What is a Holdco? Unlock the Benefits of a Holding Company for Your Business

Do you need a Holdco? For many businesses, a Holdco can offer several advantages – but there is a bit of complexity involved and a few things to watch out for when thinking about including a Holdco in your business structure. In a recent conversation, Daniel Wilson, Partner, Taxation at Segal GCSE LLP, shared the benefits and considerations for businesses to be aware of.

What is a Holdco?

A Holdco is a company that does not produce any goods or services. Instead, this type of company is generally used to hold assets, which could be in the form of excess cash, marketable securities or shares of a private company that operates as an active business.

“As an example, let’s say you have two friends who start an IT consulting company, where each own 50% of the common shares. Each individual may decide to interpose a Holdco between them and the IT company,” explains Wilson. “A Holdco could also be used to hold shares of several companies, each of which owns a different part of the same business.” Wilson provides an example of a pharmaceutical company, where the sole purpose of one business is to manufacture products, another is to own the real estate and a third could own the intellectual property – each business ladders up to the Holdco.

Benefits of a Holdco

There are several distinct advantages to setting up a Holdco:

Asset protection

“As a business owner, you want to have peace of mind that your hard-earned assets won’t be at risk if the company is subject to litigation or creditor claims in the future. If you move assets from an operating company to a Holdco, such as excess cash or real estate, you can achieve asset protection,” explains Wilson. Moving assets to a separate legal entity puts them out of reach of creditors who could go after the operating company. It is important to have the proper structure in place at the outset, and not wait until the creditors are at the door.

Control over dividend income

Going back to Wilson’s example of the IT consulting company, he explains that each shareholder may want – or need – different amounts of cash to fund their lifestyle. Each shareholder may own the IT consulting company through a separate Holdco. “The operating company can pay the after-tax income up to each Holdco on a tax-free basis. At that point, the individuals have total control over how much they wish to pay themselves in dividends from the Holdco,” he explains. They are also in control of the timing of the dividends.

Tax purification

When you make a profit from selling a small business in Canada, the lifetime capital gains exemption (LCGE) could spare you from paying taxes on all or part of the profit you earned. Under the 2024 Federal Budget, the LCGE exemption limit is proposed to increase to $1.25 million as of June 25, 2024, up from just over $1 million. But to qualify for the exemption, the shares you’re selling must be Qualified Small Business Corporation (QSBC) shares, meaning there is a set of conditions that dictate whether or not those shares are eligible for the LCGE. 

Here are the criteria in a nutshell:

• Asset test – 90% or more of your company’s assets must be used in an active business conducted primarily in Canada at the time of sale.

• Basic asset test – 50% or more of your company’s assets must be used in an active business conducted primarily in Canada for the entire 24-month period before the sale.

• Holding period test – The owner of the business must have held the shares for at least 24 months before the date of the sale. 

Wilson explains how a Holdco can help an owner meet some of these criteria. “If you have accumulated assets in a company and you have excess cash over and above what your general working capital requirements are, or you have passive investments, those would be considered as non-active assets,” says Wilson, explaining that this situation could negate an owner’s LCGE eligibility. Having excess cash and investments in a Holdco as opposed to an operating company, however, keeps the operating company “purified” so that at least 90% of its assets are used in the active business. The result is that its shares may qualify for the LCGE.  In order to qualify for the LCGE, the non-active assets should not be owned by a Holdco which is a direct shareholder of the operating company.  This generally means undergoing a series of transactions to remove redundant assets before a sale can take place, or setting up a more complex ownership structure that will permit ongoing purification.   

Estate planning

Another advantage of a Holdco is the ability to do estate freezes and succession planning. In an estate freeze, the company’s share value is frozen for the original shareholders and all future growth is passed on to the next generation.  

“Let’s say you have a parent who is nearing retirement who owns shares of a successful operating company that’s continuing to grow. The parent could transfer their shares of the operating company to a Holdco and take back fixed value or frozen preferred shares,” explains Wilson. “The adult children could then subscribe for common shares at a nominal amount. What has happened is the parent now has limited their estate tax liability by freezing the value of their shares.” At the same time, the Holdco provides a place from which the parent can pay dividends to fund their lifestyle costs.  

The estate planning strategy may be combined with LCGE planning so that the parent may claim any eligible LCGE at the same time of the estate freeze.  The parent’s ability to claim the LCGE will not be affected by the future direction of the company.   

Tax deferral  

Operating companies in Canada have low tax rates on business income. So, by keeping funds in a Holdco rather than paying dividends to an individual shareholder, you can also create tax deferral opportunities. For instance, an Ontario operating company might pay 12.2% corporate tax on the first $500,000 of their active business income. If this were paid to an Ontario resident, individual shareholder, they would pay 47.74% tax on those dividends. “But if the after-tax income is paid to a holding company, you won’t need to pay any additional taxes on these profits until the funds get distributed to the individual shareholder,” explains Wilson.  

Holdco tips for business owners

While there are many benefits to a Holdco, there is some complexity involved in setting one up so that it provides all the benefits you expect to gain. Wilson offers these tips:

• Have a team to help set up your Holdco. Accountants, tax advisors and investment advisors can help design what your company structure should look like according to your intentions for your business, the type of growth you’re looking for and your plans for selling. “You want to have the right structure in place from the beginning so that everything operates smoothly,” advises Wilson.  

• Make a practice of regularly transferring excess assets to a Holdco. If you’re considering selling your company or looking to protect your assets from creditors, shares must be held in a Holdco for at least 24 months. Regularly transferring excess assets can keep you from scrambling right before you’re looking to sell or seek protection for your assets from creditors.  

• Be as proactive as possible. If you feel there is potential to sell your business in the future, it’s important to remember the criteria involved in qualifying for the LCGE. “Your business has to be purified and your assets have to be in the right place before you sell,” advises Wilson. “You must have a clear 24-month period where more than 50% of the company’s assets are used in an active business for the entire 24-month period before the sale [to qualify].” 

For many businesses, a Holdco can offer several significant benefits, including a deferral of income taxes and asset protection. However, establishing a Holdco does add an extra layer of complexity to your business structure. Seeking advice from financial, tax, legal and accounting experts can help ensure you structure your Holdco properly from the outset and realize the many advantages it has to offer.

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