Two tax reasons to "purify" your corporate structure: proper planning can help simplify, and even lessen, the tax burden.(Financ

It's possible to achieve a significant income tax deferral each year by retaining business income in your corporation, rather than paying out a bonus or dividends. The deferral is the difference between the low rate of tax paid by the corporation on its business income (15.5 per cent in Saskatchewan in 2009), and the high rate you would pay on the same amount of income earned personally (up to 44 per cent in Saskatchewan in 2009).

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However, the resulting buildup of excess cash in the operating corporation may lead to other tax issues that require "purification" to cure.

Purify: To qualify for the $750,000 Capital Gains Exemption ("CGE")

On the sale of shares of a Canadian-controlled private corporation ("Opco"), a Canadian resident individual (not a corporation) may be able to use the CGE to shelter up to $750,000 in capital gains from tax. However, you will NOT qualify for the CGE unless, at the time of the sale, 90 per cent or more of the fair market value ("FMV") of the assets of Opco are assets used in an active business carried on primarily in Canada. A buildup of passive assets--such as excess cash and investments--can quickly throw you offside this 90 per cent test.

Furthermore, you will NOT qualify for the CGE unless, throughout a period of up to two years prior to the sale, more than 50 per cent of the corporation's FMV of the assets were active business-use assets. (This 50 per cent test may become more strict if you have a "tiered" corporate structure, in which you own shares of a corporation which in turn owns shares of another corporation.)

A possible solution is to "purify" Opco by transferring the passive assets to a separate holding corporation ("HoldCo"). The steps required to achieve this without incurring unnecessary tax may be very complex or relatively straightforward, depending on the circumstances. Complex anti-avoidance rules must be carefully considered. There can be harsh tax consequences where this kind of "purification" is considered to have been done as part of a transaction or series of transactions that includes a sale to an unrelated person.

It's important to do this kind of planning sooner rather than later. The planning gets more complicated and risky, and likely more expensive, if you are contemplating it on the eve of a sale.

Purify: To stave off "Corporate Attribution"

Where family members hold shares of your corporation, either directly or through a family trust, certain tax rules known as "corporate attribution" must be considered. The circumstances under which corporate attribution applies will not be discussed in detail here, but suffice it to say that corporate attribution is almost always relevant, if not applicable, where you have done an "estate freeze," in which the parent owns preferred "freeze" shares, while other family members (or a family trust) own common "growth" shares.

If the corporate attribution rules apply, you may have to pay tax each year on a certain amount of deemed interest income. In the context of an estate freeze, the deemed interest income is often calculated as the value of your "freeze" shares multiplied by a certain interest rate prescribed under the tax rules. The resulting tax is punitive, as it applies to "income" you didn't actually receive, and for which the corporation didn't get a deduction.

Fortunately by ensuring that the corporation meets the 90 per cent active business asset test at all times, corporate attribution rules may not apply. The possible solution here is to use the Holdco to purify Opco on an ongoing basis. Provided certain requirements are met, Opco may pay tax-free dividends to Holdco. Holdco can therefore be used to keep Opco free of excess cash--without spoiling the tax deferral you've been enjoying by retaining business income in the corporation.

The foregoing is not intended to be, and should not be construed as, legal or tax advice. Readers are urged to consult their legal and tax advisors before acting on any of the matters discussed herein. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

Jos Herman

Financial Advisor,

Assante Financial Management Ltd.

Jos Herman, CA, Financial Advisor, is part of the advisor team with Darrell Nordstrom, Senior Financial Advisor with Assante Financial Management Ltd. This article was co-written by Sean Rheubottom, B.A., U.S., TEP, the Regional Vice President, Wealth Planning with United Financial Corporation.

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