Tax Strategy
Shareholder Agreements
Tax consequences of shareholder agreements
FROM: JUL-AUG 2004 ISSUE | BY FRANCINE ST-ONGE
When the shares of a private corporation are held by more than one shareholder, it is essential for the shareholders to formalize their relationship in a shareholder agreement. This agreement usually sets out how the activities of the corporation will be managed. For example, it may require that decisions be unanimous in certain cases. The agreement also deals with other aspects, such as disputes between shareholders and the retirement or death of a shareholder. From a legal standpoint, there are few restrictions on what can be set out in a shareholder agreement. Some clauses, however, can have significant tax consequences. Here are a few clauses that may cause problems.
Veto Rights or Limitations on the Powers of the Board of Directors
If a minority shareholder wants to increase the protection of his interests (this is often the case in a venture capital corporation), he may insist on having some control over the corporation’s operations. In some cases, the amount of control granted and the method used can mean that the minority shareholder will have de jure control (control in law) or de facto control (control in fact) of the corporation. For example, when a minority shareholder is granted the right to choose the majority of members of the board of directors or to veto important decisions usually made by the board, he might be considered to have de jure control if these powers are conferred by a “unanimous shareholder agreement” within the meaning of the applicable corporate legislation. On the other hand, the shareholder might be considered to have only de facto control if the agreement does not meet the criteria for a “unanimous shareholder agreement.”
The concept of control is important for the purposes of several provisions of the Income Tax Act (ITA), such as the following:
- associated corporations — de jure and de facto control;
- related persons — de jure control; and
- Canadian-controlled private corporations — de jure and de facto control.
Buy-Sell Clause
When a shareholder agreement, unanimous or otherwise, provides that a shareholder has a right, either immediately or in the future and either absolutely or contingently, to purchase the shares of another shareholder or to require the corporation to redeem or purchase the shares of another shareholder in circumstances other than the death, bankruptcy or permanent disability of an individual, the shareholder is deemed to be the owner of the shares that he is entitled to acquire, or to have the same position in relation to control as if the shares had been redeemed or acquired under paragraph 251(5)(b) and subsection 256(1.4) of the ITA. Thus, if the agreement provides for a right or an obligation to sell or purchase shares in the case of retirement, fraud, or termination of employment, this right may create an undesired relationship of association or non-arm’s length relationship.
In Interpretation Bulletin IT64R4, paragraph 37, the Canada Revenue Agency specifies that the deemed ownership of shares does not apply to:
- a right of first refusal granted to a shareholder, that is, a clause providing that if a shareholder wishes to sell his shares, he must first offer them to the other shareholders in the corporation, who have the option to purchase them or not; and
- a shotgun arrangement under which, if a shareholder offers to purchase, at a given price and under specific conditions, the shares of another shareholder, the latter must either accept the offer or purchase the shares owned by the offering party at the same price and under the same conditions.
Death
One of the most important clauses of a shareholder agreement is the one that deals with the procedure to follow in the event that a shareholder dies. From a tax standpoint, there are a number of points to consider in order to come up with a structure that satisfies the parties involved. There are two basic scenarios when a shareholder dies:
- the shares of the deceased shareholder are purchased by the surviving shareholders; or
- the shares held by the estate of the deceased shareholder are redeemed or purchased by mutual consent by the corporation.
The tax consequences for the estate and the surviving shareholders will vary considerably depending on the scenario chosen. Consider a simple example. Martin is deceased. Before his death, he owned 40 per cent of Corporation A. These shares had a paid-up capital (PUC) and an adjusted cost base (ACB) of $4,000, and a fair market value of $604,000. Martin and the other shareholder, Denise, whose shares have a PUC and an ACB of $6,000, signed a shareholder agreement in 1998, under which the surviving shareholder would become the sole shareholder following the death of the other party. The purchase of the deceased shareholder’s shares is financed by a life insurance policy held by Corporation A. The capital dividend account (CDA) created when the proceeds of the life insurance policy are received is equal to the price paid for the shares. The personal tax rates are 30% on dividends and 45% on other income. The shares are not eligible for the capital gains deduction.
Scenario 1
Under the agreement, Denise purchases the shares of the estate at their market value.
Tax consequences for Martin
| Taxable capital gain resulting from the deemed disposition at death |
| 50% x ($604,000 – $4,000) = |
$300,000 |
| Tax @ 45% = |
$135,000 |
Tax consequences for the estate
There are no tax consequences because the ACB of the shares for the estate is equal to the selling price of the shares.
Total tax — Martin and the estate
$135,000
Tax consequences for Denise
Denise now owns 100% of the shares of Corporation A, which have an ACB of $610,000 ($6,000 + $604,000).
The proceeds of the life insurance policy were received by Corporation A, which paid Denise a dividend out of the CDA to enable her to purchase the shares held by the estate. Therefore, Denise does not have to pay tax on the dividend that enabled her to acquire the shares.
Scenario 2
Under the agreement, Corporation A purchases by mutual consent the shares held by the estate at their market value — without using the CDA to pay the estate.
Tax consequences for Martin
| Taxable capital gain resulting from the deemed disposition at death |
| 50% x ($604,000 – $4,000) = |
$300,000 |
| Tax @ 45% = |
$135,000 |
Tax consequences for the estate
| Deemed dividend |
| $604,000 – $4,000 = |
$600,000 |
| Tax @ 30% = |
$180,000 |
| Allowable capital loss carried back against Martin’s gain, under ITA 164(6) |
| 50% x [$604,000 – ($604,000 – $600,000)] = |
– $300,000 |
| Tax savings resulting from the capital loss |
– $135,000 |
| Total tax — Martin and the estate |
| $135,000 + $180,000 – $135,000 = |
$180,000 |
Tax consequences for Denise
Following the purchase by mutual consent of the shares held by the estate, Denise owns 100% of the outstanding shares of Corporation A, but the ACB of the shares will be $6,000. Corporation A has a CDA of $604,000, and it will be able to pay Denise that amount in tax-free dividends in the future.
Scenario 3
Under the agreement, Corporation A purchases by mutual consent the shares held by the estate at their market value — using the CDA to pay the estate.
Tax consequences for Martin
| Taxable capital gain resulting from the deemed disposition at death |
| 50% x ($604,000 – $4,000) = |
$300,000 |
| Tax @ 45% = |
$135,000 |
Tax consequences for the estate
| Deemed dividend |
| $604,000 – $4,000 = |
$600,000 |
There is no tax payable on the dividend because it is paid from the CDA.
| Allowable capital loss |
| 50% x [$604,000 – ($604,000 – $600,000)] = |
– $300,000 |
| Limit, under ITA 112(3.2), to the loss that can be carried back against Martin’s gain, under ITA 164(6) |
– $150,000 |
| Tax savings resulting from the capital loss |
– $67,500 |
| Total tax — Martin and the estate |
| $135,000 – $67,500 = |
– $67,500 |
Tax consequences for Denise
Following the purchase by mutual consent of the shares held by the estate, Denise owns 100% of the outstanding shares of Corporation A, but the ACB of the shares will be $6,000. Corporation A no longer has a CDA and will not be able to pay tax-free dividends to Denise in the future.
Conclusion
This simple illustration shows that the chosen strategy can have significant tax consequences for the various parties. Things become complicated when the shares are eligible for the capital gains deduction, when the proceeds of the life insurance policy are insufficient, or when transitional rules pertaining to arrangements in place before April 26, 1995, may apply.
Drawing up a shareholder agreement is a complex undertaking in which the corporation’s legal counsel, accountant, and tax expert should always be involved. Yet it is important to remember that shareholder agreements are primarily drawn up for business purposes. Tax concerns are only one consideration when structuring the agreement.
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Francine St-Onge, BBA, BCL, LLB, FCGA, practises tax and corporate law in Sutton, Quebec. She is co-author of the CGA-Canada course Taxation 2.
"Tax Strategy" is co-ordinated by J. ThomasMcCallum, CBV, FCGA, a business valuation and income tax consultant based in Whitby, Ontario, and author of several CGA-Canada professional development courses. E-mail jtmc@jthomasmccallum.com.
The information appearing in "Tax Strategy" is provided for the interest of the readers. Neither CGA Magazinenor the column authors and co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.