Share and Share Alike 

Tax Strategy

Share and Share Alike

FROM: SEP-OCT 2004 ISSUE | BY DAVID NOLKE

Doug and Mary Brown are the owners of a Canadian-controlled private corporation called Serviceco, which has been very successful over the years. Serviceco has been in the business of selling investments and mortgages on behalf of financial institutions since 1989. Doug owns 20 Class A voting common shares and Mary owns 20 Class Cnon-voting common shares.

Collectively, these shares are equal to the fair market value of the company. Even though Mary's shares are non-voting, they are of the same value as her husband's voting shares. The company does not qualify as a "small business corporation" for purposes of the enhanced capital gains deduction. If the company did qualify, the Browns would try to sell their shares directly to a purchaser to take advantage of the capital gains exemption; however, it might not be possible to convince a buyer to tie up cash in a non-deductible investment just so the Browns can realize a tax savings.

With no child heir to the family business, the Browns would like to bring in a new shareholder to eventually assume sole ownership of Serviceco. This will allow them to start planning for their retirement. At first, no one comes up with the money to buy them out. As interest rates continue to fall, a few serious inquiries are made. Because this is a service business with clients, any sale should be staged over time so the clients can get to know the new owner. Then along comes John Smith who expresses interest in buying Serviceco from the Browns. He offers to make a down payment of $100,000 to purchase some shares and have 50 per cent of the votes.

Both parties agree that the company is worth $960,000 before tax and that the company will have to fund most of the purchase cost from future revenues. Mr. Smith will receive bonuses based on performance, the net of which he will receive and lend back to the company to pay the Browns.

Tax-Free Exchange

To minimize the tax impact on this transaction, the Browns will look to the Income Tax Act. Depending on the situation, several sections of the Act — sections 51, 85, 85.1, and 86 — can be used to execute a reorganization of share capital. Several Canadian Tax Foundation articles include comparisons of these sections. However, for the Browns' purposes, let's look at section 86.

Section 86 provides for a tax-free exchange of shares provided the following requirements are met:

• The exchanged shares must be capital property.
• The exchanged shares must be all of the shares of a particular class of the corporation's capital stock that the taxpayer owned at the particular time.
• The exchange of shares must occur "in the course of a reorganization of capital" of the corporation.
• The consideration received must include other shares of the corporation.
• Section 85 does not apply to the transaction, as long as an election is not filed.

The Act does not define the phrase "reorganization of capital" and the Canada Revenue Agency (CRA) has not issued any policy pronouncements on its definition. However, the general belief is that an amendment to a corporation's articles of incorporation constitutes a reorganization of capital sufficient to meet section 86 requirements.

Section 86 is commonly used in estate or other types of freeze transactions where it is important to exchange a class of share capital with specific features for a class of share capital with different features. The common transaction would be to exchange common shares for preferred shares with high redemption value and low paid-up capital.

In the Browns' case, Doug will exchange his 20 Class A voting shares for 430 Class Enon-voting preferred shares, redeemable and retractable for $1,000 each; 25 Class B voting common shares; and 50 Class G voting preferred shares, redeemable for their paid-up capital value.

Mary will exchange her 20 Class C Shares for 430 Class Enon-voting preferred shares, redeemable and retractable for $1,000 each; 25 Class B voting common shares; and 50 Class Fnon-voting preferred shares redeemable for their paid-up capital value.

The before and after votes and values look like this:

Before

Doug Brown
— 20 Class A voting shares (fair market value is $480,000)

Mary Brown
— 20 Class C non-voting shares (fair market value is $480,000)

After

Doug Brown
— 430 Class E non-voting preferred shares (fair market value is $430,000)
— 25 Class B voting common shares (fair market value is $50,000)
— 50 Class G voting preferred shares (fair market value is negligible)

Mary Brown
— 430 Class E non-voting preferred shares (fair market value is $430,000)
— 25 Class B voting common shares (fair market value is $50,000)
— 50 Class F non-voting preferred shares (fair market value is negligible)

The Browns have received equal value for the shares that they exchanged, and the paid-up capital of the Class A and Class C shares will be allocated proportionally among the new shares issued. They will then sell their Class B voting shares to John Smith for $100,000.

Balanced Transfer

So what have the Browns accomplished with this section 86 reorganization?

First, they have frozen part of the value of their original shares and placed a portion of the total value ($860,000) in preferred shares, which will rank ahead of the common shares on dissolution. While these shares are non-voting, they are retractable; therefore, the Browns can trigger their redemption whenever they want to. This is the portion of the purchase price that the Browns will receive out of the future profits of Serviceco.

Second, they have created Class G voting preferred shares with nominal value, otherwise known as skinny preferred shares, to provide Doug with 50 per cent of the votes.

Third, they have created Class F non-voting preferred shares with nominal value (more skinny preferred shares) to balance the number of shares issued so that Mary will have half of the shares and value.

Finally, they have placed the remainder of the share value ($100,000) in Class B voting common shares that they will immediately sell to John. After John buys these shares, both he and Doug will hold 50 per cent of the voting shares issued.

Once the Browns fully redeem their Class E preferred shares, John Smith would purchase their "skinny preferred shares," or the corporation would redeem them, so that John would assume 100 per cent share ownership of Serviceco. John would probably want to stagger this process over time to avoid a situation where Doug has only a nominal investment left in Serviceco but still 50 per cent of the votes. Of course, Doug might not agree since he'd want all of his money before releasing his voting power. They would need to negotiate this as part of the business transaction.

Section 86 allows the Browns to restructure their shareholdings on a tax-free basis. Otherwise, the Browns would be deemed to have disposed of their shares at fair market value and as a result, would have made a large, taxable gain.

Many side issues in this type of arrangement would explain why the share reorganization is structured in this way. The health of the vendors, the difficulty in attracting a new shareholder, or the need to provide some continuity with existing clients before the entire business is sold could all play a role. In addition, there are other rules to consider in applying section 86, including benefit or gifting rules in subsection 86(2), computation of paid-up capital in subsection 86(2.1), and computation of adjusted cost base in subsection 86(4). So you must consider and research many things before attempting this type of share reorganization with your business.

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David Nolke, FCGA, is proprietor of Nolke & Co., Certified General Accountant, in Calgary, and president of Integrated Business Advisory Services Inc., providing tax and management counsel to industry, government and other professionals. E-mail dgn@shawbiz.ca.

"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 Magazine nor 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.