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All in the Family: The family shareholders' agreement

By McInnes Cooper


The family is the fundamental societal unit, and the family business a fundamental economic vehicle. Family businesses make up about 80 percent of all businesses in Canada and contribute about 60 percent of Canada’s annual economic output. Yet the unique relationship between family owner(s) and business and an extended ownership tenure make family businesses challenging to manage and transition. Investing in a family shareholders’ agreement maximizes the probability of maintaining family harmony and prosperity through the triumphs and trials of running a business, and successfully transitioning the business to the next generation.


The family shareholders’ agreement

Reaching a family shareholders’ agreement early and periodically revising it as circumstances change minimizes family discord by guiding ownership, decision-making, conflict resolution, and the distribution of money within the family. A unanimous shareholders’ agreement (USA) has particular utility in the family context. The real benefit is that the corporate laws deem a transferee of shares to be a party to the agreement. In the family context, this effectively means that by signing a USA, the founders can set the rules of their successors’ ultimate engagement with the family business, whether they receive shares directly from their parent(s), a discretionary family trust, or an inheritance. To qualify as a USA, however, the shareholders’ agreement must meet specific criteria, including that it be in writing and executed by all the shareholders.

Key tax challenges

Unique tax challenges apply to the family USA that require special consideration. The Income Tax Act includes numerous rules applicable only to transactions between “related parties.” The magic phrase in tax law is “arm’s length.” To be effective, the family USA terms must work with the Act’s rules respecting transactions between family members, that is, parties not at arm’s length. Three such considerations are:


Fair market value

An important consideration is the fair market value (FMV) requirement. A non-arm’s-length buyer that overpays for shares is deemed to have paid FMV, but the seller must report their capital gain based on the actual sale price. This eventually results in double tax in the family to the extent of the difference between the actual selling price and the FMV, because the buyer must also pay tax on that difference when they dispose of the shares. A non-arm’s-length seller that undercharges for shares is deemed to have actually received, and must pay capital gains tax based on, FMV. This also leads to eventual double tax because the buyer doesn’t receive a corresponding increase in their tax cost. The transfer of property for less than FMV might also make the related buyer vicariously liable for any of the seller’s past tax liability.


Leveraged buyouts

The leveraged buyout model most often used in typical USAs needs special consideration and modification to fit family shareholders’ agreements. USAs between unrelated parties often contemplate holding company leveraged buyouts within the shareholder group: a shareholder forms a holding company that then borrows the funds for the share acquisition, after which the holding company amalgamates with the operating company. The corporation can thus deduct the interest expense from operating profits and it (not the individual shareholder) repays the loan principal, avoiding tax on a dividend otherwise needed for the individual to repay the loan. The Income Tax Act transforms the proceeds received in a non-arm’s-length leveraged buyout from a capital gain into a taxable dividend, robbing the seller of the benefit of the lower effective capital gains tax rate and the benefit of the lifetime capital gains exemption.


Amicable split

One option to consider during the family shareholders’ agreement discussion is a division of the family business before an inter-generational transfer. If the business could survive if divided, this allows siblings to maintain a positive relationship by not working together in one business, instead controlling separate businesses. Splitting up a corporation is relatively easy where a related group controls it. For this single purpose, siblings are deemed “unrelated” to each other. So carefully consider potential corporate divisions in the drafting of the family shareholders’ agreement.

To discuss this or any other legal issue, contact any member of McInnes Cooper’s Corporate & Business Law Team. Read more McInnes Cooper Legal Publications and subscribe to receive those relevant to your business.

This article is information only; it is not legal advice. McInnes Cooper excludes all liability for anything contained in or any use of this article. © McInnes Cooper, 2020. All rights reserved.


Caroline Watton, McInnes Cooper


Caroline Watton is a leading business lawyer with McInnes Cooper in St. John’s. She provides strategic legal advice to start-ups, SMEs, and large corporations, assisting business owners, partnerships, and corporations on a wide range of corporate matters, including incorporation, corporate structuring, reorganization, mergers, acquisitions and dispositions, asset and share purchases, commercial leasing, and corporate governance and shareholder matters. Active in her community and profession, Caroline is a member of NLOWE, chair of McInnes Cooper’s local Collective Social Responsibility and Business Development Committees, and chair of the Canadian Bar Association’s provincial Business Law Section.

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