The following article will appear in an upcoming edition of the HLA Journal.
One wouldn’t think that entering into a shareholder agreement should have anything to do with the availability of the $500,000 small business deduction for a corporation, but in fact such an agreement could require the corporation to share the deduction with another that is otherwise unrelated. Buy-sell arrangements or rights to purchase shares in shareholder agreements can have unexpected results for the ownership or deemed ownership of shares for the purposes of the deduction. The results of the application of the rules relating to share ownership can be a nasty shock for the entrepreneurs seeking to take advantage of the low tax rates available to Canadian controlled private corporations (CCPCs) through the deduction.
A Canadian controlled private corporation that earns active business income pays tax on the first $500,000 of that income at a favourable rate (currently 15.5% in Ontario) unless the corporation is associated with another corporation. The favourable rate is still available for associated corporations, but they must share the $500,000 “limit”. If each of two associated corporations earns $400,000, then they must file an agreement with the CRA in which they agree to allocate the limit between them. $500,000 of the $800,000 total income earned by the corporations will be taxed at the favourable rate; the remaining $300,000 will be taxed at the general corporate rate applicable to active business income (currently about 28% in Ontario).
The Income Tax Act (the “Act”) contains complex rules for determining whether two corporations are associated. Essentially, the Act treats corporations with certain degrees of common ownership and de facto control as associated. Two corporation controlled by the same individual will be associated. Two corporations controlled by the same group of individuals will be associated. The Act contains a series of deeming rules that will treat a person as an owner of shares who is not otherwise a shareholder of a corporation. For example, a shareholder of a corporation is deemed to own shares in another corporation owned by the first corporation.
For those tasked with drafting shareholder agreements, one of the trickier deeming rules relates to options or rights to acquire shares. The Act, subject to several narrow exceptions, deems a person with almost any right to acquire shares, contingent or otherwise, to be the owner of the shares subject to the right. Paragraph 256(1.4)(a) of the Act states that, if a person has a right, under a contract, in equity or otherwise, “either immediately or in the future, and either absolutely or contingently,” to acquire shares or to control their voting rights, the shares are deemed to be issued and outstanding and to be owned by the person.
Given the phrase “either immediately or in the future, and either absolutely or contingently,” the CRA has taken the position that almost any right to acquire shares will trigger the application of the rule.# The Act provides, however, that paragraph 256(1.4)(a) does not apply to a right that is exercisable only upon the death, bankruptcy or permanent disability of an individual. As a result, the deeming rule would not apply to an option to purchase shares upon the death of an individual. The CRA has also said that paragraph 256(1.4)(a) will not be considered to apply to rights under a standard shotgun clause or a right of first refusal.
The exceptions set out above, however, have some limitations that are not immediately apparent. The exception relating to bankruptcy, for example, applies only in respect of the bankruptcy of an individual. If a right to acquire shares is exercisable upon the bankruptcy of a corporate party to the agreement, then the exception will not apply, and the person entitled to acquire shares upon the bankruptcy of the corporation will be deemed to own them. Similarly, it might be argued that “bankruptcy” has its technical meaning so that a right exercisable upon the insolvency of an individual will not come within the exception either. In the same vein, the exception relating to disability requires that the relevant individual be permanently disabled. As a result, the CRA has stated that the exception will not be available for a typical disability clause in a shareholder agreement that defines an individual to be disabled if the person is disabled for, say, nine months in a 12-month period.#
An example will help to clarify the operation of thes rule and their exceptions. Suppose that X owns all of the shares of XCo and 30% of the shares of YCo. The remaining 70% of the issued shares of YCo are owned by YHoldco, which is wholly-owned by Y. X and Y are unrelated, and they deal at arm’s length. All other things being equal, then, XCo and YCo should not be considered to be associated. Unfortunately, however, X and YHoldco have entered into a shareholder agreement under which X, among other things, is entitled to purchase the shares of YHoldco in the capital of YCo if YHoldco goes bankrupt. The exception for bankruptcy will not apply because YHoldco is not an individual, of course, and so X will be deemed to own YHoldco’s shares. X will be deemed to control YCo, and so YCo and XCo will be associated and required to share the $500,000 small business deduction. (It doesn’t matter, by the way, that YHoldco actually controls YCo. The Act provides that control by one person does not exclude control by another for the purposes of the association rules.) X and Y will be unhappy with their lawyer if this result was unexpected.
Of course, generally speaking, a shareholder agreement will not create unexpected association problems if all of the parties to it do not hold interests in other corporations, and many entrepreneurs find coping with an interest in one corporation more than enough to go on. Some entrepreneurs find running only one business “limiting”, however, and so they buy shares in multiple corporations. The lawyer advising such an entrepreneur will need to keep in mind the deeming rule described above if the entrepreneur will sign a shareholder agreement for one or more of the corporations.
