The current economic climate has put a general damper on transactional activity. Many business owners, prospective purchasers and practitioners point to uncertainty as the primary culprit for this climate. It may be that such uncertainty persists for another 3.5 years or so, but that should not hinder the business owner from engaging in some good old fashioned tax planning in the meantime. A first step in considering tax planning is to ask the question – do you have the right share capital?
What is share capital?
Authorized share capital is the types of shares that a corporation is allowed to issue to its shareholders. A corporation’s authorized share capital is documented in its articles at the corporate registry of its home jurisdiction. Simply put, if a certain type of share does not exist, then that type of share cannot be issued unless a corporation’s articles are amended. Furthermore, any amendment to articles cannot be “backdated”. In other words, if articles that authorize a certain type of share are not filed until Day 1, then a reorganization that utilizes such shares generally cannot be completed until Day 1 or later.[1]
What type of shares do I need and what are some potential tips and traps?
Different shares achieve different objectives. Generally speaking, types of shares commonly utilized and that are recommended for tax planning flexibility include the following:
- Common voting shares – The default position. These shares grow in value with the corporation, carry voting rights, are entitled to dividends and share equally in distributions on wind-up of a corporation. In theory, a simple corporation may have only 1 class of common voting shares authorized. However, if the intention is to “dividend sprinkle” (i.e. pay more dividends on Class “A” vs. Class “B”), then multiple classes are required and a clause permitting “dividend sprinkling” must be included.
- Common non-voting shares – Do you want a shareholder to participate in growth and receive dividends, but generally not vote? Common non-voting shares can be issued so they get benefits of equity without the ability to vote on shareholder matters. However, it should be noted that they may still be able to vote on certain matters under the corporation’s governing legislation (ex: Business Corporations Act).
- Skinny voting shares – Shares may be issued which carry the right to vote, but otherwise are not entitled to growth in value, dividends or to share in liquidation proceeds. These types of shares are often issued to founders of a business when they bring in the next generation to ensure they maintain control.
- “Rollover” preferred shares – These shares are utilized in reorganizations involving estate freezes or rolling assets into a corporation. They have a redemption value equal to the fair market value of shares of another class or the assets transferred to the corporation in exchange for such shares. Furthermore, their value is fixed (subject to adjustments discussed below), but they are paid out prior to common shares on a liquidation. A few nuances here:
- Price adjustment clauses (“PAC”) – These shares will often include a PAC which allows for their redemption value to be adjusted in case value is reassessed (e.g. by the Canada Revenue Agency (the “CRA”)). However, note that PACs are not always desirable. In particular, you may not want a PAC in the context of a reorganization involving a family dispute or parties dealing at arm’s length as that could disrupt negotiated values.
- Redeemable / retractable – A share is “redeemable” if the corporation has the option to repurchase it from a shareholder. A share is “retractable” if the shareholder has the option to force a corporation to repurchase it. A preferred share should typically be both redeemable and retractable to ensure it is indeed worth its redemption value from any potential tax assessment on value perspective.
- Dividends – The articles will often restrict dividends payable on these shares to a percentage of redemption value. The dividend percentage is sometimes tied to the prescribed rate[2] as this permits cross-shareholdings under the association rules.[3] However, if the intention is to pay dividends greater than the prescribed rate and the association rules are not a concern, then a greater dividend cap could be inserted.
- Stock dividends – These types of shares should not be used for stock dividends as no property is given to the corporation in exchange for stock dividend shares. As such, when issued as a stock dividend, their redemption value would be $0 based upon the formula. As an aside, a formula could be utilized whereby a preferred share issued by stock dividend is (e.g.) equal to the underlying value of the corporation. However, it should be noted that the CRA has opined it does not respect PACs used in those scenarios since no property was exchanged for the shares.
- “Fixed value” preferred shares – Similar to “rollover” preferred shares, but they instead have a fixed redemption value such as $1 / share. They can still be issued in exchange for other shares or property transferred to a corporation so could be appropriate in the context of family disputes or arm’s length transactions. However, if a PAC is still desired, it should specify that the number of shares is adjusted as opposed to the redemption value (which is fixed). Furthermore, these types of shares may be utilized as payment for stock dividends.
Review your share capital and amend now if needed
Tax planning flexibility is a desirable trait for any corporation and it can be too late to implement a certain type of reorganization if the right share capital does not exist on the desired effective date. Contact us today to see if you have the right shares for future tax planning opportunities.
[1] It is important to note that this is a general rule with exceptions. The Tax Court of Canada case of Dale et al. v. The Queen, [1994] 1 C.T.C. 2303 stands for the proposition that an agreement to issue shares pursuant to subsection 85(1) of the Income Tax Act (Canada) may be valid under certain circumstances even where such shares are not authorized by the corporation’s articles at the date of such agreement. While the CRA has accepted this position as an administrative practice in limited circumstances, it is still best practice that a corporation’s articles include the requisite share capital on the desired effective date of a reorganization.
[2] The prescribed rate is an interest rate set by the CRA from time to time that will apply to any amounts owed to the CRA and any amounts owed by the CRA.
[3] While beyond the scope of this article, generally the association rules may cause corporations with common ownership to be “associated” for tax purposes such that they must share the small business deduction. However, certain preferred shares may be excluded from any common ownership analysis where, among other things, such shares are not convertible or exchangeable, are non-voting, have a fixed value and have their dividends limited to the prescribed rate of interest at the time such shares are issued.
