A Tax Guide to Preferred Share Financing for Family-Owned Enterprises

Preferred share financing can be a game-changer for family-owned businesses in Canada. Imagine having a tool that not only helps you raise capital without giving up control but also offers significant tax advantages. Preferred shares are exactly that—a strategic financial instrument designed to meet the unique needs of family enterprises. But as with any powerful tool, using preferred shares incorrectly can lead to costly mistakes, including hefty penalties from the Canada Revenue Agency (CRA).

For family-owned businesses, preferred shares are more than just a way to attract investors—they are a critical component of effective tax planning and succession management. Whether you’re looking to pass your business on to the next generation, minimize your tax liabilities, or restructure your company, preferred shares can provide the flexibility and efficiency you need. However, the benefits come with potential risks. Missteps in structuring or managing preferred shares can result in severe tax consequences, including fines, interest charges, and even legal disputes with the CRA.

This blog post will guide you through the essential tax implications of preferred share financing, helping you understand both the opportunities and the challenges. As experts in the field, we at Shajani CPA are here to help you navigate these complexities, ensuring that your business remains compliant while maximizing the benefits of preferred share financing. Let’s dive into how preferred shares can work for your family-owned enterprise and what you need to know to use them wisely.

What Are Preferred Shares?

Preferred shares are a unique class of equity that offer distinct advantages and characteristics compared to common shares, making them an appealing option for family-owned enterprises looking to structure their finances efficiently. Unlike common shares, which provide ownership in a company and voting rights, preferred shares generally do not carry voting rights but come with other financial benefits, such as a fixed dividend and priority over common shares in the event of liquidation. Understanding the intricacies of preferred shares is crucial for family businesses aiming to balance the need for capital with the desire to retain control over their operations.

Definition: Characteristics of Preferred Shares

Preferred shares, often referred to as preference shares, are a type of equity security that typically grants the shareholder a fixed dividend, paid out before any dividends are distributed to common shareholders. This dividend preference is one of the primary reasons why preferred shares are attractive to investors seeking stable income streams. In addition to dividend preference, preferred shares often carry other characteristics, including:

• Priority in Liquidation: In the unfortunate event of a company’s liquidation, preferred shareholders are paid out before common shareholders, though after debt holders. This priority reduces the risk for preferred shareholders, making these shares a safer investment option, particularly for those concerned with capital preservation.
• Fixed Returns: Unlike common shares, where dividends are variable and dependent on the company’s profitability, preferred shares typically offer a fixed dividend rate. This fixed return provides a predictable income stream, which can be particularly appealing for family members who rely on steady cash flows from their investments.
• Convertible and Redeemable Features: Some preferred shares come with the option to be converted into common shares at a later date, providing flexibility for shareholders who may want to participate in the company’s growth. Additionally, companies may issue redeemable preferred shares, which can be bought back by the company after a certain period or under specific conditions.

The combination of these features makes preferred shares a hybrid security, offering both equity and debt-like characteristics. This hybrid nature is particularly beneficial for family-owned enterprises that need to raise capital without diluting ownership or control significantly.

Types of Preferred Shares

Preferred shares can be further categorized into different types, each with unique features that cater to various investor needs and corporate strategies. Understanding these types is essential for family-owned enterprises when designing a financing structure that aligns with their long-term goals.

1. Cumulative Preferred Shares
   • Definition: Cumulative preferred shares entitle the holder to receive dividend payments that accumulate if the company fails to pay them in any given year. This means that if a company skips a dividend payment, it must pay the missed dividends before any dividends can be paid to common shareholders.
   • Benefits: For family-owned businesses, issuing cumulative preferred shares can be a way to attract investors who seek assurance that they will eventually receive their dividends, even if the business experiences temporary financial difficulties.
   • Drawbacks: However, the obligation to pay accumulated dividends can create financial pressure on the company, especially during periods of low cash flow.
2. Non-Cumulative Preferred Shares
   • Definition: Non-cumulative preferred shares, unlike their cumulative counterparts, do not accumulate unpaid dividends. If the company decides not to pay dividends in a given year, the shareholder loses the right to those dividends forever.
   • Benefits: This type of preferred share is less burdensome for the issuing company, as there is no obligation to make up for missed dividends in future years. This feature can make non-cumulative preferred shares more attractive to the issuing company while still offering an appealing fixed return to investors.
   • Drawbacks: For investors, the lack of cumulative dividends means higher risk, which might require the company to offer a higher dividend rate to compensate.
3. Retractable Preferred Shares
   • Definition: Retractable preferred shares give the shareholder the right to sell the shares back to the company at a predetermined price after a specified period. This feature provides the shareholder with a level of protection against market fluctuations.
   • Benefits: For family-owned businesses, retractable preferred shares can be an effective way to attract capital by offering investors an exit strategy. It can also be a tool for managing ownership structures by allowing the company to regain shares from external investors.
   • Drawbacks: The obligation to buy back shares at a fixed price can create future financial liabilities for the company, which needs to be managed carefully.
4. Perpetual Preferred Shares
   • Definition: Perpetual preferred shares do not have a maturity date, meaning they remain outstanding indefinitely unless redeemed by the company. These shares provide a continuous stream of fixed dividends.
   • Benefits: Perpetual preferred shares can be an excellent option for family-owned enterprises seeking long-term capital without the pressure of repayment or buyback obligations. They allow the company to secure funding while maintaining focus on long-term growth strategies.
   • Drawbacks: The indefinite duration of perpetual preferred shares can lead to an ongoing financial commitment to pay dividends, which can be a burden during times of financial stress.

Relevance to Family-Owned Enterprises

Preferred shares are particularly well-suited for family-owned enterprises due to their ability to provide necessary capital while minimizing the dilution of control and ownership. Family businesses often face the challenge of balancing the need to raise funds with the desire to keep the business within the family. Preferred shares offer a solution to this dilemma by allowing businesses to bring in external capital or reward family members without relinquishing significant control.

Preserving Control: One of the most significant advantages of preferred shares for family-owned enterprises is that they generally do not carry voting rights. This feature allows the family to maintain control over the business’s strategic direction, even as they raise capital through the issuance of preferred shares. For families that prioritize keeping decision-making within the family, preferred shares are an invaluable tool.

Raising Capital Efficiently: Preferred shares enable family-owned businesses to access capital markets or family members’ investments without the need to issue new common shares, which could dilute existing ownership. This is particularly beneficial when the business is looking to finance growth, manage debt, or undertake significant projects such as expansion or acquisition.

Wealth Transfer and Succession Planning: Preferred shares can also play a critical role in succession planning for family-owned enterprises. By issuing preferred shares to younger family members or trusts, the senior generation can begin transferring wealth while retaining control over the company. This strategy can also be tax-efficient, as preferred shares can be structured to minimize tax liabilities during the transfer of ownership.

Stability in Returns: For family members who may not be involved in the day-to-day operations of the business but rely on its financial success, preferred shares provide a stable income stream through fixed dividends. This stability can be crucial for maintaining family harmony, especially when different family members have varying levels of involvement and expectations from the business.

Strategic Flexibility: The various types of preferred shares—cumulative, non-cumulative, retractable, and perpetual—offer family-owned enterprises the flexibility to design a financing strategy that meets their specific needs. Whether the goal is to secure long-term capital, provide an exit strategy for investors, or manage financial obligations effectively, preferred shares can be tailored to fit the family’s objectives.

In conclusion, preferred shares are a powerful financial instrument for family-owned enterprises in Canada. They offer a blend of equity and debt-like features that provide stability, preserve control, and support strategic financial planning. By understanding the different types of preferred shares and their relevance to family businesses, you can make informed decisions that align with your long-term goals, ensuring the continued success and sustainability of your family enterprise.

 

Tax Benefits of Preferred Share Financing

Preferred share financing is not only a strategic tool for raising capital without diluting control in a family-owned enterprise but also offers significant tax benefits. These benefits can be pivotal in managing the overall tax burden of the business and its shareholders. This section explores the tax advantages of preferred shares, focusing on dividend tax treatment, capital gains implications, income splitting, and the role of preferred shares in inter-generational wealth transfers.

Dividend Tax Treatment

One of the primary tax advantages of preferred shares is the favorable treatment of dividends compared to regular income. In Canada, dividends received from preferred shares are typically eligible for the dividend tax credit, which can significantly reduce the effective tax rate on this income compared to other forms of earnings, such as salary or interest.

The Dividend Tax Credit: When a corporation pays dividends to its shareholders, those dividends are generally subject to taxation. However, the Canadian tax system recognizes that the corporation has already paid corporate taxes on its earnings before distributing dividends. To mitigate double taxation, shareholders who receive eligible dividends can claim the dividend tax credit, which reduces their personal tax liability.

For example, if a family-owned business distributes $50,000 in dividends from preferred shares to a shareholder, that income will be taxed at a lower rate due to the dividend tax credit. This is particularly advantageous for family members who are in higher tax brackets, as the tax savings can be substantial. In contrast, if that same $50,000 were paid out as salary, it would be taxed at the recipient’s full marginal tax rate, resulting in a higher overall tax burden.

Implications for Family-Owned Enterprises: For family-owned businesses, the tax-efficient distribution of profits through preferred share dividends can be an attractive way to compensate family members who are not actively involved in the business. This approach ensures that the income they receive is taxed at a lower rate, preserving more wealth within the family. Additionally, by structuring dividend payments through preferred shares, the business can maintain control over how and when dividends are paid, providing flexibility in managing cash flow and tax obligations.

Capital Gains Implications

Another significant tax benefit of preferred shares lies in the potential for capital gains when these shares are sold or redeemed. Capital gains are typically taxed at a lower rate than regular income, making them a desirable outcome for shareholders.

Capital Gains on Sale or Redemption: When a shareholder sells or redeems preferred shares, any increase in the value of those shares over the original purchase price is considered a capital gain. In Canada, only 50% of capital gains are included in taxable income, which effectively halves the tax rate compared to regular income.

For example, if a shareholder originally purchased preferred shares for $100,000 and later sells them for $150,000, the $50,000 gain is subject to capital gains tax. However, only $25,000 (50% of the gain) is added to the shareholder’s taxable income, significantly reducing the tax liability compared to receiving the same amount as salary or interest.

Strategic Use in Tax Planning: Family-owned enterprises can strategically use preferred shares to manage tax liabilities through planned sales or redemptions. For instance, preferred shares can be issued with a predetermined redemption schedule, allowing shareholders to realize capital gains over time. This approach can smooth out tax liabilities and take advantage of lower capital gains tax rates, particularly in years when the shareholder’s other income is low.

Moreover, capital gains can be further optimized through the use of the lifetime capital gains exemption (LCGE) available to shareholders of qualified small business corporations (QSBCs). Under the Income Tax Act (Canada), shareholders can shelter up to a specified amount of capital gains from taxation when they sell their shares in a QSBC, provided certain conditions are met. This exemption can be a powerful tool in inter-generational wealth transfer strategies, as discussed in the following sections.

Income Splitting

Income splitting is a tax planning strategy that involves distributing income among family members to take advantage of lower tax brackets. Preferred shares are an effective vehicle for income splitting within a family-owned enterprise, allowing the business to reduce its overall tax burden by spreading income across multiple shareholders.

Using Preferred Shares for Income Splitting: By issuing preferred shares to family members, particularly those in lower tax brackets, a family-owned business can distribute income in the form of dividends in a tax-efficient manner. Since dividends from preferred shares are eligible for the dividend tax credit, they are taxed at a lower rate than regular income, making this an attractive option for families looking to optimize their tax position.

For example, consider a scenario where the parents own a family business and have children who are either full-time students or earning minimal income. By issuing preferred shares to the children and paying dividends to them, the family can take advantage of the children’s lower tax brackets, significantly reducing the overall family tax burden. This strategy is particularly effective if the parents are in a high tax bracket, as it shifts income to individuals who will pay less tax on it.

Attribution Rules Consideration: It is important to note that Canadian tax law includes attribution rules designed to prevent income splitting in certain situations. These rules, found in sections 74.1 to 74.5 of the Income Tax Act, may attribute income earned on transferred property back to the transferor if the recipient is a spouse or minor child. However, preferred share dividends may still be a viable income-splitting tool if structured correctly, particularly when dealing with adult children or through the use of a family trust.

Preferred Shares in Inter-Generational Wealth Transfers

One of the most powerful applications of preferred shares in family-owned enterprises is their role in facilitating inter-generational wealth transfers. Preferred shares can be used to freeze the value of a parent’s interest in a corporation, allowing the children to acquire future growth in the business at a nominal value. This strategy, often referred to as an “estate freeze,” is a cornerstone of tax-efficient succession planning.

The Estate Freeze Strategy: An estate freeze involves converting common shares held by the senior generation (typically the parents) into preferred shares with a fixed value, while issuing new common shares to the next generation (typically the children) at a nominal value. This freezes the value of the parents’ interest in the corporation at its current level, capping the future tax liability on their estate. Meanwhile, the children hold the new common shares, which will appreciate in value as the business grows, enabling them to benefit from future profits and growth.

For example, if the parents own 100% of the common shares in a family-owned business valued at $5 million, they can exchange their common shares for $5 million worth of preferred shares. The children are then issued new common shares for a nominal amount (e.g., $1). As the business continues to grow, any increase in the value of the corporation is attributed to the new common shares held by the children. This strategy effectively shifts future growth to the next generation while locking in the current value of the parents’ interest.

Tax Act Considerations: The Income Tax Act (Canada) provides specific rules governing estate freezes, primarily found in sections 85 and 86. Section 85 allows for the tax-deferred transfer of assets to a corporation, which is essential for implementing an estate freeze without triggering immediate tax liabilities. Section 86 deals with share exchanges within the same corporation, facilitating the conversion of common shares into preferred shares.

When implementing an estate freeze, it is crucial to adhere to these provisions to avoid unintended tax consequences. Proper valuation of the shares is also essential to ensure the freeze is effective and that the CRA does not challenge the transaction.

Benefits of an Estate Freeze with Preferred Shares: The estate freeze not only minimizes the tax burden on the senior generation’s estate but also facilitates a smooth transition of the business to the next generation. By using preferred shares, the parents can retain control over the business and continue receiving dividends, while the children benefit from the future growth of the corporation. This approach ensures that the business remains within the family, preserving its legacy and providing financial security for future generations.

Using Trusts in Conjunction with Preferred Shares: To enhance the effectiveness of an estate freeze, families often use trusts in conjunction with preferred shares. A family trust can hold the new common shares on behalf of the children, providing flexibility in distributing future income and capital gains. This structure also allows the family to delay the allocation of shares to individual beneficiaries, which can be advantageous if the children’s future needs and circumstances are uncertain.

Conclusion

Preferred share financing offers a range of tax benefits that can significantly enhance the financial efficiency of a family-owned enterprise. From the favorable tax treatment of dividends to the strategic use of capital gains and income splitting, preferred shares provide powerful tools for managing tax liabilities. Moreover, in the context of inter-generational wealth transfer, preferred shares play a pivotal role in estate freezes, enabling families to pass on the future growth of their business to the next generation in a tax-efficient manner. By understanding and leveraging these benefits, family-owned businesses can achieve their financial and succession planning goals while preserving wealth for future generations.

 

Tax Risks and Considerations

Preferred share financing offers significant benefits for family-owned enterprises, but it also presents substantial tax risks that must be carefully managed to ensure compliance with the Canada Revenue Agency (CRA). The Income Tax Act (Canada) contains specific provisions designed to regulate the tax treatment of preferred shares, and failure to adhere to these rules can lead to severe financial consequences. This section discusses the key tax risks associated with preferred shares, including the Taxable Preferred Shares Rules, Distress Preferred Shares provisions, and Anti-Avoidance Rules, highlighting the relevant sections of the Income Tax Act.

Taxable Preferred Shares Rules

The Taxable Preferred Shares Rules, found in sections 248(1) and 187.1 of the Income Tax Act, are designed to limit the tax benefits associated with certain types of preferred shares that closely resemble debt instruments. These rules are intended to prevent corporations from issuing preferred shares that provide tax advantages similar to interest-bearing loans, which could otherwise be exploited to reduce or defer tax liabilities.

Overview of the Rules: According to section 248(1) of the Income Tax Act, taxable preferred shares are defined as shares that confer on the holder a right to a fixed dividend or other amounts determined by reference to factors such as interest rates. When preferred shares meet the criteria outlined in this section, they are classified as “taxable preferred shares,” and the issuing corporation may be subject to the Part VI.1 tax under section 187.1.

Part VI.1 Tax: Section 187.1 imposes a 25% tax on dividends paid on taxable preferred shares. While this tax is refundable in certain circumstances, it can create a significant financial burden for the issuing corporation, particularly for smaller family-owned enterprises. The refundability of this tax is contingent upon the corporation paying dividends to common shareholders within a prescribed period, which can strain the company’s cash flow.

Implications for Private Corporations: Private corporations, including family-owned enterprises, must be cautious when issuing preferred shares to avoid triggering the Part VI.1 tax. Key factors that may lead to shares being classified as taxable preferred shares include:

• Dividend Rights: Preferred shares that provide a right to dividends computed by reference to an interest rate or other similar benchmarks may fall under the taxable preferred shares definition in section 248(1).
• Redemption Features: Preferred shares that are redeemable at the option of the holder, or that possess other debt-like characteristics, are more likely to be classified as taxable preferred shares.
• Undue Tax Advantages: If the CRA determines that the primary purpose of issuing preferred shares was to gain an undue tax advantage, the shares may be classified as taxable preferred shares under the anti-avoidance provisions in the Income Tax Act.

Potential Pitfalls: The imposition of the Part VI.1 tax can significantly reduce the financial benefits of issuing preferred shares. In addition, if the CRA deems that the issuance of preferred shares was primarily for tax avoidance, the corporation could face penalties under section 245 of the Income Tax Act, which deals with the General Anti-Avoidance Rule (GAAR).

Compliance Strategies: To mitigate these risks, family-owned businesses should ensure that preferred shares are structured with a clear business purpose and that they do not resemble debt instruments. Consulting with tax professionals and obtaining legal advice during the issuance process can help ensure compliance with sections 248(1) and 187.1 of the Income Tax Act.

Checklist for Identifying Taxable Preferred Shares:

• Are the dividends on the preferred shares fixed or linked to an interest rate or other benchmark?
• Do the preferred shares have redemption features that resemble debt obligations?
• Is there any indication that the primary purpose of issuing these shares is to achieve a tax advantage?

For more detailed guidance, refer to the CRA’s guidelines on taxable preferred shares.

Distress Preferred Shares

Distress preferred shares are a specialized category of preferred shares issued by corporations facing financial difficulties. The CRA has specific guidelines regarding these shares, particularly when they are issued under conditions of financial distress. The tax treatment of distress preferred shares is governed by various sections of the Income Tax Act, including sections 112 and 115, which relate to the deductibility of dividends and the calculation of taxable income.

CRA’s Stance on Distress Preferred Shares: The CRA closely scrutinizes distress preferred shares because they are often issued at a discount to their face value, which can create opportunities for tax avoidance. According to the CRA’s archived guidelines, distress preferred shares are typically issued as part of a restructuring plan by a corporation that is insolvent or nearing insolvency.

Tax Consequences under the Income Tax Act: The CRA may challenge the tax treatment of distress preferred shares under sections 112 and 115 if it determines that the shares were issued primarily to create a tax advantage. For example:

• Denial of Dividend Deductions: Under section 112(1) of the Income Tax Act, dividends received from distress preferred shares may be subject to special rules that limit their deductibility if the CRA determines that the shares were issued as part of a tax avoidance strategy.
• Recharacterization of Gains: If distress preferred shares are issued at a low value and subsequently redeemed or sold at a higher value, the CRA may recharacterize the resulting capital gain as ordinary income under section 115, which would be taxed at a higher rate.
• Penalties and Interest: If the CRA concludes that the issuance of distress preferred shares was abusive, the corporation could face penalties under section 162 of the Income Tax Act, along with interest charges on any reassessed amounts.

Best Practices for Compliance: To avoid these adverse tax consequences, corporations issuing distress preferred shares must ensure that the shares are issued for genuine business purposes related to financial restructuring. Proper documentation of the financial distress and the reasons for issuing the shares is essential. Additionally, corporations should be prepared to justify the valuation of the shares and demonstrate that the transaction was not primarily designed to achieve a tax benefit.

Checklist for Identifying Distress Preferred Shares:

• Was the corporation facing financial distress at the time of issuing the preferred shares?
• Were the preferred shares issued at a significant discount to their face value?
• Is there a clear business rationale for issuing these shares beyond achieving tax benefits?

For additional details, review the CRA’s archived guidelines on distress preferred shares.

Anti-Avoidance Rules

The General Anti-Avoidance Rule (GAAR), found in section 245 of the Income Tax Act, gives the CRA broad powers to challenge transactions that are perceived as abusive tax avoidance schemes. GAAR applies to a wide range of transactions, including those involving preferred shares, where the CRA believes that the primary purpose of the transaction was to obtain a tax benefit in a manner that abuses the provisions of the Income Tax Act.

General Anti-Avoidance Rule (GAAR): Section 245(2) of the Income Tax Act allows the CRA to deny tax benefits arising from transactions or series of transactions that are considered abusive. To apply GAAR, the CRA must establish that the primary purpose of the transaction was to obtain a tax benefit and that the transaction resulted in a misuse or abuse of the provisions of the Income Tax Act.

Preferred shares are often scrutinized under GAAR, especially when they are structured in ways that closely resemble debt instruments or create artificial tax benefits. For instance, if preferred shares are issued with the intention of converting regular income into capital gains, thereby reducing the overall tax liability, the CRA may challenge the transaction under GAAR.

Notable Cases and Rulings: The CRA’s application of GAAR to preferred share transactions has been highlighted in several cases and rulings. Income Tax Technical News No. 36 provides detailed examples where the CRA successfully applied GAAR to recharacterize transactions involving preferred shares.

• Case Example 1: In one case, a corporation issued preferred shares with a high dividend rate, which were later redeemed at a significant profit. The CRA argued that the transaction was designed primarily to convert taxable income into capital gains, thereby reducing the corporation’s overall tax liability. The court upheld the CRA’s position, applying GAAR under section 245 to deny the tax benefits.
• Case Example 2: In another case, the CRA challenged an estate freeze transaction involving preferred shares, arguing that it was structured to avoid capital gains tax on the appreciation of the corporation’s assets. The court ruled in favor of the CRA, applying GAAR to recharacterize the transaction and assess additional tax liabilities.

Implications for Family-Owned Enterprises: The application of GAAR to preferred share transactions underscores the importance of ensuring that these transactions have a genuine business purpose beyond obtaining tax benefits. Family-owned enterprises must be particularly cautious when structuring preferred share issuances in the context of estate freezes or income splitting, as these transactions are frequently scrutinized by the CRA.

Compliance Strategies to Avoid GAAR: To reduce the risk of a GAAR challenge, family-owned businesses should adhere to the following best practices:

1. Business Purpose Documentation: Clearly document the business purpose of the preferred share issuance, including how it aligns with the corporation’s overall business strategy. This documentation is critical in demonstrating that the transaction was not primarily for tax avoidance.
2. Fair Market Value: Ensure that preferred shares are issued at fair market value, supported by an independent valuation. This helps to counter any allegations that the shares were artificially undervalued to create a tax benefit.
3. Legal and Tax Advice: Engage experienced legal and tax advisors to structure the preferred share issuance in compliance with sections 245, 112, and 115 of the Income Tax Act. Advisors can help identify and mitigate potential risks associated with the transaction.
4. Comprehensive Documentation: Maintain thorough documentation of all aspects of the transaction, including board minutes, valuation reports, and legal opinions. This documentation can be crucial in defending against a GAAR challenge.
5. Advance Rulings: Consider seeking an advance tax ruling from the CRA if the transaction is complex or involves significant tax implications. An advance ruling can provide greater certainty and reduce the risk of a GAAR challenge.

Checklist for Identifying GAAR Concerns:

• Does the preferred share transaction have a primary purpose of achieving a tax benefit?
• Is there a legitimate business purpose for the issuance of preferred shares, apart from tax considerations?
• Are the preferred shares structured in a way that could be seen as mimicking debt instruments?
• Could the transaction be perceived as a misuse or abuse of the Income Tax Act provisions?

For more detailed information, consult the CRA’s guidance on GAAR.

 

Conclusion

While preferred share financing provides valuable opportunities for family-owned enterprises, it also comes with substantial tax risks that must be managed carefully. The Taxable Preferred Shares Rules, Distress Preferred Shares provisions, and Anti-Avoidance Rules, including GAAR, are key areas where the CRA closely monitors compliance. Adhering to the relevant sections of the Income Tax Act, such as sections 248(1), 187.1, 112, 115, and 245, is essential to avoid severe tax consequences, including the denial of tax benefits, reassessment of tax liabilities, and the imposition of penalties and interest.

Family-owned businesses must take a proactive approach to ensure that preferred share transactions are structured with legitimate business purposes and are compliant with the Income Tax Act. By working closely with experienced tax professionals, maintaining comprehensive documentation, and considering advance rulings where appropriate, businesses can leverage the benefits of preferred share financing while minimizing the potential for costly disputes with the CRA.

 

Structuring Preferred Share Financing in Family-Owned Enterprises

Preferred share financing is a powerful tool for family-owned enterprises, particularly when used strategically in tax reorganizations. These shares can be structured to achieve specific goals such as estate freezes, corporate restructuring, and inter-generational wealth transfers. In this section, we will explore how to effectively use preferred shares in these contexts, with a detailed case study of how Shajani CPA successfully implemented such a strategy for a client. Finally, we will provide best practices for structuring preferred share offerings to minimize tax exposure and ensure compliance with Canada Revenue Agency (CRA) regulations.

Strategic Use in Tax Reorganizations

Tax reorganizations are critical events for family-owned enterprises, often involving complex planning to achieve long-term financial and succession goals. Preferred shares play a vital role in these reorganizations, offering flexibility and tax efficiency. Here are some common scenarios where preferred shares are used strategically:

1. Estate Freezes: An estate freeze is a technique used to “freeze” the value of an owner’s interest in a corporation at its current level, allowing future growth to accrue to the next generation. This is typically achieved by converting common shares into preferred shares with a fixed value, while new common shares are issued to the younger generation at a nominal value. The goal is to minimize future tax liabilities on the estate by locking in the current value of the business.
2. Corporate Restructuring: Preferred shares can be used in corporate restructuring to streamline the ownership structure, separate voting and economic rights, or create different classes of shares for different family members. This allows for better control over the distribution of profits and the management of the company.
3. Inter-Generational Wealth Transfer: In family-owned enterprises, transferring wealth from one generation to the next while minimizing tax liabilities is a significant concern. Preferred shares can be structured to facilitate this transfer, often through the use of a family trust that holds the shares on behalf of the next generation.

Key Considerations in Structuring Preferred Shares:

• Valuation: Proper valuation of the preferred shares is essential to ensure that the transaction reflects fair market value. This is particularly important in estate freezes and wealth transfers, where undervaluation can lead to significant tax penalties.
• Tax Compliance: Structuring preferred shares in compliance with the relevant sections of the Income Tax Act is crucial. This includes adhering to the rules for taxable preferred shares under section 248(1) and ensuring that the transaction does not trigger anti-avoidance provisions under section 245.
• Flexibility: Preferred shares can be customized with features such as retractability, convertibility, and cumulative dividends to meet the specific needs of the family and the business.

Case Study: Shajani CPA Navigates Preferred Share Financing for a Family-Owned Enterprise

At Shajani CPA, we had the opportunity to assist a family-owned business, the Patel family, in navigating a complex tax reorganization involving preferred share financing. The Patel family owned a successful manufacturing business, and the patriarch, Mr. Patel, wanted to implement an estate freeze to pass on the future growth of the company to his children while minimizing tax liabilities on his estate.

Initial Situation:

• Business Valuation: The business was valued at $10 million, with Mr. Patel owning 100% of the common shares.
• Family Goals: Mr. Patel wanted to freeze the current value of his shares and ensure that the future growth of the company would benefit his two children, who were actively involved in the business.

Shajani CPA’s Strategy:

1. Estate Freeze Implementation: We recommended converting Mr. Patel’s common shares into preferred shares with a fixed value of $10 million, representing the current value of the business. New common shares were issued to his children at a nominal value, allowing them to benefit from any future growth.
2. Preferred Share Structure: The preferred shares were structured with a fixed dividend rate, ensuring that Mr. Patel would continue to receive income from the business. The shares were non-voting, allowing his children to take over the management and decision-making of the company.
3. Family Trust: To provide flexibility and protect the interests of the next generation, a family trust was established to hold the new common shares. This allowed for the income and growth from the business to be distributed to the children according to the terms of the trust, providing an additional layer of control and tax efficiency.
4. Compliance and Documentation: We ensured that the transaction was fully compliant with sections 85 and 86 of the Income Tax Act, which govern tax-deferred share exchanges and reorganizations. We also obtained a formal valuation of the business to support the freeze and documented the entire process to ensure that it would withstand any CRA scrutiny.

Outcome:

• Tax Efficiency: The estate freeze successfully locked in the value of Mr. Patel’s interest in the business at $10 million, significantly reducing the potential tax liability on his estate.
• Wealth Transfer: The children now owned the future growth of the company through their common shares, allowing them to benefit from the business’s continued success without incurring immediate tax liabilities.
• Compliance: By adhering to the relevant sections of the Income Tax Act and maintaining thorough documentation, the reorganization was structured to minimize the risk of CRA challenges.

This case illustrates how strategic use of preferred shares in a tax reorganization can achieve multiple objectives—tax efficiency, wealth transfer, and compliance—while supporting the long-term goals of a family-owned enterprise.

Best Practices for Structuring Preferred Share Offerings

To ensure that preferred share offerings are structured effectively and comply with CRA regulations, consider the following best practices:

1. Engage Professional Advisors: Work with experienced tax professionals, legal advisors, and valuation experts to structure the preferred share issuance. This ensures that all aspects of the transaction are compliant with the Income Tax Act and that the shares are appropriately valued.
2. Thorough Documentation: Maintain comprehensive documentation of the transaction, including the business rationale, valuation reports, and legal opinions. This is crucial for defending the transaction in the event of a CRA audit or challenge.
3. Advance Rulings: If the transaction is complex or involves significant tax implications, consider seeking an advance ruling from the CRA. This provides greater certainty and can reduce the risk of future disputes.
4. Consider the Long-Term Implications: When structuring preferred shares, think beyond the immediate tax benefits. Consider how the shares will affect the business’s governance, future financing needs, and the family’s long-term goals.
5. Customize Features to Meet Family Needs: Preferred shares can be tailored with features such as retractability, convertibility, and cumulative dividends to meet the specific needs of the family and the business. Ensure that these features align with the family’s financial and succession planning goals.
6. Monitor and Review: After the preferred shares are issued, regularly review the structure to ensure it continues to meet the family’s needs and complies with any changes in tax law or CRA guidelines.
7. Stay Informed on Tax Law Changes: The Income Tax Act and CRA guidelines are subject to change. Staying informed about updates to the law and how they might impact preferred share structures is essential for ongoing compliance and tax efficiency.

Conclusion

Structuring preferred share financing within a family-owned enterprise requires careful planning and a deep understanding of both the business’s goals and the applicable tax laws. By leveraging preferred shares strategically in tax reorganizations, such as estate freezes and corporate restructuring, family businesses can achieve significant tax savings, facilitate inter-generational wealth transfers, and maintain control over the company’s future.

The case study of Shajani CPA’s successful navigation of a preferred share financing reorganization for a client demonstrates the importance of a well-planned approach that prioritizes compliance, tax efficiency, and alignment with long-term family goals. By following best practices and working with experienced professionals, family-owned enterprises can confidently utilize preferred share financing to achieve their financial and succession planning objectives.

Conclusion

Preferred share financing is a versatile and powerful tool for family-owned enterprises, offering a range of benefits from a tax perspective. Throughout this discussion, we’ve explored how preferred shares can be strategically utilized in tax reorganizations, such as estate freezes and corporate restructuring, to achieve specific goals like minimizing tax liabilities, facilitating inter-generational wealth transfers, and preserving control over the business. However, these advantages come with inherent risks, including potential tax pitfalls related to taxable preferred shares, distress preferred shares, and the application of the General Anti-Avoidance Rule (GAAR).

The complexities surrounding the structuring and issuance of preferred shares highlight the importance of careful planning and compliance with the Income Tax Act. Missteps in these areas can lead to significant tax consequences, including reassessment of tax liabilities and penalties from the CRA. Therefore, it is essential to approach preferred share financing with a thorough understanding of the relevant tax rules and regulations, ensuring that each step aligns with both the business’s financial goals and legal obligations.

Call to Action
Given the intricate nature of preferred share financing and the substantial tax implications involved, consulting with a tax expert is not just advisable—it’s essential. At Shajani CPA, we specialize in guiding family-owned enterprises through these complex transactions, ensuring that they are structured to maximize benefits while minimizing risks. Our expertise in tax law, combined with our deep understanding of family business dynamics, allows us to provide tailored advice that meets the unique needs of each client. Whether you’re considering an estate freeze, corporate restructuring, or any other tax reorganization involving preferred shares, our team is here to help you navigate the process with confidence.

Final Thought
Sound tax planning is a cornerstone of preserving family wealth and ensuring the long-term sustainability of family-owned enterprises. By leveraging preferred share financing effectively, families can not only achieve their immediate financial objectives but also secure the future of their business for generations to come. At Shajani CPA, we are committed to helping you build and protect your family’s legacy through strategic, compliant, and forward-thinking tax solutions. Let us guide you in making the most of preferred share financing, so your family-owned enterprise can continue to thrive in the years ahead.

 

This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. ©2024 Shajani CPA.

Shajani CPA is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning service.

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