Shareholder Loans

One of the ways in which you, as a shareholder can withdraw funds from your corporation is by taking out a loan from your corporation. However, you have to be aware of the potential income tax consequences of receiving a loan from the corporation. If you are a shareholder of a corporation, a rule in the Income Tax Act (the “ITA”), section 15(2) provides that the full principal amount of the loan must be included in your income. The purpose of the shareholder loan rule is to prevent shareholders from taking money out of the company in the form of loans, which would be tax-free and a means to eliminate the shareholder’s personal tax liability on salary or dividends if the rule were not in place. This post will discuss the 3 exceptions where this rule does not apply. The IT Bulletin IT-119R4 released on August 7, 1998 discusses these exceptions.

3 Exceptions to Shareholder Loan Rules:

1. One Year Rule

First, the shareholder loan rule does not apply if the loan is repaid within one year after the end of the taxation year of the corporation in which the loan was made. But note that in order for this exception to apply, the repayment cannot be part of a series of loans and repayments.

2. The Lenders Rule

Another exception to the shareholder loan rules applies to loans made by employers who are in the business of lending money. This exception applies to a debt that arises from normal business activities, provided standard arrangements for repayment are made and maintained.

3. Principal Residence Rule

If the shareholder is also an employee and a loan is advanced to purchase a principal residence, new shares in the corporation, or a vehicle to be used for business purposes then the loan is not considered income. In addition, the loan must be advanced due to employment and not due to shares held and standard arrangements are made for repayment are made and maintained.

The important thing to note here is that the ITA contains this rule to prevent shareholders from taking a series of back-to-back loans from the corporation in order to avoid income tax. If you are using shareholder loans in your business, you should be aware of the risk of having those loans included in your personal income which may have substantial tax consequences. You must discuss with your lawyer while structuring your loans so as to obtain the most optimum result. Future posts will deal with deemed interest benefit and repayment of shareholder loans. Please get in touch with us if you want referrals to more knowledgeable people on the subject.

In other posts at StartupLegals, your can further explore various important legal considerations for your small business.

What are share classes?

Any ‘person’ can own a share in a corporation and be a 'shareholder.' 'Person' includes individuals, corporations and trusts. Shares are a form of property, and can be bought and sold. However, these rights may be subject to any limitations that may be set out in the Canada Business Corporations Act (the "CBCA") (or similar legislation such as the Business Corporations Act (Ontario), the articles of incorporation, or the shareholders’ agreements. Generally, there are three types of rights associated with shares:

•  the right to vote
•  the right to receive dividends
•  the right to receive the remaining property of the corporation upon dissolution.

These rights can be divided among different types or classes of shares. Classes can be assigned names: common, non-voting, preferred or Class A, Class B, Class C. The articles of incorporation described the characteristics of different classes of shares. At a minimum you should have one class of shares (as required by legislation- section 22(3) of the CBCA.)  

Where there is only one class of shares, the rights of all shareholders are equal. Where there are more classes of shares, each class may have different rights, privileges, restrictions and conditions. The number of shares issuable of each class will be unlimited, unless there is a maximum specified in the articles. The name of the shares is not what's important. What's important is the way you define the rights and privileges attaching to the shares.  

[We have seen corporations incorporated provincially that didn't specify the classes of shares, resulting in ... lots of administrative headache so make sure that your articles of incorporation have the share terms properly drafted and reviewed by a competent professional.]

Some Types of Share Classes:

Common Shares: These usually refer to the share class that gets the remaining property of the corporation if it is dissolved. Common shares also usually have the voting rights.

Non-Voting Shares: They do not carry a vote in the normal running of the corporation. They are often paid dividends but at the sole discretion of the Board of Directors.

Preferred Shares: This usually means that there’s some ‘preference’ attached to these shares, such as the right to get dividends before the holders of common shares and/or at some fixed rate of return whether dividends are paid to other classes of shares or not.

Here are some ways the rights of share classes are allocated:

Class A/Common/Voting Shares:

• Entitle the shareholders to vote at all shareholder meetings.
• Entitle the shareholders to receive dividends as declared from time to time and in the discretion of the board of directors (the shareholders vote in the board of directors through an election).
• Entitle the shareholders to receive the remaining property after dissolution.

Class B/Preferred/Non-voting shares:

• Do not allow the holders to vote at all shareholder meetings (i.e. they can’t vote in the board of directors meeting);
• Give the holders the right to a dividend in advance of a dividend to the holders of the Class A, Voting, or Common shareholders; and
• Give the holders the right to receive the corporation’s remaining property in advance of the Class A, Voting, or Common shareholders.

Authorization for variations of rights by special shareholders:

The shareholders of a class or series are entitled to vote separately as a class or series for a proposal to amend the articles in certain cases which are specified in section 170(1) of the OBCA. The shareholders of a class or series are entitled to vote separately only if the series is affected by the amendment in a manner different from other shares of the same class. A proposed amendment to the articles is adopted when the shareholders have approved the amendment by a special resolution of the shareholders of the shares of each class or series entitled to vote thereon.

In another post at StartupLegals, we will discuss why you may want to create different classes of shares.

Can the NRC-IRAP be a source of funding for your business?

The National Research Council (NRC) is an agency of the Government of Canada which conducts scientific research and development. The Industrial Research Assistance Program was set up the NRC for advancement of technological innovation. The NRC-IRAP provides advisory and financial assistance to help small and medium sized enterprises (SMEs) build their innovation capacity and create high paying jobs through a grant program. This programme is regarded world wide as one of the best programs of its kind. The NRC-IRAP is also an important source of early source of funding for start-ups.

The NRC-IRAP brings together a diverse network of organizations, services and programs to help Canadian SMEs to develop their technologies. The programme will provide your startup customised solutions via expert technical and business advice, financial assistance, access to business information, contacts, and national and international networks.

An extensive network of experienced Industrial technology Advisors (ITAs) located across Canada assist with projects. In order to apply for the grant you need to contact the local ITA who then walks you through the steps and provides guidance. Both your startup and your project will undergo extensive due diligence by the IRC-IRAP before you can obtain funding. The due diligence will specifically check for:

• the business and management capabilities of your startup and your potential to achieve the expected results and outcomes associated with the proposed project;
• your financial capabilities and plan to commercialise the developed technologies; and
• the technical aspects of the project and its potential impact on your business.

How do you get access to NRC-IRAP funding?

To seek funding you must fulfill these criteria:

• be a small and medium-sized enterprise in Canada, incorporated and profit-oriented;
• have 500 or fewer full-time equivalent employees; and
• have the objective to grow and generate profits through development and commercialization of innovative, technology-driven new or improved products, services, or processes in Canada.

Contact information of the NRC-IRAP offices in each of the four regions can be found here.

In other posts at StartupLegals, your can further explore various important legal considerations for your small business.

What are the "Articles of Incorporation" of a Canadian corporation?

The Articles of Incorporation is a legal document, filed with the federal or provincial government in Canada that sets out a corporation's purpose and regulations. It is one of the documents that provide the legal structure of your corporation.

Section 4 of the Ontario Business Corporations Act; and Section 5 of the Canada Business Corporations Act deals with the Articles of Incorporation. A corporation may be incorporated by one or more individuals or some other legal entity like another corporation (or another legal entity) by appropriately filling out and signing the Articles of Incorporation. The Articles of Incorporation are sent to the "Director", i.e. the relevant ministry in either the Federal government or a Provincial government, which then endorses a certificate of incorporation. The certificate of incorporation is conclusive proof that the corporation has been incorporated on the date set out in the certificate.

The following pieces of information are required in the Articles of Incorporation:

·   

• The name of the corporation.
• The address of the registered office of the corporation.
• The number of directors.
• The first director, their contact information and whether or not they are Canadian residents.
• Whether there are any restrictions on the business that the corporation will carry on and the powers it can  exercise.
• The maximum number of shares and the classes of shares that the corporation is authorised to issue.
• Rights, privileges, restrictions and conditions attaching to each class of shares and directors authority with respect to any class of shares which may be issued in series.
• The restriction on the issue, transfer, ownership of shares.
• Name and addresses of the incorporators.
• Signatures of the incorporators

It is very important to note that all information should be filed correctly. If the Directors' names are incorrectly specified, it will have to be amended, a process which is time-consuming. If the share provisions (maximum number, share class, rights of each class) are not properly set out, there may be issues with organising your company.

If you are incorporating your business federally, the Form 1 is available online here.

If you are incorporating provincially, links for Form 1 for each of the provinces are available online. For example, if you are incorporating in Ontario, the Form 1 is available here at Service Ontario. 

Here are the links to some of the other provinces: Alberta, British Columbia, Manitoba, New Brunswick, Newfoundland and Labrador, Nova Scotia, Northwest Territories.

Incorporating your Canadian Business: Federal or Provincial?

Here is a quick way to decide if you want to opt for federal or provincial incorporation. Remember you can always change to your provincially incorporated company to a federal one as and when you expand your business.

Recognition & Protection of Name: Federal incorporation may be considered a sign of distinction by companies you contract with outside Canada, although it is unclear how often this is true. Tough tests will be applied before allowing you to use a particular company name. If your business is incorporated in a particular province or territory, it is only entitled to operate in that jurisdiction and has no name protection outside that province or territory. If you decide to change to federal incorporation at a later stage, your company name may not be available. Federal incorporation allows your business to operate using its corporate name across Canada, which is especially beneficial if you decide to expand your business to other provinces or territories. Section 9 of the CBCA provides for protection of corporate name. It is important to note that this name protection is similar to, but is not as strong as trade-mark protection.

Extra Provincial Licence: A federally or provincially incorporated business will, generally be required to register or obtain an extra-provincial licence in each province in which it carries on business. However, doing business in Ontario does not require any corporation incorporated anywhere in Canada to hold an extra-provincial license. Keep in mind that there will be other filings requirements such as under other Ontario legislation such as the Corporations Information Act. 

Location: CBCA does not set restrictions regarding the province or territory where the head office or registered office is located, corporate records are maintained and annual general meetings are held. Provincial legislation often does, for example your Ontario corporation will be required to keep its registered office in Ontario.

Paperwork: A federal corporation requires greater disclosure and filing requirements. The amount of paperwork required to be filed in the case of provincial incorporation can be considerably less, especially with regard to getting the name of your company cleared. Sometimes, getting your company incorporated provincially can be a little too easy as it doesn't have the rigorous checks and balances of the federal process.

Costs: Federal incorporation set up costs are generally higher compared to provincial incorporation.

Scope of Business: A federal corporation will be able to carry on business in all provinces and territories, as long as it is registered in all the provinces in which its business will be conducted. A small business when starting out can incorporate itself provincially before it establishes its presence in other provinces. The incorporation can be changed to federal at a later stage as it expands its scope of business.  A federal corporation will be able to carry on business in all provinces and territories, as long as it is registered in all the provinces in which its business will be conducted. A small business when starting out can incorporate itself provincially before it establishes its presence in other provinces. The incorporation can be changed to federal at a later stage as it expands its scope of business.

Director Residency requirements: You may choose your incorporation based on residency requirements for Directors.

Jurisdiction:	Director Residency Requirements
Canada (federal)	At least 25% of the directors of the corporation must be Canadian residents. If a corporation has less than four directors, at least one director must be a Canadian resident.
Alberta	At least 25% of the directors of the corporation must be Canadian residents. If a corporation has less than four directors, at least one director must be a Canadian resident.
British Columbia	No requirements
Prince Edward Island	No requirements
Ontario	At least 25% of the directors of the corporation must be Canadian residents. If a corporation has less than four directors, at least one director must be a Canadian resident.
Manitoba	At least 25% of the directors of the corporation must be Canadian residents. If a corporation has less than four directors, at least one director must be a Canadian resident.
New Brunswick	No requirements
Nova Scotia	No requirements
Nunavut	No requirements
Québec	No requirements
Saskatchewan	At least 25% of the directors of the corporation must be Canadian residents. If a corporation has less than four directors, at least one director must be a Canadian resident. At least one director must be a resident of Saskatchewan. If there is no Saskatchewan director, a Power of Attorney must be appointed.
Newfoundland and Labrador	At least 25% of the directors of the corporation must be Canadian residents. If a corporation has less than four directors, at least one director must be a Canadian resident.
Northwest Territories	No requirements
Yukon	No requirements

Bottom Line:

Federal incorporation can be an excellent choice if your business needs the nation-wide business name protection that federal incorporation provides, or if you think this will put your customer or partners at ease. If your business is and plans to be operating primarily within one province, provincial incorporation will generally be ok. Incorporating in a province can sometimes be easier and faster (and potentially bad because it can let you make mistakes that may affect you later.)

International companies setting up in Canada may choose to incorporate in a province that does not have residency requirements (but they will need to do extra-provincial registrations, even in Ontario, if they conduct business there.) Provincial incorporation can be changed to federal incorporation later, although there's no guarantee that the same name will be available for the federally incorporated company.

As always, the devil is in the details. Contact us if you need legal advice on these topics or related topics and we'll answer you or put you in touch with the right people. Follow our posts at our blog at StartupLegals, to continue exploring important legal considerations for your small business.

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Questions to Angels

HB (moi!) asks a question to an angel (one with money and no wings) early one Sunday morning:

What are the three most important questions, startups will hit in their first year?

He responds:

1. How do you make money?
2. Who is in your team and what are their backgrounds?
3. Have you sold anything yet?

So let me develop/decode that. His three questions are filters for assessing risk in investing in your company.

• If you make money now, that means you have figured out at least one way to make money through this company/this business model, that lowers risk.
• If your team has people that know how to generate money from business opportunities soon (or eventually) OR know how to make products that other people will be able to generate money from, that lowers risk.
• If your team have sold something,  a) you know how to sell, b) you have identified one or more customers, that lowers risk.

Now let us flip over from risk to reward, to three other criteria in which an Angel will evaluate you when looking at your company:

1. Product
2. Team
3. Prospects

#3 is the future.

It is the dollar signs in the eyes of the investor when (s)he exits the investment in your company at a handsome profit. It comes from #1 and #2.

#1 is the Product

Maturity

• Is you product mature enough for someone to want to spend money on it and feel satisfied? Really?
• How much more time and money will it cost to get there? Really?

Capability

• Can you get to the right design, technology, and ideal/identified customer base? 
• What is the cost in terms of people, money and time?
• Can you get there without getting sued?

Competitors

• Have you properly identified existing competitors?
• Can you, through product design/IP/channels/relationships, prevent other people getting there?
• Are the barriers to competitor entry large enough to give you enough time/opportunity to be (reasonably) successful?

#2 is the Team

• Have you identified and attracted the right people? 
• Can you take care of them and keep them with you?
• Can you identify new types of people your company will need and "part ways" with people your company does not need?
• How seasoned/realistic/knowledgable is your team about 
1. the markets you want to hit
2. the products you want to build
3. your growth plan

These questions will show up regularly. If you keep thinking about them, having answers and updating your answers regularly, you may get more investor interest and you will consistently improve your company's market offering.

As always, ping me if you want me to connect you with more knowledgable people on the subject.

Compensating Team Members

FA writes: When a Canadian startup starts to make revenue, how do you pay yourself and your team without a) getting hit by lots of taxes and b) doing it wrong and making it an accounting nightmare.

Dear FA,

First of all, if your wish is that you could pay no taxes on this, join the club. We have a large membership.

The only thing we all aim for is the best combination of techniques that reduce or defer payment of taxes. The important questions, as I see them, are:

a) can you defer the taxation of money received to a point in time when the person won't be taxed too heavily when (s)he receives it?

b) can you defer the tax on money received to a point in time where it needs to be taxed differently, i.e. ordinary income versus dividend income versus capital gains?

c) can you move the money from income directly to expenditure without ever receiving it, so the money is never taxable as income in your hands?

Let's say all of your team are shareholders and employees in the company.

When the company makes revenue, you can:

a) channel money to the employees through their employment payments. That will probably be taxed in their hands as ordinary income and your corporation will get a deduction for it.

b) channel money to them as dividends. That will probably be taxed as ordinary income as well (it may be taxed on a lower rate because of the dividend tax credit but unlikely in the case of a startup because startups often benefit from preferential tax rates.)

c) channel money to the employees if they are managers through other mechanisms such as management fees (basically turning the employment relationship to an arm's length business-to-business relationship.)

d) benefit your employees in other ways through things like lunches or other general employment benefits (which will probably not be appreciated as much as cold hard cash.)

e) keep most of the money in the company so that when you sell all or  part of the company, your team gets the money as a 'capital gain' (rather than ordinary income.) 
     - [If the corporation is a "qualifying small business corporation" then it is possible to take the money out of a corporation through a tax strategy called crystallisation. However it will be important to do that over a long term tax plan and this is something to discuss with a friendly tax planner I can put you in touch with.] 
     - This has the added benefit of moving the money from income to expense without taxation. The corporation can benefit from deduction of income whereas Johnny Employee or Johnny Shareholder can't.

Now suppose your team doesn't hold shares in the company directly but each of them has, say 100% of the shares in a corporation (a holding company or Holdco) then you can issue dividend from your company to their companies on a tax free basis. 

 [This allowance is to ensure that money only gets taxed once (the exception to that rule is taxation on consumption, i.e. sales tax, GST)]

If each team member has his or her own holding company, then (s)he will have some flexibility as to how to take the money out but the tax issues related to that Holdco will be another story.

Now, suppose your business grows to the point where it isn't benefitting from small business tax rates. Then you can think of running the partnership as a limited partnership between holding companies.

Finally, you can use a bonus plan or a stock option plan. But such plans bring up a lot more complexity.

Moral of the story. It's hard to reduce the tax burden markedly without a combination of things, a.k.a, accounting nightmare. Of course, if the amount in question is large enough, any nightmare can be overcome.

You'll have to tailor your solution after a more detailed discussion with a tax lawyer/accountant. Ping me for a referral.