Getting Capital out of your Holdco

Investors end up with capital inside holding companies for a variety of reasons including inheritance, tax & estate planning, and after the sale of an operating business. A holding company (“holdco”) is simply a corporation that earns passive income. Passive income is income earned from investments such as dividends from stocks, interest from loans & bonds, rent from real estate, and other passive royalties. Passive income contrasts with active business income, which is the income earned from revenue received from operating a business selling products & services.

The tax rate of passive corporate income is close to the highest level. This is so because of integration. The government wants to prevent taxpayers from avoiding tax by sheltering passive income inside corporations.

This post will describe the basic principles of receiving income from your holdco, including:

• Integration
• Shareholder Loans
• Paying Yourself a Salary
• Taxable Dividends
• Capital Dividends (“CDA”)
• Refundable Dividend Tax on Hand (“RDTOH”)

Integration

A central theme of the Canadian income tax system is tax integration. Tax integration is the attempt by governments through the income tax act to make the tax on income received at the corporate level the same or similar to the tax on income received at the personal level.

With integration in mind, to get cash into your hands from a holdco that can be freely spent on personal consumption, a similar rate of tax between corporate and personal will need to be paid. The timing and nature of this tax between corporate and personal levels is where there is room for planning and customization.

So, what are the best ways to get capital out of your holdco?

Repay Shareholder Loans

Oftentimes, when investors contribute funds to their holdco, they do so by way of a shareholder loan. The other way is by issuing shares. The benefits to issuing shares to shareholders of an active business is they can then take advantage of lifetime capital gains exemption (LCGE). But passive corporations are not eligible for this benefit, so contributing capital to a holdco by way of shareholder loans has advantages.

Interest rates and repayment terms applied to shareholder loans made from capital contributions are flexible. For example, the sole shareholder of a holdco can contribute $10 million cash to their holdco in exchange for a shareholder’s loan with flexible repayment terms. Capital can then exit the business in the future, flowing back to the shareholder at their discretion, by drawing down this loan amount. Documenting shareholder loans may be wise.

Pay Yourself

To withdraw cash from your holdco, shareholders can simply pay themselves a salary. The corporation will recognize an expense of this amount, but the income will be taxable in the shareholder’s personal name. If your personal tax rate is lower than the highest marginal rate, this method may be advantageous. The amount of the salary also needs to be “reasonable” based on the services provided. Although, with holdcos these services may be limited (since the holdco has no active operations).

Pay a taxable dividend

Corporations can pay dividends to their shareholders. The dividends received by shareholders are then taxable in the shareholder’s name. Issuing yourself taxable dividends from your corporation may be a good strategy if you also consider other ways to withdraw capital including a combination of salary, taxable dividends, and other non-taxable dividends as explained below.

Pay Capital Dividends

Arguably one of the best ways to withdraw capital from your holdco is to use the capital dividend account (“CDA”). Generally, the CDA is the non-taxable portion of the excess of capital gains over capital losses. The CDA is a notional account kept for tax reporting purposes. Anytime a holdco recognizes capital gains, a portion of the capital gain amount gets notionally credited to the capital dividend account. The proceeds from life insurance policies minus their cost base also generates a credit to the CDA.

The balance of the CDA can then be distributed to shareholders as capital dividends. Capital dividends are not taxable in the shareholder’s name, in line with the principle of integration. The CDA exists to level the rate between passive income earned within a corporation and the tax rate on those capital gains in someone’s personal name.

The RDTOH account

The refundable dividend tax on hand (“RDTOH”) account is like the CDA. The RDTOH account is a notional account kept for tax reporting purposes. The RDTOH account serves to track the “excess” tax that a holdco may pay on dividends compared to the tax shareholders may pay on those same dividends in their personal name. Like the CDA, when eligible dividends are earned inside a holdco, a portion of those dividends are notionally credited to the RDTOH account.

If/when a holdco makes a taxable dividend payment to shareholders, the holdco can claim a tax credit for a portion of those dividends, notionally debiting the RDTOH account.

Keeping Track of CDA and RDTOH balances

You may want to withdraw capital from your holdco, and so would like to see how much CDA and RDTOH account room is available. Shareholders can find the balances of their CDA and RDTOH account balances on the corporation’s tax return. In many cases, you may want to limit the amount you withdraw from your corporation by the amount of any shareholder’s loan, CDA, and RDTOH account balances your holdco has outstanding.

Loan Money to Others

If you want to withdraw cash or capital from your holdco, but don’t need or want that capital in your own hands. You can also simply lend the capital to others (including your family members). When you lend money to your family or others that are non-arms length including business associates, attribution rules may apply. So, its important to consult your accountant for tax advice.

Your holdco can also use assets as collateral to guarantee a loan for someone (or something) else. Once again, attribution rules may apply if this person is a family member or close business associate. The same collateral guarantee strategy could also be used by family foundations to aid other charities although its uncommonly used.

Generally, the CRA doesn’t have a problem if you lend money at market rates/terms to anyone since there would likely be no tax benefit to you. But, when making loans, consult with your accountant to consider the proper way to structure these loans to avoid attribution rules.

Our Family Office

Our family office works with investors with holding company structures and we consult with accountants and lawyers to consider the best strategies for you. Generally, our family office attempts to avoid complex tax structures. We have found over the years that the benefits of simplification far outweigh the perceived benefits of complex tax structuring. Especially when considering intergenerational planning.