1 TAX ISSUES FOR COMMERCIAL PRACTITIONERS PAPER 3.1 Share Structures and Rollovers These materials were prepared by Annie H. Chen of Richards Buell Sutton LLP, Vancouver, BC, for the Continuing Legal Education Society of British Columbia, May Annie H. Chen
2 3.1.1 SHARE STRUCTURES AND ROLLOVERS I. Introduction... 2 II. Share Structures... 2 A. Technical Corporate Law Considerations Articles Special Rights and Restrictions... 2 B. Non-Technical Considerations... 4 C. Tips and Traps... 5 III. Rollovers... 5 A. The Basics... 5 B. A Typical Section 85 Rollover Eligible Parties Eligible Property Election Amount & Election Form Valuation Price Adjustment Clause... 7 C. Types of Consideration Preferred Shares Common Shares Assumption of Debt Others... 8 D. Effective Date Required Entities Required Share Capital Cash Flow... 9 E. Tips and Traps Other Considerations for Rollovers Effective Date Share Capital Review of Minute Book Transfer of Legal Title to Property Section Indirect Gift Rule Division/Allocation of Tasks Existing Credit Arrangements & Other Agreements... 12
3 3.1.2 I. Introduction The topic of share structures and rollovers is a very broad and expansive area which cannot be covered in the scope of a single paper of this type. As such, this paper is intended only to be a brief general overview of share structures and rollovers. It focuses on some basic principles and discusses some of the more practical considerations ( tips and traps ) that commercial practitioners may want to note and be cautious of when dealing with these issues in their practice. This paper also assumes that the audience has some level of general knowledge and experience with corporate law and corporate planning. II. Share Structures As most practitioners in BC will mainly be dealing with BC companies incorporated and governed by the BC Business Corporations Act, S.B.C. 2002, c. 57 (the BCA ), this paper will focus on BC companies and will not discuss companies that may be governed by other provincial jurisdictions or governed federally. A. Technical Corporate Law Considerations In order to design and implement a proper share structure for clients, there are technical corporate law issues that must be taken into consideration. The following is an overview of some of those technical considerations. 1. Articles The Articles of a company are the rules, rights and restrictions which govern the conduct of the company. The Articles may include a section or sections which set out the special rights and restrictions for each of the various classes of shares in the authorized share capital of a company. The authorized share capital of a company is the number, kinds and classes of shares that the company is authorized to issue. 2. Special Rights and Restrictions There are three general rights for shares that are mandatory and must be encompassed in one or more classes of shares of a company. These are: Voting rights. This is the right to vote for the board of directors of the company and to vote on various other shareholder matters. Dividend entitlement rights. This is the right to participate in the profits/earnings of the company by way of dividends. Participation rights to the assets of the company on wind-up or dissolution. As noted above, these three basic general rights must be in the shares of a company. If the Articles of a company are silent as to whether or not a particular class of shares has any of the above rights, that particular class of shares will be deemed to have that basic right. For example, if the Articles do not specifically state if a particular class of common shares have voting rights, that class of common shares will be deemed to have general unrestricted voting rights.
4 3.1.3 Conversely, if the Articles of a company specifically states that a particular class of shares has a specified right of a specific type, then that class of shares will be deemed to only have that specified right and no further expanded rights. For example, if the Articles of a company states that a particular class of shares only has a right to a fixed dividend amount every year, then that particular class of shares will only be entitled to that fixed dividend amount and will have no further dividend entitlement rights. There are other types of rights that are optional and can be included or attached to one or more classes of shares of a company. Some examples are: Redemption rights This is the right of the company to redeem (buy back) the shares of a shareholder. Retraction rights This is the right of the shareholder to require the company to retract (buy back) the shares of a shareholder. Variations on dividend entitlement rights Dividend rights can be structured in a variety of ways, such as the following: Dividend rights may be cumulative or non-cumulative; A certain class of shares may be given priority to dividends over other classes of shares; and Dividend rights may be fixed at a certain amount or rate or in the alternative, dividend rights may be discretionary. Priority rights to the assets on wind-up or dissolution of the company Certain classes of shares can be given priority before other classes of shares to participate in the assets of the company on a wind-up/dissolution. This priority participation right can be restricted to a certain amount (i.e., the redemption price of the shares or the par value/paid-up capital amount of the shares). Conditional rights Certain rights can be taken away or given to a class of shares upon the occurrence of certain conditions/events. For example, in a family business, the voting rights can be associated with the shares of the parent who established the business and upon the passing of the parent, the parent s shares can lose their voting rights and the voting rights can be given to the class(es) of shares held by the next generation. This allows the parent to retain voting control during the parent's lifetime and facilitates the automatic transfer of voting rights to the next generation upon the passing of the parent without any delay or further paperwork. The above examples are but a small sampling of the types of special rights and restrictions that may be contemplated and used in designing share structures. The only real limit to the type of customized structures that can be designed is the imagination of the practitioner.
5 3.1.4 B. Non-Technical Considerations In addition to the technical issues related to share structures, there are also non-technical considerations (i.e., soft issues) that can be equally as important as the technical considerations when designing a share structure for clients. There is no one size fits all when it comes to share structures. Each client s circumstances, needs and objectives will be unique and different. Some of these other non-technical considerations are discussed below. Client s needs and objectives It goes without saying that all of the client s needs and objectives should be thoroughly canvassed and considered. It is helpful to have the client describe in his or her own words what they want to achieve as this can at times afford the practitioner more insight into the client's priorities and goals at the big picture level. Parties can often get too focused on the technical details that they lose sight of the overall goals of the client. Tax considerations Tax considerations are always a factor in designing share structures. There are too many considerations to be covered in this paper; however, some of the main issues may include: Income splitting; Deferral of Taxes (income taxes and capital gains taxes); Use of Trusts; and Cash flow/distribution options (i.e., dividends, salaries, loans). Simple vs. complex While simple is generally best, for some clients, a more complicated structure may offer benefits that outweigh the disadvantages that can come with more complexity. A client should be advised of all of the planning options and a cost/benefit analysis should be undertaken with the client to determine which option is best for the client. Flexibility The practitioner may also wish to take into consideration the possible future plans and goals of the client (i.e., future exit strategies or succession plans) and design a share structure that has the flexibility to contemplate and facilitate such future plans and goals. Asset protection Asset protection can also be an important consideration. The client may wish to protect assets against future potential liabilities that may arise from the business (i.e., lawsuits). Asset protection may also be more internal and personal to the client. For example, the client may wish to use a Trust vehicle to own corporate shares instead of issuing shares directly to other family members. This would help to protect those shares from spendthrift family members, bankruptcy or legal action claims such as family law actions.
6 C. Tips and Traps Review of existing structure and minute book When altering or designing share structures for clients with existing companies, it is prudent to conduct a full review of the minute book, particularly where the minute book is coming in from another office or the client. While most minute books, especially where it has been maintained by a law firm, will be in good shape, every so often there are surprises that may be found that will need to be dealt with and cleaned up before a new structure can be implemented. It is also important that a review of the entire minute book is done including the full Articles of the company is done (not simply just the special rights and restrictions) and the other sections of the minute book as well as there can sometimes be provisions in another section of the Articles or other documents that may be relevant, particularly in companies that have a longer history. Association of Companies When designing share structures, it is important to understand the big picture and the various other companies or entities that the parties may be involved in or related to. A practitioner should be cautious of inadvertently associating companies (and thereby reducing the number of small business deductions and other benefits that the companies may have otherwise had). In considering these possible issues, the various look-through rules that apply to children and beneficiaries of trusts must be reviewed as well. III. Rollovers A. The Basics A s. 85 rollover under the Income Tax Act (Canada), R.S.C. 1985, c.1 (5th Supp.), as amended (the ITA ) is where a transferor is allowed to transfer eligible property to a transferee corporation on a tax deferred basis in exchange for consideration which includes shares of the corporation. A s. 86 exchange under the ITA must occur in the course of a reorganization and is where a transferor transfers all of the transferor s shares of a particular class in a corporation to the corporation on a tax deferred basis in exchange for consideration which includes shares of the corporation. A s. 51 exchange under the ITA is where a transferor exchanges shares held by the transferor in a corporation to the corporation on a tax deferred basis in exchange for consideration which can only include shares of that corporation. The remainder of this paper will focus on s. 85 rollovers. B. A Typical Section 85 Rollover 1. Eligible Parties Transferor The transferor in a s. 85 rollover can be any taxpayer which can include an individual, a corporation or a trust. The transferor does not need to be a resident of Canada.
7 Transferee The transferee in a s. 85(1) rollover must be a taxable Canadian corporation. This means that the transferee must be a corporation that is resident in Canada that is subject to Canadian tax. 2. Eligible Property There are certain types of property that are eligible for a s. 85 rollover. These are set out in s. 85(1.1) of the ITA and include: capital property; eligible capital property; inventory (other than real property inventory); and resource properties. It is important to note that real property inventory is not eligible property for a s. 85 rollover. 3. Election Amount & Election Form In a s. 85 rollover, the transferor and transferee must file a joint election form (T2057). The T2057 form will set out the amount that the transferor and transferee jointly elect to be the proceeds of disposition for the transfer of the eligible property (the elected amount ). There are limits to what the elected amount can be which will vary depending on the type of property that is transferred (i.e., depreciable property, inventory or capital property). In general, the elected amount should be between the cost base for the transferred property and the fair market value of the transferred property. To defer all of the gains, the transferor and the transferee can choose an elected amount equal to the cost base for the transferred property. In some cases, an elected amount may be chosen that is more than the cost base to intentionally trigger some capital gains. These capital gains can be used to take advantage of capital gains exemptions or to offset capital losses that the transferor may have. The election form is due on or before the earlier of the income tax return filing deadline date for the transferor or the transferee for the year in which the s. 85 rollover occurred. An election form can be filed late; however, there are penalties for late filings. 4. Valuation A s. 85 rollover will require a valuation of the fair market value of the property being transferred. Generally, a valuation of the fair market value of the property as of the effective date of the rollover will not be available prior to or at the same time as the effective date. It is important that the valuation is completed within a reasonable timeframe after the effective date and that the rollover documents are completed appropriately with the valuation numbers as soon as is practicably possible. The valuation process should be contemplated and started as soon as possible and it should be clear who will be responsible for completing the valuation. Thought should also be given to whether appraisals or other professional valuations, such as a valuation by a Chartered Business Valuator, may be advisable.
8 Price Adjustment Clause When preferred shares are issued as all or a part of the consideration in a s. 85 rollover (see discussion below for more details), the s. 85 rollover will generally include a price adjustment clause (a PAC ). There are various forms of PACs. A PAC generally allows for an adjustment to the redemption price of a preferred share in the event that the Canada Revenue Agency reassesses or challenges the fair market value of the transferred property determined by the transferor and the transferee. In such a case, the redemption price of the preferred shares can be retroactively adjusted to the new reassessed value thereby avoiding the triggering of any additional capital gains due to the reassessment. The Canada Revenue Agency has indicated (IT-169) that it would accept PACs where the parties can show that they intended to transfer the property at fair market value and had made a reasonable bona fide attempt to determine a fair market value based on a fair and reasonable method. PACs may be found either in the s. 85 purchase and sale agreements or in the special rights and restrictions in the Articles of the company. C. Types of Consideration As noted above, the consideration in a s. 85 rollover must include shares in the transferee corporation. These shares can be common shares or preferred shares or a combination of both. If preferred shares are issued, there are specific characteristics that the preferred shares must have which are set out in more detail below. Other possible forms of consideration are also discussed below. If there is more than one form of consideration, the documents should clearly set out what those forms of consideration are and how the purchase price is to be allocated among the various forms of consideration. 1. Preferred Shares If preferred shares are issued as consideration in a s. 85 rollover, the preferred shares should generally have the following characteristics: The shares should be redeemable by the company. The shares should be retractable by the shareholder. There should be a PAC. The shares should have a priority on the wind-up or dissolution of the company to receive an amount equal to the redemption price of the shares. There should be no restrictions on the transfer, redemption or retraction of the shares other than as may be required by corporate law. If the shares have any dividend entitlement, such entitlement should be noncumulative and should not exceed a reasonable amount. The Articles of the company should further include a provision that does not allow for the declaration and payment of dividends to other classes of shares if that declaration or payment of dividends would reduce the net assets of the company below the aggregate redemption price of the issued preferred shares.
9 Common Shares The shares that are issued as consideration in a s. 85 rollover need not be preferred shares. Common shares can be used as well or a combination of preferred and common shares can be used. If garden variety or vanilla common shares are issued, no PAC will be needed for the value of the common shares. If there are existing common shareholders in the company, careful consideration must be given to whether the issuance of the new common shares will affect the entitlement and value of the existing issued common shares as this could trigger unwanted adverse tax consequences. 3. Assumption of Debt As a part of the consideration on a s. 85 rollover, the transferee corporation can assume some of the existing debt obligations of the transferor. For example, if real property (capital property) is being transferred which is subject to an existing mortgage debt, the transferee corporation can assume and take over the mortgage obligation as part of the consideration. If an assumption of debt is part of the consideration, the creditor should be notified in advance and the creditor s approval/consent, if needed, should be obtained prior to the rollover. 4. Others There are various other forms of consideration that can be a part of a s. 85 rollover. There are too many different possible types to be covered in this paper. Some examples of other forms of consideration can include promissory notes, cash or other property. D. Effective Date When undertaking corporate restructuring and reorganization work, one of the initial items that should be discussed with the client is the target effective date for the planning. This effective date should ideally be a current or future date. However, while a current or future effective date is ideal, sometimes practitioners will be asked to back-date a transaction. Back-dating is a grey area and the general accepted practice is to back-date documents only where it is clear that the agreement was contemplated and agreed to by all of the relevant parties at the time of the effective date in question and the documents being prepared are simply to document the agreement that was already in place at that time. Having said that, there are certain steps that should be in place prior to an effective date and it is generally not advisable to back-date these types of steps. Once an effective date is identified, all steps should be taken to secure that effective date for the client by undertaking and implementing all of the steps that should be in place prior to the effective date. These required steps will vary depending on the reorganization work to be done but some of the main steps are discussed below. 1. Required Entities All of the required entities involved in the reorganization and rollover should exist and be in place at the effective date for the rollover. For example, if a rollover involves a new company, that company should be incorporated and be in existence prior to the effective date.
10 Required Share Capital The share capital (i.e. classes and types of shares) required for the reorganization should be authorized and in place prior to the effective date. This includes any preferred shares that may be issued on the rollover as well as any new shares that will be issued after the rollover (i.e., the issuance of new growth shares subsequent to a freeze). If new share classes or additional shares must be authorized for the reorganization work, this will need to be done by way of a share alteration and as noted above, a share alteration will not be effective until all of the required resolutions are signed and the required form is filed with the Corporate Registry. The filing cannot be back-dated. As such, if any share alteration is required, that step should be given priority and completed in a timely manner. While everything should be done to try to ensure that the required authorized share capital is in place prior to the effective date, there may be some exceptional circumstances where the share capital cannot be put in place before the effective date. In those instances, the documents for the rollover should be drafted to clearly indicate that this was the case and the company and other parties should undertake and agree to take all actions necessary to alter the share capital of the company to create the required shares. It would also be prudent to include in the documents a detailed listing of the shares that are to be created and the specific rights and restrictions that are to be attached to those shares. 3. Cash Flow Shares of a company are not considered to be validly issued until the shares are fully paid for by the subscribing shareholder (s. 64 of the BCA). As such, it is important to ensure that all shares that are issued in the rollover and subsequent to the rollover are fully paid for prior to or on the date that the shares are to be issued. Any other cash flow steps that may be required for the reorganization should also be completed prior to the effective date. E. Tips and Traps Other Considerations for Rollovers There are various other considerations that should be taken into account when performing a corporate reorganization. The following section discusses some of these other considerations. 1. Effective Date As discussed above, when undertaking corporate restructuring and reorganization work, one of the initial items that must be considered is the target effective date for the work. All steps should be taken to secure that effective date for the client. 2. Share Capital The required share capital should be in place prior to the effective date. All steps should be taken to ensure that the required share capital is in place prior to the effective date of the reorganization. If this is not possible, as discussed above, provisions and undertakings should be included in the documents setting out the details of the share capital to be created and requiring that the share alteration be completed and filed as soon as possible.
11 Share Alterations If a share alteration is required to create the share structure needed for the reorganization, a practitioner should be careful when altering the special rights and restrictions in the Articles so as to avoid triggering any deemed disposition of any existing issued shares. The Canada Revenue Agency has an administrative policy (IT-448) which sets out certain circumstances where it will consider there to have been a fundamental change in the special rights and restrictions of shares and thereby be a deemed disposition of those shares. As set out in IT-448, these circumstances include: a change in voting rights attached to shares that effects a change in the voting control of the corporation; a change in a defined entitlement (e.g., a change in par value) to share in the assets of a corporation upon dissolution (preferred shares only); the giving up or the addition of a priority right to share in the distribution of assets of the corporation upon dissolution; the addition or deletion of a right attaching to a class of share that provides for participation in dividend entitlements beyond a fixed preferential rate or amount; or a change from a cumulative to a non-cumulative right to dividends or vice versa. While these Canada Revenue Agency views are not shared by all tax practitioners, it would be prudent to try to avoid falling under any of these circumstances. In the same IT-448, the Canada Revenue Agency also sets out some circumstances, which when taken individually, will not be considered to be deemed dispositions: the addition of the right to elect a majority of the directors of the corporation if, at that time, the shareholders of that class are already in a position to control the election of directors; a change in the number of votes per share if the ability of any one shareholder to influence the day-to-day affairs of the corporation is neither enhanced nor impaired thereby; the giving up of contingent voting rights which, in the event they were exercised, would not be of sufficient number to control the affairs of the corporation; restrictions added or removed concerning transfer of shares; the addition of a right of redemption in favour of the corporation; stocks splits or consolidations; a change of shares with par value to shares without par value or vice versa, provided that there is no change in any pre-set entitlements to dividends and/or distribution of assets upon dissolution; a change in ranking concerning preference features, (e.g., 1st preference to 2nd preference); or an increase or decrease in the amount or rate of a fixed dividend entitlement.
12 Use of Existing Shares If the existing share structure of the company already appears to have the required share capital in place to effect the reorganization and rollover, no share alteration may be needed. If the practitioner intends to use the existing share structure, it would be prudent to conduct a thorough review of the existing Articles and the special rights and restrictions to ensure that the existing share capital is appropriate for the planning work and includes all of the required characteristics for the rollover. This should be completed well in advance of the effective date to allow time for a share alteration to be done (as share alteration filings cannot be back-dated) if it is determined that the existing share structure is not sufficient or appropriate. 3. Review of Minute Book A review of the minute book prior to the start of any reorganization or restructuring work is prudent and generally advisable. As noted above, while in most circumstances, the review may be uneventful and turn up no surprises, there can at times be discrepancies or issues that arise which may be problematic and must be dealt with before the planning work can be implemented. 4. Transfer of Legal Title to Property If property is being rolled into a company, the attributes and characteristics of the property and the steps that may be required to transfer the legal title to the property should be reviewed and considered. Attention should be paid to whether the transfer would result in the obligation to pay any fees or other taxes (i.e., Property Transfer Taxes or PST/GST). If there are fees or other taxes that may be triggered upon a change of legal title to the property, bare trust or other forms of planning should be considered to determine whether there are any options or alternatives that can minimize the fees or other taxes payable now and in the future. In addition, consideration should be given to whether the legal title transfer would eliminate or reduce any benefits that are currently being enjoyed by the owner. 5. Section 84.1 When implementing a s. 85 rollover, consideration should be given as to whether s (surplus stripping rules) of the ITA may apply. If s applies, it can deem the transferor of the property to have received a taxable dividend from the transferee corporation. A detailed discussion of s is beyond the scope of this paper but generally, the following circumstances will be required before s will be deemed to apply: The transferor is a taxpayer resident in Canada (other than a corporation). The transferor disposes of shares (the subject shares ) of a corporation resident in Canada (the subject corporation ) to another corporation (the purchaser corporation ). The subject shares are capital property to the transferor. The transferor and the purchaser corporation do not deal at arm s length with each other. Immediately after the sale, the subject corporation and the transferor are connected (as defined in the ITA).
13 Indirect Gift Rule Section 85(1)(e.2) includes some indirect gift rules for s. 85 rollovers. The indirect gift rule applies where: the fair market value of the property disposed of in a s. 85 rollover is greater than the fair market value of the consideration received for the property and the amount that the transferor taxpayer and the transferee corporation agreed on in their election in respect of the property (without reference to s. 85(1)(e.2); and it is reasonable to regard any part of the excess as a benefit that the taxpayer desired to have conferred on a person related to the taxpayer (other than a corporation that was a wholly owned corporation of the taxpayer immediately after the disposition). In IT-291R3, the Canada Revenue Agency sets out some of its comments on this topic. It is fact dependent whether or not a benefit was conferred; however, the Canada Revenue Agency is generally of the position that when the parties are not dealing with each other at arm s length, then there is deemed to be a conferred benefit unless the parties can show otherwise. If s. 85(1)(e.2) applies, then the amount otherwise agreed to between the parties will be increased by the amount of the conferred benefit. This only applies to increase the elected amount and does not increase the adjusted cost base ( ACB ) of the shares received as consideration in the rollover (IC-76-19R3) and could therefore result in double taxation. 7. Division/Allocation of Tasks Organization and file (and client) management are key to the successful implementation of a corporate reorganization. Particularly when working with other advisors or professionals (i.e., accountants, other lawyers, the client, the client's internal staff, investment brokers), it is important that all of the required steps to implement the planning are identified and the party(ies) responsible for each task are set out and communicated to all of the parties so that no tasks or deadlines are missed. These tasks would include identifying what filings/elections are required and the deadlines for the filings and how any valuations/numbers required for the reorganization will be determined and by which party(ies). 8. Existing Credit Arrangements & Other Agreements One issue that can often be overlooked in corporate reorganizations is the presence of any existing credit arrangements and other agreements that the company or companies involved in the reorganization may be a party to or that may be associated with the property being rolled in. If the company/companies have existing credit facilities or if there are financial encumbrances against the property being rolled in (such as mortgages, lines of credit or general security agreements), prior notice and/or approval may be required from the existing creditors before the reorganization work can be undertaken. Failing which the client may find themselves in technical default of the terms of the credit facility. In addition, there may be other agreements in place, such as shareholders agreements, that may need to be reviewed or amended in light of the reorganization work. Notices may also need to be given to the other parties and in some instances, the consent/approval of the other parties may need to be obtained as well.