Tax Factor 2012-05

September 18, 2012

The 2012-05 issue of the Tax Factor is available for download. In this issue, we cover:

Do you need a shareholders' agreement?
Taxpayer successfully challenges interpretation of the restricted farm loss rules

Do you need a shareholders' agreement?

Are you running an incorporated business with family or non-family members? If so, are you and your co-owners working in a harmonious environment and agreeing on the direction in which the business is currently going? If this is your situation, it's definitely a good place to be; but be mindful that challenges can arise that will require you to resolve disputes or deal with unfortunate situations — such as if a shareholder dies or becomes disabled. It is these types of challenges which make it imperative to have a shareholders' agreement in place. And to be an effective agreement, it needs to reflect the key principles and philosophy of all of the shareholders.

What is a shareholders' agreement?

A shareholders' agreement is a contract between shareholders of an incorporated business that provides mechanisms to deal with important issues before they become problems. Of course, corporate law sets out specific rules that must be followed when corporations are being used, but a shareholders' agreement goes beyond corporate law to set rules for corporate governance and how shareholders will deal with each other. It is an invaluable tool you can use to help ensure that your business grows and prospers.

Ensure your agreement is consistent with your philosophy and principles

Although a shareholders' agreement is in essence a legal document, it should be principles-based. This means that the starting point should be a full review of all the key issues facing the business and the people that own it. At a minimum, the agreement needs to deal with these key business questions:

  1. How do you become a shareholder?
  2. How are decisions made?
  3. What is the compensation structure?
  4. What is the expected return on investment?
  5. How do you exit ownership?

We recommend that you start with a discussion among family members and other key players to determine the basic principles and philosophy of the business around these questions in particular, and then use this information to construct an agreement. Our BDO SuccessCare Program™ team can provide an educational program on developing a principles-based shareholders' agreement and they can help you develop your specific agreement. For more information, contact your BDO advisor.

What specific rules and issues are dealt with in a shareholders' agreement?

An agreement will be unique to each corporate situation and there is a wide range of issues that can be dealt with through various rules. However, in addition to the key business questions just discussed, there are other key issues that all agreements should address. A shareholders' agreement allows shareholders to deal with governance issues by setting specific rules as agreed upon by the shareholders. In particular, an agreement should include rules for resolving disputes, as well as rules to end deadlocks (such as arbitration, mediation or appointing additional directors).

Another key area covered in an agreement will be how to deal with future events that may happen, including death, bankruptcy, divorce or incapacity of a shareholder. An agreement could provide for different options — for example, a mandated succession plan where each shareholder would pass on their interests to the next generation or a buy-sell agreement which would allow one or more shareholders to buy another's shares at a time when that other shareholder becomes unable to carry on in the business due to poor health. These are only a couple of options, and the key point is to ensure an approach has been set.

As we have discussed, the actual process of working through a shareholders' agreement will help you and your co-owners identify possible business risks and provide an opportunity in advance to discuss how to resolve issues should they arise. It can also give you the chance to set aside resources such as life, disability or critical illness insurance. In addition to setting a specific transition plan while working through the agreement, you could also deal with retirement planning for the current owners. It is beneficial to work through this process at the beginning of the business relationship, or at least when goals are similar and shareholders are in good health and in a position to be objective over who should take over the business in the future.

Although it may be possible for shareholders to try to negotiate an arrangement once an unfortunate event has happened, depending on the event, the interests of each shareholder may have diverged creating the potential for disharmony in the business relationship. And in the situation where one shareholder becomes ill, they may be at a disadvantage in any negotiations if they are no longer able to continue in the business. Therefore, it is essential to get an agreement in place before any unfortunate events happen.

In addition to the specific issues that we have already discussed, a shareholders' agreement will usually include mechanisms to help shareholders deal with other key issues such as:

  • Major business decisions, such as a merger;
  • Rules for employing family members;
  • Rules for disposing of major assets or a business line;
  • Corporate financing decisions;
  • Rules for determining a price of a shareholder's interest and the conditions under which the interest can be transferred (in addition to illness or death); and
  • Liquidation of a shareholder's interest in the event of disagreement, disability or death (this would include buy-sell agreements for shares).

This list is not exhaustive — any issue of mutual concern to the shareholders of a company can and should be covered in the agreement.

Considerations from a tax perspective

The manner in which a shareholders' agreement is set up and the rules included in an agreement can have an impact on the tax situation of the corporation, as well as other corporations under common control. It is important to keep this in mind when setting out rules in the agreement that impact who can control the corporation, who can acquire shares and how to value the company. In terms of issues around share ownership, there will also be important personal and estate related tax issues to consider. It will be critical to ensure that any buy-sell agreements used are structured properly to allow for effective post-mortem planning. As well, you don't want rules in the agreement to impede the ability to claim a capital gains exemption and the small business deduction, if they would otherwise be available. Your BDO advisor can help ensure that your agreement will be effective from a tax perspective.

If you don't already have a shareholders' agreement in place, it is very important to make this task a priority with your co-owners. Setting up a principles-based shareholders' agreement will help to ensure you have an effective agreement that can successfully deal with major decisions, unforeseen disputes and future events that may arise. And doing this at a time when you and your fellow shareholders are healthy and enjoying a good relationship, and can be objective about future decisions, will help to make the decision making process run smoother. Contact your BDO advisor to discuss the issues that need to be addressed in your shareholders' agreement.

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Taxpayer successfully challenges interpretation of the Restricted Farm Loss Rules

A recent case decided by the Supreme Court of Canada brings the issue of restricted farm losses back to our attention. After the Supreme Court decision in the Moldowan case many years ago, many tax practitioners thought that this issue had been laid to rest. However, the recent decision in the Craig case overrules the precedent set in Moldowan and the issue of when farming losses can be deducted against other sources of income is now worth revisiting. The fact that this case deals with horse racing as the farming business which generated large losses that were deducted against professional and employment income creates some interest in the case. And many would have thought that this was the type of situation that the restricted farm loss rules were meant to address.

The Craig case facts

It's difficult to generalize the facts of the Craig case; therefore, the following is a summary of the key facts in the case:

  • In the years in question, 2000 and 2001, Mr. Craig's most significant source of income was his professional income from his law practice. He also had income from investments and the exercise of stock options. His total income from all sources (before applying the farm losses) for the years in question was approximately $1,200,000 and $800,000 respectively.
  • Mr. Craig was also in the business of buying, selling, training and maintaining horses for racing – his farming business.
  • He deducted the losses of the horse racing business from his other income in 2000 and 2001 in the amounts of $222,642 and $205,655 respectively.
  • The horse racing business had some modestly profitable years, but over the years, the losses significantly exceed the profits.
  • The total hours Mr. Craig spent at his law practice exceeded that devoted to the farming business.
  • Mr. Craig also devoted a substantial amount of capital and a significant part of his daily work routine to the farming business.
  • In what might be a key fact, Mr. Craig was an active member of the standardbred racing community and served as chairperson of the industry's appeal board.
  • Mr. Craig was reassessed for the years in question, limiting the deductible losses for each year to $8,750 on the basis that the combination of his law practice and his horse racing business was not his chief source of income, because the horse racing business was a subordinate or sideline business.

The restricted farm loss rules

By way of background, the restricted farm loss rules in the Income Tax Act restrict farm losses when a taxpayer's chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income. In Moldowan, the precedent was established that if farming is a subsidiary source of income in relation to the taxpayer's other sources of income, the loss deduction limitation will apply. The implication is that in order for the limitation not to apply, farming must be the chief source of income. However, there is nothing in the relevant income tax rule stating that in order to avoid the loss deduction limitation, farming must be the major source of income in relation to other sources of income. Over the years, there has been significant judicial and other criticism of the Moldowan judgment. Therefore, while it is not common for a Supreme Court judgment to be overturned, in the Craig case it was decided that the precedent in Moldowan could be overridden based on a number of factors, including this widespread criticism.

The Craig case decision

In the Craig case, the court interpreted that using the phrase “a combination of farming and some other source of income” does not contemplate a simple aggregation of two sources of income, but instead contemplates that the taxpayer will devote significant time and resources to the farming business. And, as long as the taxpayer devotes considerable time and resources to the farming business, the fact that another source of income produces greater income than the farming business does not mean that such a combination is not a chief source of income for the taxpayer.

In this case, the judgment indicates that when evaluating whether the restricted loss rules apply in situations when farming is carried on in combination with another source of income, a number of factors should be considered, including:

  • The capital invested in farming and the second source of income;
  • The amount of income from each of the two sources of income;
  • The time spent on the two sources of income; and
  • The taxpayer's ordinary way of living, farming history, future intentions and expectations.

The court indicated that the approach to evaluating the factors must be flexible, recognizing that not each factor need be significant, and stated that “[t]he question is whether, looking at these factors together, the taxpayer places significant emphasis on each of the farming business and the other earning activity, and if so, the combination will constitute a chief source of income and avoid the loss deduction limitation”.

As mentioned in the facts above, Mr. Craig derived his principal income from the practice of law and the total hours spent at his law practice exceeded that devoted to his farming business. However, he devoted both a significant amount of capital and a large part of his daily work routine to the farming business. Mr. Craig was also an active member of the standardbred racing community, serving as chairperson of the industry's appeal board. This involvement allowed him to work to improve the integrity of standardbred racing so as to improve the potential profitability of his operation. For these reasons, the Supreme Court upheld the lower courts' decisions that farming, in combination with Mr. Craig's law practice, was a chief source of income, and that the farm loss deduction limitation did not apply based on the facts.

This decision may open up more situations where losses from farming can be deducted from other sources of income, provided that the time and effort put into the farming business are significant, even if the other sources of income produce more income.

Note that if you are considering entering into a new farm-related operation, and you believe that the Craig case would allow you to deduct losses against other sources of income, you should keep in mind that the government may change the rules that apply to farm losses. In particular, it is possible that the government believes that the tax policies set out in the Moldowan case are the ones that should apply, and could change the tax legislation for these losses to reflect that.

If you undertake farming as a significant activity but have not been able to fully deduct losses from farming, speak with your BDO advisor to see if the decision in this case is relevant to your situation.

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The information in this publication is current as of September 1, 2012.

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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