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Articles of Incorporation Basics
Background If you have the opportunity to start your business off on the right foot, why not capitalize on it? Having an effective and well thought out legal structure is not only conducive for business growth, but it can also save a lot of headaches and future problems down the road. Articles of Incorporation is going as far back, legally, as possible. Understanding what these documents are is critical to understanding how the law can directly impact your business. Articles of Incorporation are part of a legal document that is submitted to either the provincial, territorial, or federal government which registers a business as a corporation within Canada. For the purposes of this blog post, we will be examining two jurisdictions. The first is Alberta-based corporations which is governed by the Business Corporations Act (Alberta).[1] The second is federally incorporated companies which are governed by the Canada Business Corporations Act.[2] As a refresher, operating under a corporate entity separates the business from its owners. The liability attributed to the corporation is only in regard to the corporation’s assets, not the assets of the owners of the corporation. This is important if the business is being subject to any legal action or debt recovery; it limits shareholder and director liability. What is included in the Articles? Articles of Incorporation include specific information for all corporations. Requirements of the Articles are found in S.6(1) of the ABCA and CBCA. The legislation mandates the inclusion of the name of the corporation, the corporation’s share structure, the number of directors of the corporation, and restrictions. Found on the legal Articles document is the corporation’s address and date of filing. Business Name A business name is always included in the Articles. Often, you will see companies named ###### Alberta Inc., or ###### Canada Inc. This would be the legal name of the business, but the Articles allow you to have a named corporation as well like ABC Company Inc. To make sure there are no other companies with your business’ chosen name, you will have to do a NUANS report to confirm that no duplicates exists. Directors and Officers All directors’ names and their addresses must be included in the Articles. Federally, if there are only one or two directors in the company, at least one of them must be a Canadian resident.[3] In Alberta, there is a similar rule, but the Alberta corporation only mandates that one in four directors must be resident.[4] Non-Canadian residents can also be directors of the corporation, however, and in most instances, provinces will still require the company to have an attorney for service or someone in the province to be able to receive mail and more, on behalf of the corporation. When this is not the case, most provinces will require an attorney for service or someone in the province to be listed. Residential addresses for all directors are required to confirm residency status. Although officers are not legally mandated in corporations, in a small owner-operated business, it is common for the shareholder(s), director(s), and officer(s) to be all the same. For example, if Bryce is the CEO of 123456 Canada Inc, Bryce can also be listed as a director and a shareholder on the Articles. However, officers manage the operations of the business and therefore, the decision to select them should not be taken lightly. Head Office The Articles must include the corporation’s head office address. The head office of the corporation needs to be located in the province or territory in which the business is being registered. Restrictions Any restrictions that apply to the business must be included in the Articles. Restrictions generally relate to the company’s share structure and share transfers. Restrictions on share transfers allow shareholders to control who can become a shareholder in the corporation. Having this embedded in the Articles makes sure that changes cannot be made without updating the Articles with the government. In order to update the Articles, shareholders must vote to pass the amendments with a two-thirds vote. _________________ [1] Business Corporations Act, RSA 2000 c B-9 (ABCA). [2] Canada Business Corporations Act, c C-44 (CBCA). [3] Ibid at s 105(3.3). [4] ABCA, supra note 1 at s 105(3).
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Incorporating a Business – A Tax Perspective
As the business grows, entrepreneurs at some point may need to consider, or at least have heard of, the idea of incorporating their business. This is a complex decision that involves several legal, financial and tax implications. This blog will provide a brief overview some of the important consequences of incorporation from a tax perspective. An informative summary of the legal considerations can be found on the Business Venture Blog here. Why Incorporate? A corporation is one of three basic types of business organization, with the other two being sole proprietorships and partnerships. There are two basic differences between corporations from the other forms: [i] 1)Corporations have a separate legal existence. The corporation, rather than the owner, operates the business and bears all the rights and obligations that come with that business. 2)The owners and managers of the corporation become separate and have distinct rights and obligations. This has an important consequence – the income earned by the corporation running the business and the income earned by the shareholders of the corporation are separately taxable. Because there are two levels of taxation, the differences in the way they are taxed create advantages and disadvantages for the business owner. Some advantages include the ability to reduce taxes by claiming tax credits only available to corporations, controlling the timing of income, or splitting income (to a limited degree). Some disadvantages include the restriction against deducting business losses against personal income, the additional costs of maintaining a corporation such as registration and accounting fees, and the complexity of winding down the corporation when the business ends.[ii] Taxable Income – Corporations vs Unincorporated Businesses There are some differences between the tax treatment of business income earned through a corporation and business income from a sole proprietorship or partnership. For a more thorough overview of the tax treatment of business income, see our blog posting here. In short, the amount of taxes owed from a business is based on Taxable Income, which is calculated as: 1)Net income (or “profit”) based on accounting rules,[iii] then 2)Adjustments are made to calculate Net Income for Tax Purposes,[iv] then 3)Additional deductions are made to arrive at Taxable Income.[v] This calculation applies to both corporations and individuals with unincorporated businesses. However, there are different kinds of deductions available to each type of business, or the deductions may be treated differently. Deductions available to individuals but not corporations include:[vi]
Deductions that are treated differently include:[viii]
Tax Incentives Specific to Corporations Several tax incentives available to support incorporated businesses include: 1)Small business deduction – ITA s 125(1) The federal small business deduction allows Canadian-controlled private corporations (“CCPC”) reduce their taxes payable based on a limited amount of active business income earned in Canada. The business must be a CCPC, which is a private Canadian corporation that is not controlled by one or more non-resident persons or corporations whose shares are publicly traded or listed on a stock exchange.[ix] Income from an “active business” includes most kinds of business income except for income from a “specified investment business” or “personal services business”.[x] These terms have complicated meanings, but it essentially means that active business income excludes passive income earned merely by owning property (for example, stocks and bonds), and income earned by providing what could be reasonably seen as an employee service. The deduction is calculated as 19% of active business income (for the 2020 tax year) earned during the year up to $500,000.[xi] This amount would then be deducted from your federal tax payable. 2)Investment tax credits – ITA s 127(5) through s 127.1(4) Canada offers specific tax credits to support corporations investing into their business. These include credits for scientific research and experimental development (“SR&ED”), employing an eligible apprentice, and purchasing property to run a business in Atlantic Canada.[xii] 3)Foreign tax deduction – ITA s 126 Both individuals and corporations may claim a tax credit to offset foreign taxes paid on business and non-business income earned outside of Canada. The main difference is that, for foreign non-business income, the amount of credit an individual can claim is limited to the lesser of: a)15% of foreign non-business income, and b)Another limit based on a formula. There is no 15% limit for corporations – they may instead claim up to the total foreign taxes paid on foreign non-business income or the formula limit, whichever is lower.[xiii] 4)Manufacturing and processing (“M&P”) profits deduction – ITA s 125.1 The federal government offers a tax reduction based on 13% of profits earned (for 2020) from “manufacturing and processing” activities in Canada. There is no precise definition of manufacturing and processing, but the tax rules exclude activities such as logging; construction; extracting minerals; and producing industrial minerals, natural gas, and heavy crude among many other exceptions.[xiv] Note that there may not be any actual tax benefits from claiming the M&P profits deduction as any income not included in that deduction is eligible for the general rate reduction, which creates another deduction using same percentage and applies to all other income. However, Ontario, Quebec, and Saskatchewan offer their own tax credits based on M&P activities.[xv] 5)Provincial small business deductions and tax credits All provinces provide small business deductions to CCPCs like the federal deduction above. Each province also provides tax credits for corporations performing specific activities. For example, Alberta offers the Innovation Employment Grant (beginning January 1, 2021) and tax credits for scientific research and development, foreign taxes paid, capital expenditures, and production and labour costs for film and television productions.[xvi] Salary vs Dividends In the case of an owner-managed business corporation, owners have the option to pay themselves a salary, dividends, or a combination of both. This decision depends greatly on the individual circumstances of the owner and their business. Some important considerations are listed below:[xvii] 1)Provincial tax rates and credits While all Canadian corporations are subject to the same federal tax rates, different provincial tax rates and credits could weigh in favour of salaries or dividends depending on where the business is incorporated. Generally, individuals taxed at higher rates would likely prefer dividends as their tax effects are offset by dividend tax credits. Salaries of course receive no such credit. 2)Types of dividends received Corporations can pay either eligible or non-eligible dividends, each of which have their own tax treatment. Eligible dividends typically receive (are “eligible” for) more generous tax credits than non-eligible dividends. However, whether a dividend is eligible or not depends on the tax treatment of the corporate income from which the dividends were paid, and the tax credit is intended to offset that difference. Given that and the differences in the provincial tax treatment of dividends, there is no clear answer to whether salaries or dividends should be preferred. 3)CPP and EI contributions Being paid a salary allows an owner to continue making contributions to the Canada Pension Plan (“CPP”) and Employment Insurance (“EI”), whereas dividends do not. Being paid in dividends will have the effect of lowering the amounts the owner is eligible for under either plan. 4)RRSP contributions Salary payments are used to determine how much an owner can contribute to their Registered Retirement Savings Plan (“RRSP”). RRSP contributions enable individuals to defer taxes by allowing them to deduct their contributions from income. Dividends received are not factored in and so would not increase their total contribution room. 5)Childcare expense deductions Salary is also used to determine how much an individual can deduct in childcare expenses.[xviii] Dividends do not count towards this limit and so could reduce the amount an owner may claim for this deduction. GST Obligations A goods and services tax (“GST”) is charged on most goods and services in Canada and is paid by consumers. With some exceptions, the suppliers of these items (including business corporations) are responsible for collecting and remitting GST to the Canada Revenue Agency. For an overview of a business’s GST obligations, please see our blog post here. Transferring Business Assets to a Corporation It is often the case that business owners will have worked at and grown their business long before they consider incorporation. If they do decide to incorporate, owners may transfer their business assets to the corporation. However, under normal tax rules this transfer could result in the owner paying additional taxes (through capital gains and CCA recapture).[xix] Section 85 of the Income Tax Act[xx] provides a solution to this. The owner must notify CRA that he or she intends to transfer their assets to the corporation and elect to have Section 85 apply by filing certain forms. There are many detailed rules around how to properly perform the transfer, including what kinds of assets are eligible for transfer, what the owner should receive in return for the transfer (for example, shares in the corporation), and how the assets should be valued. In essence, this election may prevent owners from facing needless tax liabilities in growing their business. __________________ [i] J Anthony VanDuzer, The Law of Partnerships and Corporations, 4th ed (Toronto, Ontario: Irwin Law Inc, 2018) at 13-16. [ii] Clarence Byrd, Ida Chen & Gary Donell, Byrd & Chen’s Canadian Tax Principles: 2020-2021 Edition, Volume 2 (North York, Ontario: Pearson Canada Inc) [Byrd and Chen] at 725-727. [iii] For an explanation of “profit”, see “Basic Tax Implications for Canadian Entrepreneurs”, (30 December 2020), online (blog): Business Venture Blog http://www.businessventureclinic.ca/blog/december-30th-2020. [iv] Income Tax Act, RSC 1985, c 1 (5th Supp) [ITA], s 9(1). [v] ITA, supra note iv at s 110(1). [vi] Byrd and Chen, supra note ii at 585. [vii] In 2019, the Government of Canada proposed changes to the current treatment of employee stock options, where there will be a $200,000 limit on stock options that qualify for the stock option deduction. Employees with options over this limit would not receive the deduction on those options and include the entire excess benefit in income when the options are exercised. Instead, the employer will be able to deduct the amount that would have been eligible for the deduction. CCPCs and non-CCPC corporations with annual gross revenues of $500 million or less would not be subject to the new rules. The Government’s goal was to “ensure that start-ups and emerging Canadian businesses that are creating jobs can continue to grow and expand and attract key talent, while limiting the benefit of the employee stock option deduction for high-income Canadians who work in mature companies.” The new rules are expected to apply to options granted on or after July 1, 2021. See Department of Finance Canada, “Supporting Canadians and Fighting COVID-19: Fall Economic Statement 2020“ (2020) at 113-114, online (pdf): Her Majesty the Queen in Right of Canada https://www.budget.gc.ca/fes-eea/2020/report-rapport/FES-EEA-eng.pdf [viii] Byrd and Chen, supra note ii at 585-586. [ix] ITA, supra note iv at s 125(7). [x] ITA, supra note iv at s 125(7). [xi] ITA, supra note iv at s 125(1.1)(c) and 125(2). [xii] See Canada Revenue Agency, “Line 41200 – Investment tax credit” (date modified: 18 January 2021), online: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/deductions-credits-expenses/line-41200-investment-tax-credit.html [xiii] Byrd and Chen, supra note ii at 615. [xiv] See ITA, supra note iv at s 125.1(3) for definition. See also Canada Revenue Agency, “Income Tax Folio S4-F15-C1, Manufacturing and Processing” (last modified: 15 February 2017), online: https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax/income-tax-folios-index/series-4-businesses/series-4-businesses-folio-15-manufacturing-research-development/income-tax-folio.html#N101DD [xv] Byrd and Chen, supra note ii at 609. [xvi] See Government of Alberta, “Corporate income tax” (date accessed: 30 January 2021), online: https://www.alberta.ca/corporate-income-tax.aspx#deduction [xvii] Byrd and Chen, supra note ii at 753-758. [xviii] ITA, supra note iv at s 63(1)(e)(i). [xix] Byrd and Chen, supra note ii at 775. [xx] ITA, supra note iv at s 85(1).  Agency Costs
The “agency problem” arises whenever one person (the “Principal”) entrusts another person (the “Agent”) with the power to make decisions that affect the Principal. This could involve entrusting property to the Agent to deal with on behalf of the Principal, or it could involve delegating decision-making power to the Agent that affects the legal rights of the Principal. The core of the agency problem is that the Agent has the authority to act on behalf of the Principal and yet the interests of the Agent may diverge from the interests of the Principal.[1] For example, the Agent may not negotiate as hard as the Principal would on the price of the Principal’s goods unless there is something in it for him. This is a prime example of an “agency cost”. In Canadian common-law, the essence of an agency relationship is that the Agent can affect the legal rights and obligations of the Principal with the outside world.[2] For example, the Agent can negotiate, enter into contracts, or dispose of the Principal’s property. The list of agency relationships is not closed, but trustee-beneficiary, employee-employer, solicitor-client, and business partners all give rise to certain agency problems. In a corporation, an agency relationship exists between the corporation's shareholders (Principals) and its management (Agents). The common-law’s solution to the agency problem is the fiduciary duty. The fiduciary duty holds the Agent to a strict standard of conduct.[3] It requires the Agent to exercise reasonable care and diligence (duty of care), and to exercise his authority in the best interests of the Principal, not to obtain a benefit for himself to the detriment of the Principal (duty of loyalty).[4] Courts are reluctant to impose fiduciary duties, particularly in commercial contexts because it is thought to be a “blunt tool” in that it imposes serious legal duties upon one party without much regard for circumstances. To find a fiduciary duty at least three elements must exist (although the presence of all of them or the lack of one of them is not determinative): (1) The fiduciary has scope for the exercise of some discretion or power. (2) The fiduciary can unilaterally exercise that power or discretion so as to affect the beneficiary's legal or practical interests. (3) The beneficiary is peculiarly vulnerable to or at the mercy of the fiduciary holding the discretion or power.[5] In a corporation, it is the directors and officers who make decisions about the corporation’s business, and it is the shareholders whose property is at stake. As a result, both the common-law and legislation impose fiduciary duties on directors and officers to act in the best interests of the corporation. This public-law solution is good, but as mentioned above, it is “blunt” and not very proactive. There are several other ways that shareholders can protect themselves contractually i.e., structuring the enterprise in a way that aligns the interests of management, with the interests of owners. In a corporation, agency costs are the costs incurred by the shareholders (Principal) to supervise and control management (Agent).[6] Traditionally, economists point to three ways to effectively control and oversee management:
The market for corporate control, like the fiduciary duty, is criticized as being “blunt” and only really applies when management has seriously failed.[8] It does not proactively prevent mismanagement. The market correction also relies heavily on an efficient market where these kinds of inefficiencies can be addressed immediately. But, transaction costs, market regulations, asymmetric information, and the fact that other firms are not always in a position to acquire make the market for corporate control less efficient. Similarly, empirical research has shown that board independence is not actually very effective at reducing agency costs or improving firm performance.[9] Boards of directors are rarely truly independent, and even if they are, they are often influenced by management and are less effective at disciplining management and representing the interests of shareholders than one might think. Regardless, in a start-up company, it is unlikely that an independent board of directors is possible. In very early-stage companies the founder often holds 100% of the company’s capital and manages 100% of the affairs of the business. When the company needs to grow, it needs to attract some form of venture capital. The moment that outside capital is involved, there are going to be agency problems. What you end up with is a company with shareholders who are particularly vulnerable to the control of a single founder or group of founders, and founders who are particularly vulnerable to shareholders who want their money back.[10] Not to mention that both the founders and the shareholders are particularly vulnerable to going out of business. So naturally, agency costs are significant in start-up companies. This partially explains why start-up companies and investors make use of relatively complex investment instruments and shareholder agreements. Capital structure, shareholder agreements, bylaws, and employment agreements all play a significant role in controlling agency costs in a start-up company. The table below provides a few examples of the legal tools corporations can use to address agency problems. This table is not authoritative and the boundaries between independence, equity, and corporate control are not clear-cut, but hopefully, it gives the reader a sense of the motivation behind certain contractual provisions and rules. _________________ [1] Dalton et al, “The Fundamnetal Agency Problem and Its Mitigation: Independence, Equity, and the Market for Corporate Control” in James P Walsh & Arthur P Brief, The Academy of Management Annals: Volume 1, New York: Taylor & Francis Group, 2008) 1 [Dalton]. [2] Trophy Foods Inc v Scott, 1995 NSCA 74 [Trophy Foods]. [3] Guerin v The Queen, 1984 CanLII 25 (SCC). [4] Trophy Foods, supra note 2. [5] Lac Minerals Ltd v International Corona Resources Ltd, 1989 CanLII 34 (SCC). [6] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (Canada: LexisNexis Canada, 2018) [Tingle] at 328. [7] Dalton, supra note 1 at 3. [8] Dalton, supra note 1 at 27. [9] Dalton, supra note 1 at 10. [10] Tingle at 329. Choosing the Right Investment Structure for Financing a Start-Up:
Equity Investments, Convertible Debt, and SAFEs Choosing the right financing option for a company in its early stages will depend on the unique needs of both the start-up and its investors. The most common investment structures used for financing early-stage companies include: equity investments, convertible debt instruments, and SAFEs. Advantages and disadvantages of these different investment instruments are outlined below and should be weighted carefully so as to select the financing option that best meets both company founder and investor needs. EQUITY INVESTMENTS An equity financing involves investors directly purchasing a certain percentage of capital stock from the company based on the company’s current valuation. This could be in the form of purchasing either common or preferred shares in the company. Advantages:
Disadvantages:
CONVERTIBLE DEBT/CONVERTIBLE NOTES Convertible debt, or “convertible notes”, can sometimes be a good alternative to early-stage equity investments. Convertible debt essentially allows investors to loan money to the company in exchange for a future right to have their debt converted into shares of the company’s stock. The percentage and amount of shares the debt will convert into is determined by the terms of the agreement and is usually converted in line with the valuation given to the company in its next equity financing. Advantages:
Disadvantages:
SAFEs SAFEs (Simple Agreement for Future Equity) were first developed in Silicon Valley as a way for venture capital investors to be able to quickly put money into a start-up without the burdensome negotiations that equity financing often entails. SAFES were created specifically to avoid the debt features and repayment obligation of convertible debt notes.[1] A SAFE, like a convertible note, does not give the investor stock in the company, but rather is a promise for future stock in the company on occurrence of the next equity financing round. Unlike a convertible debt note, a SAFE is not debt, but something more akin to an equity call on options or an equity warrant.[2] Advantages:
Disadvantages:
Whatever investment structure is utilized, it is important to know the pros and cons of each investment option, as a wrong choice of financing in the early stages of a growth company can have unforeseen consequences later in the company’s lifecycle. It is also advised to seek consultation with legal professionals so as to receive tailored advice for specific company and investor needs. ________________ [1] Bryce Tingle, Start-up and Growth Companies in Canada (LexisNexis Canada Inc., 2018) at 274. [2] MARPE, “Hey SEC - SAFEs are Equity, not Debt!” (26 June 2017), online: <https://marpefinance.com/blog/HeySECSAFEsareEquitynotDe-2017-06-26> [3] Bryce Tingle, Start-up and Growth Companies in Canada (LexisNexis Canada Inc., 2018) at 274. |
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