Does your business need a shareholder agreement?

July 27, 2016

No business is free from contentious issues—and that includes from within the company. While companies started by a family, friends, or even long-time associates may run smoothly, one should never assume that issues cannot arise. That is where a shareholder agreement comes into play.

A shareholder agreement outlines the potential business, financial, and other issues that a company may face throughout its lifetime, and establishes rules for how these issues are to be handled. By pre-determining how potentially contentious issues are to be addressed, you can ensure a fairer, smoother resolution process, and reduce business impacts. 10-Essential-Questions-You-Should-Ask-Your-Auditor

When is a Shareholder Agreement Recommended?

Shareholder agreements are an obvious choice when a company is co-owned by multiple parties, even when everyone has the best intentions of the company at heart. By establishing plans for addressing disagreements in advance, you can avoid complications later when stress is high or tempers flare.

A shareholder agreement can also be useful even if you are the only shareholder. A shareholder agreement may be relevant for you as part of a plan for future business expansion or in anticipation of milestone events. For example, if you think that you may sell shares of your business at any time in the future, developing a shareholder agreement now may be a wise decision. Similarly, a shareholder agreement can provide clarity upon your death when the company shares pass on or are inherited.

Drafting a shareholder agreement is also particularly useful if you set up a trust and do an estate freeze, which transfers future growth of capital property to another individual. After a period of 21 years when you need to roll-out the shares held by the trust, you can stipulate that the shareholder agreement applies to the new shareholders who will receive the shares.

What Should a Shareholder Agreement Include?

Shareholder agreements generally cover five core areas:

  1. Governance and Decision-Making: How are business decisions to be made and disputes managed? This should include plans for specific concerns, as well as a dispute management plan and resolution process for undefined issues.
  2. Entrance: How can additional individuals become shareholders, and in what situations? Incoming shareholders will need to know that the purchase price is fair, meaning that there needs to be a clear method of determining value. The entry process also needs to align with the exit.
  3. Exit: How can shareholders exit the company, and how will their shares be handled? As with the entrance, there needs to be a clear method of determining the value of the shares. Outgoing shareholders need to receive a fair value while ensuring that payments are affordable to the remaining shareholders. There should also be provisions dealing with death and disability, and the possible role of insurance in funding a buy/sell agreement upon a shareholder death.
  4. Compensation: How will the company handle compensation for roles in the business? From a business management perspective, compensation should be based on fair value for the role, separate from individuals' return on investment as a shareholder.
  5. Return on Investment: How will shareholders' return on investment be realized? This should be measurable against the value of the investment, and should realize a reasonable return on equity. This should also include a reinvestment or dividend policy.

When looking to develop a shareholder agreement, it is best to have an understanding of what will work best for all parties. Once a general consensus has been reached, it is recommended that you work with a tax professional and a lawyer to ensure that all provisions anticipate both tax and legal issues and challenges. BDO can provide support to manage this process.

Key Tax Issues to Consider

There are a number of tax and legal implications that can arise out of decisions made in your shareholder agreement. A few key tax issues to consider when drafting your shareholder agreement include:

  • Company Control: There are many potential control structures for an organization, ranging from a single voting individual to unanimous shareholder agreement. From a tax perspective, the method of control of the company is relevant as it establishes how the company will be classified and which rules, regulations, and exemptions apply. For example, the method of control dictates whether the corporation counts as a Canadian-controlled private company (CCPC), which impacts capital gains exemptions, small business deductions, and more. These issues can also be compounded should a controlling person become a non-resident. Association issues can also arise—for example, if a controlling shareholder owns another small business and the small business deduction has to be shared. A situation of this nature may dictate provisions being added to the shareholder agreement that stipulate how tax amounts will be allocated and which shareholder-owned business can claim the small business deduction.
  • Control Through Buy/Sell Agreements: For tax purposes, if a shareholder agreement includes options to buy or sell shares under certain circumstances, CRA deems those options to have already been exercised when determining company control, unless related to death, bankruptcy, or permanent disability. Key exceptions include shotgun clauses, rights of first refusal, and anti-dilution provisions, as well as arrangements where one shareholder can force another shareholder to buy their shares. This means that if a shareholder agreement includes common triggers to sell such as termination of employment, retirement, breakdown of marital status, or criminal prosecution, CRA may deem the other shareholders to own the shares. This may impact who controls the corporation when determining company classification and taxation. Depending on the circumstances, this can result in loss of a company's CCPC status, loss of the small business deduction, and more. Care in the structure and wording of these agreements is thus required to protect all shareholders and the company interests.
  • Non-Arm's Length Buy/Sell: Another area to be cautious of when setting up the agreement is how shares will be valued for transactions between shareholders. For transactions between non-arm's length shareholders, the shares must be sold at fair market value. While many understand non-arm's length to mean associated individuals such as family members or a spouse, as well as corporations owned by such individuals, “non-arm's length” can also apply to unrelated individuals acting in concert. If CRA deems that a non-arm's length sale has been conducted at anything but fair market value, this may result in double taxation.

As each of these situations can result in serious consequences, such as a company losing its CCPC designation, or increased taxation, special care is required when crafting these areas of the agreement.

For more information on these or other issues, please see our recent webinar, or contact your BDO advisor for personal advice and support.

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The information in this publication is current as of July 27, 2016.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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