The Advantages of a Holding Company
There are numerous ways in which holding corporations can be advantageous to taxpayers. As this post illustrates, holding corporations may be used to achieve objectives such as the tax-free movement of funds between related corporations, interest charge deductibility, income splitting, or estate freezing.
Holding Companies and the Movement of Funds
Suppose company X (X Co) and company Y (Y Co) are wholly owned by a person (A). Suppose also that X Co has excess funds while Y Co lacks funds. One way by which A could move funds from X Co to Y Co would be to have X Co pay dividends to A, and for A to then move these funds to Y Co. Of course, A would have to claim the dividend received as income and pay tax before moving the funds to Y Co.
In Canada, dividends may flow between corporations on a tax-free basis. If, in the above example, A were to set up a holding corporation (Holdco), A could instead have X Co pay dividends to Holdco and avoid paying tax on the movement of funds. Holdco could then move the funds to Y Co by, for example, entering into a loan agreement or share subscription with Y Co.
Holding Companies and Deducting Interest
If Holdco decides to enter into a loan agreement with Y Co that pays interest, Y Co (and its sole owner, A) should be aware of the rule restricting its ability to deduct its interest payments from its income.
Two prominent rules in the Income Tax Act affecting a corporation’s ability to deduct interest charges are found at paragraph 20(1)(c) and subsection 9(3). The former stipulates that a corporation may deduct its interest payments from its income if those payments are incurred to gain or produce business or property income. The latter stipulates that capital gains are not property income.
Suppose Y Co borrows funds to purchase an asset that is expected to generate a significant capital gain but is generating little property income. In this instance, subsection 9(3) is likely to apply to restrict the ability for Y Co to deduct its interest payments on the loan. However, if Holdco borrows these funds instead of Y Co, and if Holdco then transfers these funds to Y Co in exchange for equity, the interest payments may be deductible. The CRA has commented in Interpretation Bulletin IT-533 and in Income Tax Folio SC-F6-C1 that the expectation of a return of funds through the receipt of dividends from a subsidiary may be sufficient for a parent company to deduct the interest it pays on a loan taken out to purchase an asset such as the above.
Holding Companies – Income Splitting and Estate Freezes
Holding corporations may also be used to achieve income splitting and estate freezing objectives. For example, family members of a taxpayer may subscribe for common shares of a family-owned holding corporation that holds shares of the taxpayer’s small business corporation. It is possible that subsection 56(2) may apply to attribute back to the taxpayer any dividend payments made through the holding corporation. However, the Supreme Court of Canada in Neuman v. The Queen held that this provision could not apply unless a family member were to have a pre-existing entitlement to dividend income from its common shares. The CRA appears to endorse the Court’s decision in Interpretation Bulletin IT-335R2 at paragraph 9.
While the above strategies highlight some of the basic advantages of using a holding corporation, the sophistication of their structures and the legal complexity of their consequences vary with the circumstances and objectives of the taxpayer. If you have questions regarding the uses of a holding corporation, or if you are interested in incorporating a holding corporation, call us today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.
Gambling and Taxable Implications in Canada
This article will examine gambling and taxable implications in Canada. Tax Court Says Holding’em Liable for Taxes In two recent 2023 decisions, the...
Gambling and Taxable Implications in Canada
Personal Income Tax Benefit & Credits for Ontarians
While the tax filing deadline is still months away, Canadians (especially Ontarians) should start sorting through receipts as some personal tax credits and...