Holding companies owais akbar - fmgt 7410 - a00760114


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Holding companies owais akbar - fmgt 7410 - a00760114

  1. 1. INTRODUCTION“Should five per cent appear too small / bethankful I dont take it all…now my advice forthose who die / declare the pennies on youreyes1”. Granted our marginal tax rates neverescalated to rapacious levels which had theBeatles singing the blues, they still drive thepublic to vigorous extents in searching for waysto minimize tax. Effective tax planning is acentral aspect of financial planning across alllevels of taxation, and it carries the prospectiveof reducing tax implications for taxpayers undercertain approaches. Before engagement withsuch endeavors, taxpayers must understand theimplication they face so as to choose a suitableapproach. As with the use of coupons and“don’t pay until” promotions, tax planningpresents analogous approaches wheretaxpayers can either reduce their taxableincome or defer the payment of taxes. Eachapproach provides varying tactics and thisarticle will aim to present one such course ofplanning. At a corporate stage, there is nocorrect structure as each taxpayer facesdiffering circumstances, which give rise tovarious opportunities and implications. In thereal world, corporate organizations can becomevery complex and one such element of thiscomplexity is the use of holding companies.These are corporations, setup primarily for thepurpose of investing in other private or publiccorporations. As they allow for a tax-freetransfer of earnings between corporations, theymay provide meaningful and substantialbenefits to users. Contrary to the complexity1The Beatles. "Taxman." Rec. 21 June 1966. GeorgeMartin, 1966. CD.holding companies create in businessorganizations, the process to set one up is fairlystraightforward. Those interested in starting aholding company must file an Articles ofIncorporation; as is the case with anycorporation. They can then transfer assets intothe company and begin investing in whatevercorporations the shareholder(s) choose.Transfer of assets into the company can bedone on a tax-free basis under section 85 of theIncome Tax Act (ITA). This is beneficial if thereare accrued gains on the assets beingtransferred as they would have pending taxcomplications. The utilization and conditionsassociated with section 85 are beyond thescope of this article but understanding theimportance of such a tax deferral is crucialwhen contemplating a startup of a holdingcorporation. I’ll now take you through some ofthe benefits associated with holding companiesand later provide some of the hazards.HOLDING COMPANYHOLDING COMPANIES:SAFEDEPOSIT BOXESApril 1, 2013Owais Akbar ▪ FMGT 7410 ▪ Victor Waese ▪ A00760114
  2. 2. INTEGRATION & DEFFERALThe integration system implemented in Canadaserves the aim to remove any partiality thatmay present itself when income is earned by anindividual through a corporation as opposed tohaving it being earned by the investor directly.In actuality, this concept falls short ofperfection and because of numerable provincialrates, certain provinces can provide for taxsavings and costs. Further associated with thissystem is the notion of tax prepayment anddeferral. A prepayment or deferral is producedthrough differences in corporate and individualtax rates. If corporate tax rates are lower thanindividual rates, then this provides a deferraland vice-versa if the opposite holds true. Fordescriptive purposes, I will assume that anytaxpayer in question is in the highest marginaltax bracket and resides within the sameprovince as the corporation used forcomparative purposes. Over the past severalyears the Canadian tax system has developedsuch that under section 123.3 of the ITA, anadditional tax has been levied on investmentincome as defined per section 129(4). Thelevying of this section eliminates any taxbenefits whether it be savings or deferrals;replacing them with additional tax costs andprepayments. Now although the CRA has madeearning investment income through acorporation disadvantageous, there is still apotential for tax deferrals if the earnings paidby the corporation are paid out of businessincome as non-eligible dividends or eligibledividends not subject to Part IV tax. As Part IVtax under section 186 is not applicable to“connected corporations” as defined persection 186(4), there becomes an immediatetax deferral available if earnings are retainedwithin a corporation. This provision of the ITA iswhat makes holding companies beneficial whendealing with the transfer of earning. ByronBeswick provides a fitting illustration in thefollowing example:“Consider a typical situation where a holdingcompany (Holdco) owns the shares of anoperating subsidiary (Opco). Both corporationsare CCPCs. Opco pays eligible dividends toHoldco, which are reinvested in shares of a publiccompany (Pubco) that pays eligible dividendswith a 5 percent yield. Since the eligible dividendson the Pubco shares should increase Holdcosgeneral rate income pool (GRIP), 18 the eligibledividends can be flowed out by Holdco as eligibledividends. Provided that Holdco does not retainany of the portfolio dividend income, no part IVtax should be payable. On an Opco dividend of$500,000, Holdco can flow out eligible dividendincome of $25,000 per year to its shareholder,who is resident in Alberta. At the top marginalAlberta rate on eligible dividends (19.29 percent),Holdcos shareholder receives $20,177 after tax.By comparison, if the shareholder received the$500,000 Opco dividend directly, the after-taxfunds available for investment would be$403,550. The after-tax dividends that would beearned on this amount invested in the samePubco shares would generate after-tax income of$16,285 per year. The incremental after-taxincome of $3,892 per year is a benefit that canbe maintained virtually indefinitely.2”CREDITOR SHELTERING“Why start a holding company when you canjust leave the money in the operating companyand defer tax that way?” One word stems ananswer: risk. If you own a company with excessfunds then you bear unnecessary risk. Anycompany, regardless of the industry, facescontingent liabilities which it would choose to2Byron Beswick and Beau Young, "Personal TaxPlanning—The Use of Holding Companies in thePrivate Business Context," (2012), vol. 60, no. 1Canadian Tax Journal, 169-191. 24-Mar-13
  3. 3. hedge against. A transfer of these funds to aholding company successfully minimizes the riskassociated with creditors as the money issheltered within the holding company. If theoperating company requires financing, theholding company can lend funds back to theoperating company while establishing itself as asecured creditor. Bear in mind that “there arelaws respecting fraudulent conveyances andpreferences3” and you should consult with aprofessional before undertaking any suchactions. Furthermore, holding companiesprovide a degree of flexibility which can beextremely favorable in situations with multipleshareholders. For instance, consider a situationwith two shareholders who equally own sharesof a closely held corporation. Since theseindividuals “may want to be business partnersbut not investment partners4” they can each setup their own respective holding companies. Theshareholder who requires funds can have themoney flow through his holding company tohim and pay his respective tax while theshareholder who doesn’t require the money,can retain it within his holding company andcontinue to defer tax.INCOME SPLITTINGAnother principal advantage of incorporating aholding company is that it provides a means totransfer shares to family members without3"Holding Corporations: What Are They and AreThey for Me?" Million Dollar Journey. N.p., 23 Oct.2008. Web. 01 Apr. 2013.4Buckwold, Bill. "Chapter 14: Multiple Corporationsand Their Reorganization." Candian Income TaxationPlanning and Decision Making. 2012-2013 Editioned. N.p.: McGraw-Hill Ryerson, n.d. 571. Print.adverse tax consequences. An individual maytransfer their shares of an operating companyinto a holding company and have the holdingcompany issue separate class shares to theirfamily. Splitting income in this manner isperfectly acceptable and “should not be subjectto the income attribution rules in the Act,provided that each family member acquires theshares for their fair market value, using his orher own funds5.” In effect, whether payment isby means of salary or dividend, this method canprovide for a lower tax assessment and isanother effective tactic in tax planning.5Byron Beswick and Beau Young, "Personal TaxPlanning—The Use of Holding Companies in thePrivate Business Context," (2012), vol. 60, no. 1Canadian Tax Journal, 169-191. 24-Mar-13INCOME SPLITTING
  4. 4. ESTATE FREEZES: U.S. &CANADIANA further and little more complex advantage ofholding companies is the aid they provide inestate planning. Now this approach definitelyrequires some professional guidance but I willdetail some of its important features. InCanada, the purpose of an estate freeze isessentially to halt the value of shares for theoriginal holder so as to minimize taximplications at death. This planning can be donethrough a holding company as it allows for anyfuture growth to be transferred to familymembers in a similar manner to the onediscussed above under income splitting. If aCanadian resident holds US investments theymay be subject to US estate tax at the samerates US citizens are subject to. Although thereare some definite tax credits available,individuals should “consider using a Canadianholding company to hold [these] investments. Acorporation doesnt die as you do, so you cansidestep U.S. estate taxes if the corporation isthe owner.6”BUSINESS ACQUISTIONS & SALESWhen acquiring a business, especially if it isfinanced by means of debt, holding companiesprovide a significant benefit in terms ofrepayment of the loan. This benefit is simplyderived from the fact that the holding companywill make payments from tax-free dividends6Cestnick, Tim. "Estate Tax: Uncle Sam Wants ThatToo." Editorial. The Globe and Mail. N.p., 26 Jan.2011. Web. 01 Apr. 2013.<http://www.theglobeandmail.com/globe-investor/personal-finance/estate-tax-uncle-sam-wants-that-too/article622489/>.after a single level of taxation, whereas anindividual will face two levels of tax. Althoughthe source of the funds is the same operatingcompany, the flow of dividends is subject todifferent levels of tax; providing a benefit underone alternative and a cost under the other. Forfurther understanding, consider that theholding company is unable to utilize its taxdeduction as a result of having no taxableincome. Under these circumstances, theselosses are carried forward and upon repaymentof the loan, the owner can choose toamalgamate the two corporations. Thiseffectively allows for the losses to be appliedagainst the income of the operatingcorporation.Upon selling a business, holding companies canyet again prove to be substantially beneficial asthe idea is to minimize tax. If an individual sellsthe shares of the operating corporation, thatindividual will be subject to tax on any accruedvalue above the cost of those shares. A holdingcorporation can however reduce this excess byhaving the operating company pay it a tax-freedividend prior to the sale. Payment of theretained earnings (safe income) as dividend willeffectively reduce the value of the shares;thereby reducing tax on the disposition. Careshould be given to provision in the ITA whichlimits tax-free dividends to the amount of safeincome.These are just some of the several advantagesof having a holding company in a corporatestructure. Benefits are specific to differentinvestors and each taxpayer should evaluatetheir situation accordingly. So as not topropagate the notion that holding companies
  5. 5. are perfectly advantageous, I will cover some ofthe potential dangers they can create.DISADVANTAGESAlthough I don’t mean to sound bias, thedisadvantages of holding companies are limited;many of which are precautions individualsshould take when attempting to exploit certainbenefits. For instance, with the income splittingbenefit described before, a taxpayer must becareful not to get caught offside by theattribution rule. Likewise, as holding companiesare not considered to earn active businessincome (ABI), they are not entitled to the smallbusiness deduction (SBD). However, evenwithin this drawback there appears to be asolution as section 129(6) deems certain incometo be ABI; allowing for holding companies toutilize the SBD. Once able to claim a SBD,individuals must be wary of the associationrules under section 256(2). This connotes thatthe holding company and operating companymust share the SBD limit unless certainelections are made. Consideration must still begiven even after such an election because “thecourts have placed the onus on the taxpayer toprove that reducing taxes was not a mainreason for the separate existence of the twocorporations7.” As divulging into the details ofthese provisions is not within the scope of thisarticle, I will just say that the general anti-avoidance rule (GAAR) under section 245 is aperpetual constraint, regulating various tax7Byron Beswick and Beau Young, "Personal TaxPlanning—The Use of Holding Companies in thePrivate Business Context," (2012), vol. 60, no. 1Canadian Tax Journal, 169-191. 24-Mar-13planning tactics. Another, but not too surprisingdisadvantage is the denial of a capital gainsdeduction (CGD). As corporations are notentitled to this to begin with, it isn’t much of ashocker. Nevertheless, it proves to be adrawback as individuals could use the CGD toshelter gains on the disposition of shares. Afinal aspect of holding companies to consider isthe limitation section 40(2)(g)(ii) creates. UnderIT-159R3, CRA holds the view that:a taxpayers capital loss on the disposition of adebt or other right to receive an amount is nilunless,(a) the debt or right was acquired by thetaxpayer for the purpose of gainingor producing income (other than exemptincome) from a business or property, or(b) the debt or right was acquired by thetaxpayer as consideration for thedisposition of capital property to a person withwhom the taxpayer was dealingat arms length.On account of this provision, losses associatedwith outstanding debt can be denied if thereisn’t sufficient evidence to uphold the “intent toearn income” clause contained within the rule.An application of this rule can be seen in thefollowing court ruling in the case of Alessandrov. The Queen.ALESSANDRO V. THE QUEENThe issue in this case is whether the appellant,Gregorina Alessandro, is entitled to a businessinvestment loss (BIL) of $497,292 in 1997 whenloans made to OPHL became bad. As a result ofthis bad debt, the appellant claims to havedisposed of the investment in OPHL for an
  6. 6. amount equal to nil. She feels entitled to the BILas she claims to own OPHL through hercomplete ownership of Arrow and AlessandroHoldings Limited (AHL). The Minister agreedthat she was a shareholder of AHL but theinterrogation regarded AHL’s position as amajority shareholder of OPHL. The Ministerdenied the BIL for the appellant on the groundsthat she was not a shareholder of OPHL. As isthe case with such appeals, the onus was onAlessandro to prove that otherwise. Aftercertain findings and disputes, it was determinedthat the appellant did in fact have control ofOPHL. The Tax Court ruled “that the taxpayercontrolled both the holding company and itssubsidiary, such that she could cause dividendsto be paid by the subsidiary to the holdingcompany and in turn from the holding companyto herself.8” This is important because thisunderlines the message that in owner-managercircumstances, BIL’s associated with debt areavailable to taxpayers. Accordingly, theappellant was entitled to the loss in 1997.Supplementary appreciation of this provisioncan come from review of Rich v. The Queen.This case establishes that so long as income-earning is one of the purposes of a loan, thenthe clause in section 40(2)(g)(ii) is met. To“satisfy the income purpose test, income neednot flow directly from a loan to the taxpayer.9”8Byron Beswick and Beau Young, "Personal TaxPlanning—The Use of Holding Companies in thePrivate Business Context," (2012), vol. 60, no. 1Canadian Tax Journal, 169-191. 24-Mar-139"Alessandro v. The Queen - Tax Court of Canada."Tax Court of Canada. N.p., n.d. Web. 01 Apr. 2013.<http://decision.tcc-cci.gc.ca/en/2006/2007tcc411/2007tcc411.html>.This was the case in The Queen v. Byramwhereby a taxpayer was ruled to have madeinterest-free loans in expectation of dividendincome. The court held the position thatshareholders “make such loans on an interest-free basis anticipating dividends to flow fromthe activities financed by the loan.10”FINAL WORDSOver the last few decades holding companieshave diversified and emerged as favorableinvestment vehicles in every industry. Withnumerous benefits and entwined with limiteddownside, their popularity as a tax planningtactic continues to grow. If a taxpayer is willingto entertain the risks and costs associated withmanaging a holding company, they canpotentially minimize their tax consequences.The question remains whether they are foreveryone and frankly, it relies upon eachindividual’s specific situation. What is without adoubt is that a penny saved is a penny earned.10Ibid