Taxing Topics - Dwyer Tax Law Canadian Tax Law Articles: August 2006

Sunday, August 6, 2006

Don't Get Yourself in a Headlock: Use a Holding Corporation

Andre has decided to take a sabbatical from his tax law practice to pursue his lifelong dream of opening a mud wrestling school. Wrestleco is the corporation that will operate the wrestling school, but Andre would also benefit from incorporating a holding company (“Holdco”) as well.

Holdco is not an active business company. Rather, it is a company that can be used to hold investments in other corporations or to hold non-business assets. In this case, Holdco would hold the shares in Wrestleco.

There are advantages to using a Holdco. One advantage is a degree of creditor protection. A hurt wrestler who was drop kicked and body slammed in the ring may decide to sue Wrestleco. Wrestleco could pay dividends up Holdco, thus decreasing the assets and value in Wrestleco that would be available to creditors. If Wrestleco needed any funds, Holdco could then lend the funds back to Wrestleco on a secured basis. The result is the shielding of assets that would otherwise be held by Wrestleco and available to Wrestleco’s secured creditors.

The best way to take advantage of the creditor protection would to be have a trust, not Andre, hold the shares of Holdco. The beneficiaries of the trust could be Andre’s family members. This allows Andre to be an active manager or wrestler of Wrestleco. Otherwise, the Holdco shares would be at risk if Andre was personally sued and if he personally owned the Holdco shares.

Another advantage of using a Holdco arises in the context of investing. Wrestleco, as a small business corporation, is taxed at a low rate of 18% on its first $300,000 of income (to be increased federally to $400,000 next year) in a taxation year. If Andre took money out of Wrestleco as a dividend and invested it himself, he would pay tax on the dividend (the top tax rate is 32%) and tax on any investment income. However, if Holdco owns shares of Wrestleco, Wrestleco can give a tax-free intercorporate dividend to Holdco using 18% tax-paid dollars. In other words, after pay the 18% tax, Wrestleco would be left with 82 cents on each dollar. Wrestleco could transfer these 82-cent dollars to Holdco without incurring further tax and Holdco could invest 82 cents for each dollar of Wrestleco profit. Holdco would have more money to invest than Andre would if he took the money directly out of Wrestleco. When Andre eventually takes the money out of Holdco, he would have to pay tax, but in the meantime, Holdco would have more money to work with.

If Andre decided to sell his business, the use of Holdco can provide another advantage. A qualified small business corporation (“QSBC”) share is a share in a Canadian company (“Opco”) that meets the following two tests.

90% or more (measured by fair market value) of Opco’s assets are used in an active business.
Throughout the two year period prior to the sale of the QSBC, 50% or more (measured by fair market value) of Opco’s assets were used in active business.

If the shareholder has held the shares for at least two years, he may use his capital gains exemption (up to $500,000 lifetime limit, to the extent none has already been used) in respect of gains resulting from the sale of the QSBC shares. Opco can pay a tax-free intercorporate dividend to Holdco and transfer excess assets or cash not used in the active business. This allows the shares of Opco to qualify as QSBC shares and the gains from sale of the shares be eligible for the capital gains exemption. Wrestleco could use a Holdco to help keep itself “pure” and have its shares qualify for the QSBC share status.

With a little extra planning at the beginning, Andre can put the headlock on the tax-man instead of on his business.

-- Devinder Sidhu

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Says CorpA to CorpB: Do not associate with me

These days, it is not uncommon for there to be more than one corporation in a family. For example, a husband and wife may both be busy professionals who do business through their own corporations. Or a father may operate a business through one corporation and his son may operate a business through a different corporation.

Whenever there is more than one corporation involved in a particular family, it is always important to turn one’s mind to the concept of associated corporations because association could result in paying a higher amount of tax.

For example, a private family corporation that carries on an active business pays an 18% tax rate on the first $300,000 of active business income. If two family corporations are NOT associated, each has a separate $300,000 limit. If the two corporations are associated, however, they have to share that $300,000 limit. This means the higher rate of tax kicks in when the two family corporations have earned $300,000 of combined income. If there are three associated family corporations, then all three corporations would have to share the one $300,000 limit, thus further decreasing the amount of income any one of those corporations can earn before a higher rate of tax kicks in. (The $300,000 limit will be increased federally to $400,000 next year.)

The Income Tax Act provides a number of ways in which two corporations can be associated with each other. This article will focus on just a couple of those ways.

In the following example, wife owns all the shares of a corporation (WifeCo) that runs a paharmacy. The husband owns all the shares of another corporation (HusbandCo) that operates a bookstore. Since neither spouse owns shares in the corporation of the other spouse, neither corporation is associated with the other and each corporation pays tax at 18% on the first $300,000 of active business income. If either spouse owned 25% or more of the common shares of the other spouse’s corporation, however, the two corporations would have to share a single $300,000 limit.

Now let us move further in time to when the husband and wife are ready for some estate planning. They have been careful to keep their corporations completely separate and they now want to do an estate “freeze” of both their corporations using a discretionary family trust with the beneficiaries being their two children, daughter and son. An estate freeze would freeze or cap their respective interests in the corporations and allow future growth in each corporation to accrue to the discretionary family trust. However, daughter followed her mother’s footsteps and she too operates her own pharmacy through DaughterCo. Association could be a problem because each beneficiary of a discretionary trust is deemed to own all the shares owned by the trust. If the family trust owned all the common shares in both the parents’ corporations, HusbandCo, WifeCo and DaughterCo would all end up being associated with each other simply because daughter is a discretionary beneficiary of the family trust.

As soon as there is more than one corporation in a family, be sure to consider whether the corporations are associated. Sometimes parents do not want their children to associate with unsavory individuals. In this case, a family may not want their corporations to “associate” with each other, irrespective of the unsavory factor.

-- Devinder Sidhu

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for information about our services and lawyers' profiles.