your hands personally in the year you receive those dividends. If, on the other hand, you have a personal holding company that owns your shares in your ABC, you can pay a dividend to your holding company that will, in most cases, be tax free to your holding company.
It's subsection 112(1) of our tax law that allows, in most cases, your holding company to claim a deduction for taxable dividends received from your ABC. And, as long as your holding company and ABC are "connected" under our tax law (which will be the case in the vast majority of situations), you'll avoid another tax called the Part Four tax.
By passing some of those earnings from your ABC to your holding company, you'll defer tax, which is essentially the difference between the tax paid by your ABC on its profits, and the amount of tax you would have paid had the profits been paid out immediately to you as a bonus. The tax deferred is approximately 30 per cent of the taxable income in most provinces for someone in the highest tax bracket.
What strategies should you be thinking about?
Multiple shareholders: If you're one of multiple shareholders in your ABC, setting up a personal holding company for each shareholder can provide flexibility to each of you. Think of each holding company as a tap to control the payment of dividends to each of you personally. Your ABC can pay dividends to each of the holding companies on a tax-free basis, and then each holding company can pay dividends to its shareholders based on his or her personal cash requirements.
Splitting income: Your holding company can be owned by more than one person in the family. Your spouse, for example, could own some shares. This will allow you to sprinkle dividends to your spouse or others in the family so that the tax burden on those dividends can be shared. It's not always advisable to issue shares in the holding company directly to your children (and if they're minors, this isn't possible), and so a family trust can be utilized, which brings me to the next strategy.
Establish a trust: I really like this structure. The shares of your ABC can be held by a family trust. The beneficiaries of the trust will include you, your spouse, your children (regardless of their age), and your holding company. Now, any dividends paid by your ABC to the trust can be distributed out to your holding company as a beneficiary of the trust, and you'll achieve the same tax-free payment to the holding company as you would achieve if the holding company owned the shares in the ABC directly, provided the two companies are "connected." The advantages, however, include: The ability to sprinkle dividends to family members or the holding company as beneficiaries of the trust, at your discretion; the ability to multiply the lifetime capital gains exemption on a sale of the shares of your ABC (assuming the shares qualify for the exemption); creditor protection over the property of the trust, including the shares of the ABC, among other benefits.
Protection from creditors: Any excess profits of your ABC can be paid to your holding company as dividends, and can be lent back to your operating business on a secured basis, if the cash is needed for the business. This will protect those excess profits from other creditors of the business.
Retirement nest egg: The accumulation of assets inside your holding company can become the type of retirement nest egg or "pension" that you will need to look after yourself in retirement.