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When several parties are working together in a business, whether as a partnership, incorporated company or any other type of formal business venture, the parties can enter into a contractual agreement that would govern their relationship. In the case of a corporation, this contract would be referred to as a shareholders’ agreement. While it is not mandatory to have a shareholders’ agreement, it can streamline the management of the business and provide guidance to shareholders at specific points during the lifetime of the business.

A shareholders’ agreement is intended to deal with potential risks and events that may arise over the course of the business relationship. Provisions can be included to recognize the relationship between shareholders, their families, other legal entities, and the corporation itself. The following list, although not exhaustive, outlines certain questions that you should ask yourself when drafting or revising a shareholders’ agreement.

Note: In creating or making changes to a shareholders’ agreement, it is crucial to consult with qualified tax and legal advisors to ensure that options and considerations have been appropriately addressed, that your individual situation has been accounted for and that all information has been properly documented.

1. Have you made any changes to the corporate structure?

Making a revision to the shareholders’ agreement following a corporate reorganization, such as an estate freeze, or even the addition or withdrawal of a shareholder, should not be overlooked. Make sure your shareholders’ agreement properly reflects your corporate structure to avoid any unforeseen issues.

2. When did you last determine the value of the business?

Oftentimes, shareholders of private corporations have a good idea of their company’s value. However, there are numerous circumstances that will require a formal determination of fair market value to be calculated by a professional business valuator, such as the sale of shares by a shareholder. Since there are numerous methods of calculating the corporation’s fair market value, the shareholders’ agreement should specify the preferred valuation method agreed to by all shareholders.

Having the valuation method pointed out in the shareholders’ agreement will help to avoid any conflicts when one shareholder is looking to enforce the agreement for the purpose of redeeming their shares or purchasing the shares of another shareholder. Furthermore, it may be prudent to include a dispute resolution plan if shareholders disagree over the final valuations.

To avoid revising the entire agreement each time the value of the business is adjusted, an appendix to the agreement can be used. A price adjustment provision may also be included to allow the value to be adjusted upward or downward, should the tax authorities disagree after the fact.

3. Have you considered shareholder illness or death?

In cases of severe illness, such as incapacity, or death of a shareholder, a share redemption clause can provide guidance as to how that shareholder’s shares will be dealt with. The redemption clauses and mechanisms may vary considerably from one agreement to the next. In some cases, the redemption clause will allow other shareholders to purchase the former shareholder’s shares. In other cases, the corporation will buy back the shares. The ultimate goal of a redemption clause is for the existing shareholders to maintain control of the shares while paying the former shareholder fair market value for the shares.

It is important for each shareholder to make sure their estate plans are drafted in keeping with the redemption clause in their shareholders’ agreement. For example, a redemption clause will prevent a shareholder from leaving his or her shares to heirs.

4. Are the redemption clauses funded?

Share redemption clauses in the event of disability or death should go hand in hand with the method and source of funding, such as life insurance, disability insurance, the company’s liquidity, the company’s borrowing capacity or even the borrowing capacity of other shareholders. Insurance is often the simplest way to exercise these agreement clauses, but in certain circumstances, other sources will be used.

Make sure you have sufficient life and disability insurance to cover the redemption of shares from each shareholder in the event of their death or long-term disability. In the absence of insurance, the agreement should provide for payment terms for the value of the shares by the company or the other shareholders.

5. Could your agreement benefit from the grandfathering provisions related to the stop-loss rule?1

Prior to February 26, 1995, a shareholders’ agreement funded with life insurance benefitted from an undeniable advantage compared with the tax rules in force today. Previously, taxes on the redemption of shares from a deceased shareholder could be significantly reduced, even eliminated, by funding the redemption of shares using the proceeds of life insurance. Since February 26, 1995, new rules have, in part, limited the tax advantage of redeeming shares with life insurance.

However, tax authorities have introduced “grandfathering provisions” for individuals who have a shareholders’ agreement that was written before February 26, 1995. In general, grandfathering provisions will apply in the following cases:

  • Where life insurance was in place before February 26, 1995, and it can be concluded that the main purpose of the life insurance policy was to fund the redemption of shares by the corporation in the event of a shareholder’s death; or
  • Where a shareholders’ agreement existed before February 26, 1995, and the redemption of shares by the corporation was planned in the event of a shareholder’s death.

If the agreement benefits from the grandfathering provisions, it may be difficult to amend it without losing the benefits conferred. Therefore, if the corporation existed before February 26, 1995, make sure you consult an expert before making any changes to your shareholders’ agreement. In case of doubt and when possible, it may be preferable to draft a separate document to complement the original agreement.

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6. Does your shareholders’ agreement consider tax opportunities and restrictions?

A shareholders’ agreement should allow sufficient flexibility to take advantage of the tax laws at the time the provisions within the agreement are applied. For example, where funds need to be distributed to shareholders, the choice of the type of income to be distributed can make a difference.

The following is a list of a few tax considerations not to be overlooked when drafting a shareholders’ agreement:

  • The citizenship of the shareholders and beneficiaries of a shareholder trust, notably U.S. citizenship.
  • The tax residence of shareholders and beneficiaries of a shareholder trust.
  • Family relationships, within the meaning of the Income Tax Act, between shareholders, including beneficiaries of a shareholder trust.
  • Where life insurance is used for the purpose of redeeming shares, define how the capital dividend account will be used. For instance, should the surviving shareholders or the deceased shareholder’s estate be favoured.
  • Ideally, as previously mentioned, the drafting of share redemption clauses should attempt to minimize the impact of the application of the stop-loss rules.

As tax rules are constantly evolving, certain clauses may include some flexibility for the surviving shareholders and estate representative to ensure that the tax rules in force at the time of death can be optimized.

7. What about your personal planning strategy?

The shareholders’ agreement is merely a document that governs the relationship between shareholders in the light of certain events. However, this agreement will not settle the distribution of an estate or the way in which a shareholder’s wealth is managed should the latter be unfit to manage it himself or herself.

It is important that each shareholder, as well as his or her spouse, review their personal planning and legal documents, including their Wills and Powers of Attorney, with the help of a qualified legal professional. These documents should be revised, as necessary, based on the relevant provisions contained in the shareholders’ agreement.

While these points provide a solid starting point for revising and updating a shareholders’ agreement, it’s important to consult with tax and legal experts who specialize in the preparation of such documents. A well-drafted shareholders’ agreement will take into consideration the economic, legal and personal reality of each shareholder, as well as the specifics of the business itself.

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8. Does the company have a contingency plan?

Although a contingency plan does not constitute part of the shareholders’ agreement, it’s still worthwhile to consider preparing such a plan at the same time as your shareholders’ agreement, and ensuring that everyone involved is aware of the contingency plan.

A contingency plan addresses the company’s operations in the face of an emergency involving the management of the corporation. Whereas a shareholders’ agreement covers transactions between shareholders, a contingency plan defines the actions to be taken by the management team to ensure the continuity of operations in situations requiring quick decisions that cannot be taken by the officer, for instance, in the event of his or her death or disability.

In an emergency situation, it is essential to have resources readily available in order to act quickly and reassure customers, creditors, employees and shareholders. For instance, it may be necessary to have life insurance protection for key employees and officers, strictly with a view to maintaining business operations.

Having a well-defined contingency plan for extreme circumstances, and implementing it when necessary, will help to reduce uncertainty and stress if a key person in your company is not available.

Reference:
  1. The rule generally applies to limit the capital loss an estate might incur following the redemption of shares from a private corporation, if more than 50 percent of the dividends used for the redemption of shares were tax-free capital dividends. Subsection 112(3) of the Income Tax Act.