Are you considering divorce but are unsure how this will impact your shared company or business? Guest writer and tax lawyer, Doug Ewens, Q.C. of PwC Law LLP, provides insight into some selected options for planning and protecting interests of separating parties when it comes to dividing companies.
Suppose during a long-term marriage, a couple (Mr. & Mrs. A) started a company that has been operating profitably for two decades. For the purpose of this post we will assume that:
- both are shareholders but only one (Mr. A) is actively involved in running the company;
- Mr. A owns all the voting common shares, and Mrs. A owns an equal number of the non-voting common shares;
- the company owns an office building and equipment that it uses to carry on its manufacturing business;
- Mr. A is the President and sole director of the company and has received annual bonuses from the company in sporadic amounts based upon the extent of its financial success each year;
- Mrs. A has never been employed by the company – her primary responsibility having been raising the couple’s children;
- dividends have been paid each year on Mrs. A’s class of non-voting common shares in order to minimize the amount of income tax borne by Mrs. A; and
- Mr. A owns $4 million of interest-bearing debentures of the company.
This post will examine creative ways for the company to be divided between the divorcing spouse/shareholders while minimizing taxes, maintaining ownership interests and ensuring that one spouse (Mr. A) has the ability to run the company and the other (Mrs. A) has the security required to protect her interests. This is merely a summary of possible solutions to these issues and does not constitute legal advice.
How to Protect Mrs. A’s Interests
The best protection for Mrs. A would be for her to own interest-bearing debt obligations of the company, which Mr. A would transfer to her as part of the Distribution Order under the Matrimonial Property Act (Alberta). That transfer should occur under a tax-deferred rollover under section 73 of the Income Tax Act. Ideally, these debentures would become secured with a mortgage on the company’s office building and a pledge of the company’s equipment that is used in its manufacturing business. The reason that this would afford Mrs. A the best protection is that those debt obligations would provide her with an enforceable right to require the company to make regular payments of interest to her and to make periodic repayments of principal at such time as the parties would negotiate. In addition, Mrs. A would not be dependent on the sole director of the company (who is Mr. A) declaring dividends on her non-voting common shares – as she is at present. Generally, dividends are able to be paid by a company only if its board of directors resolves to declare and pay them.
Preferred Shares vs. Common Shares
Preferred shares of the company would provide Mrs. A with a greater level of protection than does her existing class of non-voting common shares, since preferred shares rank senior to common shares. Consequently, if Mrs. A were to exchange all or a portion of her non-voting common shares of the company for preferred shares of the company bearing cumulative preferential dividends and being retractable for 50% of the total value of her non-voting common shares, the preferred shares would provide her with a measure of protection against a future downturn in the business of the company. The way in which preferred shares afford greater protection to the holder then do common shares is that a company that issues preferred shares generally is precluded by its articles of incorporation from declaring or paying dividends on its common shares until it has satisfied its obligation to pay all dividends that have accumulated on its preferred shares. In addition, the terms of preferred shares normally provide that the payment of dividends on the company’s common shares must not render the company unable to redeem all its outstanding preferred shares.
In many cases, shares of an operating company will be held by a holding company in which Mr. & Mrs. A own the outstanding shares. Where this type of holding company structure exists, the use of “tracking shares” to be issued by the holding company to Mrs. A also should be considered. Specifically, it would be possible for Mrs. A to change a portion of her non-voting common shares into a new class of common (or preferred) shares the terms of which would entitle her to receive dividends on that new class of those shares equal to a specified portion of the company’s (a) investment income and (b) dividends paid on the operating company’s common shares held by the holding company. The fundamental problem with that idea is that the source of possible dividend payments to which the tracking shares could apply is the operating company. Importantly, dividends are able to be paid by the operating company only if its board of directors resolves to declare and pay them and only if certain “solvency” tests are satisfied by the operating company. Thus, regardless of how intricate and specific the attributes of Mrs. A’s tracking shares might be, she would be dependent upon the directors of the operating company actually declaring and paying dividends.
The best way to protect Mrs. A’s entitlement to receive dividends on her newly created tracking shares would be for Mr. and Mrs. A, the holding company and the operating company to enter into a unanimous shareholder agreement (USA). The terms of the USA should:
- set out a formula for limiting the amount of bonuses to be paid by the operating company and the holding company to Mr. A for a particular year (ideally stipulating that such bonuses may be paid only after the holding company has satisfied its dividend payment obligations for that year under its tracking shares owned by Mrs. A and its interest payment obligations on the debentures held by Mrs. A;
- set out a formula for the amount of dividends to be paid by the holding company on the tracking shares held by Mrs. A;
- set out a timetable for the redemption of Mrs. A’s newly issued tracking shares; and
- pursuant to the attributes of the newly created tracking shares held by Mrs. A, entitle the holder thereof (i.e. Mrs. A) to have the exclusive right and power to declare dividends only on, or to effect a redemption/purchase for cancellation of, those newly created tracking shares.
The above three mechanisms should provide substantial protection and control for Mrs. A, by providing her with enforceable rights to receive income from the company, while leaving it legally controlled by Mr. A.
We hope that you will find these strategies useful. They can be used to enhance the position of a spouse who does not have control over the company that is the source of the family’s net worth and cash flow. Dividing company assets is a complex matter, if you are considering divorce and need legal advice, connect with us to set up an initial consultation. Our skilled team of lawyers have over 50 years of combined experience resolving family law matters.