Tax – Settling a Shareholder Dispute under a Unanimous Shareholders Agreement is taxed as a Restrictive Covenant – Tax Court of Canada

By Cory G. Litzenberger, CPA, CMA, CFP, C.Mgr – President & Founder of CGL Strategic Business & Tax Advisors (CGLtax.ca)

From the WTF (Weird Tax Findings) department…

Consider this, you have three shareholders with a Unanimous Shareholder Agreement (USA) that says you can’t sell shares to a third party without consent of the other shareholders. Pretty standard stuff in agreements that I’ve seen.

Now if two of the shareholders want to sell, and one does not want to agree. What do you do?

In the Tax Court of Canada ruling in Pangea v The Queen (2018 TCC 158) that came out July 31, 2018, it became a little murkier.

The day-to-day common understanding of the Restrictive Covenant rules was that it was mainly for things like Non-Competition Agreements when selling a business, etc.

In this case, a shareholder that did not want to sell received an amount from the other shareholders. Basically, they paid him to go along with the sale of the shares and not exercise their right to veto the sale.

Now to a Canadian shareholder, such a payment could be also taxed as business income as an “inducement payment” so it really doesn’t matter the characterization. However, to a non-resident shareholder, inducement payments could be treaty exempt as business profits, but restrictive covenant payments are not. This was the case for Pangea, and why it went to court.

The commentary provided by the Tax Court of Canada however got me to thinking how far does this reach, and is there something else that could have been done?

You see, the agreement between the disputing shareholders does not have to be a formal agreement. The restrictive covenant rules say that it can be an “agreement”, “undertaking”, or “waiver of an advantage or right” whether legally enforceable OR NOT.

This wording makes me concerned.

So even if the other two shareholders, tied me up, held a gun to my head, and made me agree under duress to accept the payment and sell my shares, I would still be taxed as though I was a willing participant?

Now, this didn’t happen (I think) in this case, however, it begs the “what if” question, and brings a whole new meaning to “shotgun clause” in Unanimous Shareholder Agreements.

So what if the transaction would have been structured differently?

The interpretation by the tax court, although likely correct based on the extremely broad wording of the provisions, begs the question “what if” when viewing this scenario.

The questions below do not imply that they would have been viewed favourably by the CRA or the Tax Court Justice, but it makes me wonder how they would view it.

What if, instead of the amount being to agree, it was an outright sale of the right from Pangea to the other shareholders to veto the sale? Would the result be different? Would it be considered a disposition of property and exempted from the restrictive covenant rules? The Tax Court Justice hinted that this didn’t occur, so he does not have to consider it, but what would the ruling be if he did?

What if the purchaser agreed to pay more for the shares held by Pangea than the amount paid to other shareholders?

What if the other two shareholders assigned some of the sale proceeds directly to Pangea instead of receiving it first? Would it change the outcome?

If the two shareholders committed a criminal act (which they didn’t) in forcing Pangea to agree under duress, would the CRA and Tax Court still enforce the restrictive covenant rules? It appears that they could.

Unfortunately, this ruling raises more questions than answers with disagreeing shareholders tied to a Unanimous Shareholder Agreement trying to solve a dispute.

One can only pop some popcorn and stay tuned…

Cory G. Litzenberger, CPA, CMA, CFP, C.Mgr is the President & Founder of CGL Strategic Business & Tax Advisors; member of CPA Alberta Tax Working Group advisory panel; and recently, moderator at the 2018 Canadian Tax Foundation Prairie Provinces Tax Conference in Saskatoon, SK; and Master of Ceremonies at the 2018 Canadian Association of Farm Advisors Alberta Update