Canada: No Small Matter: Minority Shareholder Disputes, Taxes And ‘Minority Discounts'

Are you a minority shareholder in a private firm? Owning and selling shares can be slightly more complex than you realize. From buying or selling shares and handling disputes with majority shareholders, to understanding the true financial value of your shares (hint: it may not be what you think), as well as the tax implications, here is what you need to know.  

Shareholder agreements = your corporate "Holy Grail"

Minority shareholders at most companies have two kinds of legal protection: securities legislation and shareholder agreements. The latter includes additional rights that extend beyond what's included in legislation.

It is important to remember that a shareholder agreement doesn't simply fall into your lap. It must be proactively and independently created. In these agreements, the majority shareholder usually gives up rights to the minority. The agreement also provides guidance on how shareholders are expected to conduct themselves.

If you've joined an established firm, they likely already have an agreement in place, so you should familiarize yourself with the advantages and limitations of being a minority shareholder. Then if a dispute arises, you know the options available to you.

Breaking up is hard

Shareholder disputes do not necessarily evolve because people don't get along. Most disputes occur when one party wants to retire or get their money out of the firm. Their motivation may be a timing issue, not necessarily a disagreement with the direction the firm is taking. It doesn't have to be a clash of egos, but when disagreements arise a dispute resolution forum is necessary.

Public courts typically aren't the best way to resolve shareholder disputes. The proceedings are public and the process slow. For privately owned firms, there are better alternatives: mediation or arbitration.

Mediation brings all parties in a dispute together, usually with the help of a mediator. The mediator hears the evidence and makes a recommendation to resolve the issue, but it's not binding.

Arbitration provides a less open-ended solution. This process takes place in a private court where the parties have signed a legally binding contract agreeing that the decision of the arbitrator will be enforced.

This option is faster and allows for more privacy. However, in my experience, mediation is preferable because you still have some control over the outcome.

Before you move on

Divesting yourself of shares doesn't have to be a fight. Generally there are up to three options available if you want to sell your shares in a firm (likely outlined in your shareholder agreement):

  1. Sell your shares back to the company
  2. Sell your shares to another stakeholder in the firm
  3. Sell your shares to an outside buyer 

Option 2 is usually only available if the firm's board of directors has set up a marketplace and an established price for the sale/purchase of minority share holdings.

Option 3 is often not available to you because many shareholder agreements don't allow the sale of shares outside the firm, wanting to keep wealth and ownership within the company.

With all of the options, you may be at the mercy of a concept called "minority discount". Also referred to as "discount for the absence of control," it's exactly what it sounds like.

You may not receive full-value payment because you have a "non-controlling interest." While there is no objective tool or formula to quantify this minority discount, in my experience, shareholders could receive as much as 30% less than the allocated-share value, (when selling shares as a stand-alone transaction as opposed to being part of the sale of the whole business). 

But there's one more thing to consider – do you and your firm actually know the true value of the shares?

What's in a share?

When your board of directors sets the value of company shares, it's often based on their estimation of how well (or not) the firm has done in the past year. Sometimes, they may consult with the company accountants or experts, but even then it may not be a thorough valuation exercise. So the current price of your shares may be under or over-valued in the open marketplace (i.e. if the company were to sell the business as a whole), especially considering the minority discount concept.

In order to learn the true value of your company assets, it's usually necessary to utilize business valuation techniques or (preferably) hire an expert business valuator. The process considers both the firm's income and cashflow streams, the assets and liabilities of the company and transactions in the greater marketplace.

This knowledge is not only invaluable when selling shares and/or handling a dispute, it is also important for personal financial planning – from individual estate and tax planning (for instance, passing on shares in the case of death) to asset measurement in cases of matrimonial dispute.

The taxman's share

So you've dealt with any disputes and/or found a buyer for your shares. How much are you going to have to pay in tax?

Let's return to buyer options. If you're selling to another shareholder or outside buyer, the proceeds will be taxed as a capital gain. Even if you pay the top marginal tax rate for capital gains (26.76% as of 2016), that's better than if you redeem the shares (sell them back to your firm). In this case the proceeds will be taxed as dividend income with top rates between 39% and 45%.

To add to the reasons why you may prefer to sell to other shareholders or an outside buyer, there's also a lifetime capital gains exemption that allows you to sell up to $824,176 (as of 2016) worth of qualified shares, tax-free. There are a series of tests that determine whether your shares are eligible for this exemption, but the major requirements are:

  1. Your company must be a CCPC (Canadian Controlled Private Corporation)
  2. The firm must carry on active business
  3. A specified portion of the company's assets must be used for active business purposes

Keep in mind

In the end, whether you're holding your shares, selling them or addressing a dispute, arm yourself with knowledge. Learn the true value of your company's shares and understand the implications of your shareholder agreement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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