Accountants and other professionals often advocate incorporating a holding company (“holdco”). But now what? Establishing a holdco is most commonly used to hold the shares of an operating company (“opco”). Retained earnings of the opco can be transferred to the holdco through a tax-free intercompany dividend, in most cases.
The two key reasons for structuring ownership this way are:
- To reduce liability in the opco by protecting retained earnings from litigation
- To defer taxes until the funds are needed personally by the shareholder
Once funds have been moved to the holdco, they can be loaned back to the opco through a promissory note. This provides the opco with access to additional working capital if needed.
When not needed for working capital in the opco, funds can be accumulated in the holdco. Often business owners do not have an immediate personal need for those funds, thus providing investment opportunities.
So what should you do with the funds that the holdco has accumulated?
1. Hold Guaranteed Investment Certificates (“GICs”)
As GICs are very low risk, this can be a good option for the risk-averse, or those who require their principal within a relatively short period of time. GICs allow you to protect your principal, while growing those funds at a low interest rate over a specific term. Therefore, if you need the funds in 90 days, you may invest in a 90 day GIC allowing you to protect your principal while earning some interest in the time before the funds are needed.
2. Hold an Investment Portfolio
Investment portfolios are often managed by a professional and therefore can be tailored to your specific needs from the flow of income, to your risk level and desired diversification. You can, of course, choose to hold a self-managed portfolio in your holdco, but that is riskier as you do not have a professional helping you diversify and manage risk.
3. Invest in Real Estate
Real estate in Ontario has a history of appreciating in value. By purchasing real estate for rental, you earn a steady stream of rental income while enjoying growth in the value of the property. Of course, this option is not risk-free. Risk considerations with real estate are:
- Impaired property value in a declining housing market
- Vacancy leading to reduced rental income
- Costs to repair damage to your unit(s)
However, additional profit can be made if you can complete repairs and renovations yourself.
If the aggravation of managing rental units is not for you, you could access this market by investing in a real estate investment trust (“REIT”). This allows you to benefit from the positives of the real estate rental market, while not having to be involved in finding and purchasing units and managing those rentals.
4. Offer Private Mortgages
Lending funds to others looking for capital often provides high returns, but again not without risk. Private mortgages are often the vehicle of choice for such lending as they provide collateral security over the loan (as you hold the property being mortgaged), which reduces the risk related with lending. Private mortgages also charge a premium rate as those looking at private funding generally are not in a position to borrow from a financial institution. If the borrower does default, you will be left holding the collateral and therefore may need to arrange for a sale to collect your principal. However, by being selective about who you lend to, you can generate a strong return on your funds.
While your holdco generates income on the investment of your choice, the holdco will be subject to a higher rate of corporate tax compared to the effective tax rate in your opco. However, this higher rate has a refundable portion. Therefore, once the funds are needed personally and a dividend is paid out to the shareholder, the holdco will benefit from a refund of the refundable portion of taxes paid. Meeting with an advisor and planning in advance will ensure you fully understand the investment strategy and the timing of the tax implications.
The goal of the holdco is to provide you with a flow of funds that meets your personal needs while being as tax effective as possible. Regardless of the investment you pick, it is important that your accumulated funds are working as hard as you do.
Want more information? You can contact Kim at 519-822-9933 or visit www.rlb.ca!
