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 slow down. It may be that such uncertainty persists for another 3.5 years, but that should not hinder business owners 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 class of share has not been created in a corporation's articles, then that type of share cannot be issued unless the 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.
What type of shares do I need and what are some potential tips and traps?
Different shares achieve different objectives. Generally speaking, share types 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 in the articles.
- Common non-voting shares – Do you want a shareholder to participate in growth and received dividends, but generally not vote? Common non-voting shares can be issued so those shareholders 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.
- 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 to ensure they maintain control when they bring in the next generation.
- “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 the corporation to repurchase it. A preferred share should be both redeemable and retractable to ensure it is indeed worth its redemption value from any potential tax assessment on value perspective.
- Dividends – The corporation's articles will often restrict dividends payable on these shares to a percentage of redemption value. The dividend percentage is sometimes tied to the prescribed rate1 as this permits cross-shareholdings under the association rules.2 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 should 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 – These are 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.
Footnotes
1. 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.
2. 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 their dividends are limited to the prescribed rate of interest.
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.
