Corporations can own stocks, bonds, mutual funds and rental properties. Taxpayers could set up their own company and transfer their investments into it. But would this make sense?
For most taxpayers, the answer is probably "no." Corporations pay tax just like individuals do, and the corporate tax rate on investment income is high. In Ontario, for example, interest income and rental income earned by a private company attract an initial tax rate of about 50%. In contrast, the top personal tax rate is about 46%.
There is also a second layer of personal tax when that income is withdrawn from the company. At that time, the company receives a partial refund of the tax it has paid, to offset the personal tax and eliminate double-taxation. Thus, the combined net corporate and personal tax on investment income earned by a private holding company and paid out to the shareholder is almost identical to the personal tax that would be paid if the income had been earned personally.
Some other disadvantages include the costs to incorporate, ongoing fees to maintain the company and file tax returns, and the need to separate corporate and personal transactions carefully. Tax issues also arise on the transfer of assets into the company.
Despite the apparent disadvantages, many people do in fact hold investments inside a company. Following are some of the circumstances in which this might be appropriate:
Personal Tax Deferral
Many business owners accumulate significant profits in their companies. Typically, these profits have been subject to a corporate tax rate of only about 19% for most owner-managed businesses. A personal tax rate of up to 31% (Ontario rate) applies when the owner withdraws these profits from the company as dividends. But this tax liability is deferred as long as the profits are retained in the company. The deferral is a big incentive to invest profits through the corporation rather than drawing them out, paying a large tax bill, and having significantly less to invest personally.
We see many clients maintaining large investment portfolios within their companies for just this reason. A private company in this situation could be described as something akin to a corporate RRSP, where personal taxes are deferred until funds are withdrawn.
Pre-1996 Tax Rates
Prior to 1996, there was a significant imbalance in the tax system. Personal tax rates were as high as 54% while the top corporate tax rate was 45%. At that time, putting investments into a company provided a large tax deferral until the income was distributed to the shareholder. Many personal holding companies were set up in the early 1990s to take advantage of this situation, and continue to exist today.
U.S. Estate Taxes
A personal holding company can reduce exposure to U.S. estate taxes. The estates of high-net-worth Canadians who die owning U.S. assets can face large tax bills and complex paperwork from Uncle Sam. Taxes are levied on the gross value of the estate assets regardless of whether they have increased in value. Several strategies exist to minimize the impact of these taxes. One such strategy is to hold U.S. assets inside a Canadian corporation, as U.S. estate taxes apply only to assets owned by an individual directly. For example, shares of General Electric owned by a Canadian holding company are not considered to be owned by the individual shareholder and are therefore not subject to U.S. estate taxes.
Income-Splitting
Previously, the use of a holding company sometimes provided a means to split investment income between family members in certain circumstances and with careful planning. However, as a result of complex rules enacted by the Canada Revenue Agency, few opportunities now exist to split income in this way.
Those who already own investments inside a holding company likely will want to maintain the status quo. There probably were, and continue to be, good reasons for keeping the investments in the company. Conversely, if you are considering putting investments into a company now, consult with your Collins Barrow advisor to determine whether there are any other investment strategies more appropriate for your circumstances.
Written by Collins Barrow
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