Tax Considerations In Corporate Creditor Proofing

Some of you may have read articles in the newspapers a few years ago about the demise of a small, but prominent, Toronto-area book chain.

It seems that a related holding corporation ("Holdco") actually put the operating company ("Opco") into receivership, and effectively jumped ahead of trade creditors when it became clear that the business could not operate profitably. Presumably, the debt payable to Holdco was secured.

If nothing else, this can illustrate the benefits of a creditor-proofed corporate structure. In many cases, even highly profitable corporations should be looking at putting such structures into place as "insurance" in the event that the business turns sour. As any lawyer who deals with debtor-creditor law is likely to tell you, the best time to implement creditor-proofing reorganizations is when things are looking good-not when the business is already bleeding.

There are many approaches that can be used in relation to creditor proofing, and over the years I have been involved in advising re the tax aspects dozens of corporate reorganizations that had this as one of its aims. Tax is usually a major factor, since the shareholders of Opco normally do not want to create a personal tax liability as a result of such reorganizations.

The simplest approach to tax-effective creditor proofing is, firstly, for the shareholders of Opco to transfer their shares to a Holdco (if this has not already been done) so that Opco becomes a wholly-owned subsidiary of Holdco. This can be effected without recognizing any capital gain if subsection 85(1) of the Income Tax Act ("the Act") is properly used.

Next, a dividend would be paid by Opco to Holdco equal to Opco's retained earnings (or more, if there are unrealized gains, goodwill, etc.). To the extent Opco does not have funds to pay this dividend, a note could be issued by Opco to Holdco, which would be secured by a charge on Opco's assets. No tax would be payable on this dividend, except to the extent that Opco has "refundable dividend tax on hand" which is recovered.

Additional dividends could be paid each year as additional retained earnings are built-up.

Although this is the simplest approach to creditor proofing, the imposition of Holdco ABOVE Opco may prove disadvantageous at the time of sale. For example:

(1) If investments are accumulated in Holdco, gains from the disposition of shares in Holdco (which includes the value attributable to Opco) may not qualify for the $500,000 capital gains exemption normally applicable to "qualified small business corporation shares", and


(2) Even if the Holdco shares qualify (or, alternatively, if there has been a prior "crystallization" of gains) the shareholder(s) will only be able to receive the tax-free gain in their PERSONAL HANDS free of tax if the shares of Holdco are sold. If there are investments in Holdco this may be unacceptable to the purchaser, and may trigger additional gains.

One approach to avoiding these problems would be to form "Investco", which would be a sister corporation of Holdco. Investment assets of Holdco (other than shares in or loans to Opco) would be moved periodically from Holdco to Investco.

The obvious question then is how will the investment assets be transferred from Holdco to Investco (free of tax). Two approaches come to mind, but these approaches may not work in certain cases if there are unrelated shareholders in Opco.

(1) The first approach, which I also often use in connection with reorganizations aimed at "purifying" corporations so that they qualify as "small business corporations", is to use a "high-low" stock dividend. In essence, this method would entail, periodically, declaring a stock dividend (in the form of redeemable/retractable special shares) on the common shares of Holdco; rolling these shares over to Investco (under subsection 85(1) of the Act) ; and then redeeming the shares by transferring excess cash to Investco. If executed properly, this can allow the "sideways" transfer of retained earnings from Holdco to Investco without the imposition of income tax.

(2) Or, Investco could just subscribe for a special class of shares in Holdco for nominal consideration. The terms of these shares would be such that any amount of dividends could be paid at the discretion of the directors. This approach is mechanically easier than the "high-low" stock dividend approach, but is probably riskier in situations where surplus that accrued prior to the issuance of these special shares is to be transferred.

Michael I. Atlas is a Chartered Accountant specializing in tax planning for over 27 years. He has published several books including: "Canadian Taxation of Nonresidents" and "Taxation of Real Estate in Canada." Michael is a regular contributor to businessmatch-maker.com