What’s a holding company?

Quoth the late, great Notorious B.I.G., “I don’t know what, they want from me / It’s like the more money we come across / The more problems we see.” As an entrepreneur with a thriving business, Biggie waxed poetic on the ever-increasing difficulty of managing one’s affairs as the size and scope of one’s operation increases.

The DIY entrepreneurial spirit and flying-by-the-seat-of-your-pantsness of running a small business will only get you so far. Nobody ever really explains to you that the mo’ better you do at running your business, the mo’ difficult it gets to figure it out on your own. If you’re lucky (and good), the problems you never knew you had won’t come back to bite you… or if they do, hopefully not too hard. Obviously it’s impossible to negate all of the risk of your business, but what you can control is how much damage it will do.

One of the most important tools in your damage control toolbox comes from the shockingly unsexy world of corporate restructuring. It sounds fancy, but it’s really just another example of lawyer and accountant dweebs trying to make what we do sound impressive. Corporate restructuring means assembling a series of business entities and contracts to limit how much of your businesses’ money and assets are exposed to creditors.

Creditors are anyone your business owes money to. They can be anyone from an unpaid supplier, to a jilted landlord, to a former employee, to someone who wins a lawsuit against your business. The potential liabilities – or the amount of money you could owe creditors if things go bad – can be hefty. Say you’re opening a second location for your business. Your corporation signs a 5 year lease with a landlord for $3,000.00 per month. That’s $36,000.00 per year in rent. If the second location goes out of business after 1 year, you could still be on the hook for $144,000.00 in unpaid rent. The landlord can go after your surviving location to pay the debts from the failed one. That would suck.

A well planned and implemented corporate restructuring can protect the assets of one part of your business from the risks of another. At the heart of this lawyerly magic is something called a “holding company” – or a HoldCo.

What is a Holding Company?

A HoldCo is a corporation that doesn’t do anything other than own shares of other corporations. It’s a corporate shareholder, and nothing else. It’s called a holding company because it “holds” the shares, and it also holds on to & invests the profits that come along with those shares.

A corporation that actually does business (making/selling goods, providing services, etc) is known as an “operating company” – or an OpCo – when it’s owned by a HoldCo. A HoldCo can own all or part of one, or many OpCos, or even other HoldCos.

Profits are paid from the OpCo to the HoldCo by a dividend, which is a payout of the after-tax profits of a corporation to its owners. In Canada, dividends paid by an OpCo to a HoldCo that owns its shares are generally not taxed. This means that instead of holding a bunch of cash in your OpCo, you can hold it in the HoldCo instead, without paying more tax on it.

Why would I do that???

It may seem goofy to move the cash out of your business – after all, you may need it again. The problem is that any cash in the business is an asset that can be used to pay your creditors. Once cash is moved to the HoldCo, it no longer belongs to the OpCo. Obviously you can’t use this to hide money from creditors you already have or know about – that would be fraud, and also a dick move – but if you do it in the ordinary course of business, it’s allowed. It’s called “creditor proofing”. The OpCo only hangs on to the money it needs to run the company, and the rest is paid by dividend to your HoldCo.

Secondly, if you’ve got multiple businesses, or multiple locations of the same business, the HoldCo makes it really easy to move money between the two without paying more taxes. Since corporate tax rates are generally lower than personal tax rates, using dividends from one OpCo to fund another OpCo, rather than investing your personal after-tax income means you have more to invest.

You can also keep money in the HoldCo indefinitely, or pay yourself slowly over time to keep your personal taxes to a minimum.

Ooh, clever! How do I do it?

Every business is different, and should be set up in a way that’s designed just for it. There is no silver bullet answer. There are two approaches that I see the most often in small businesses which I’ll use as examples:

HoldCo Graphic 1

Advantages:

Simple, compared to Option 2. This means that it’s cheaper to set up and run.

It separates the assets and liabilities of each separate business, or each location or division of your business. If OpCo2 gets sued by its landlord for $144,000.00, the landlord can’t go after OpCo1 or the HoldCo for payment, because they’re separate businesses.

As we know, the excess profits of each OpCo can be paid to the HoldCo as a tax-free dividend. So, if one OpCo is doing well, and the other isn’t, the HoldCo can lend the money to the struggling company, which can be paid back later tax-free. If you didn’t have the HoldCo, you’d pay tax on the dividends you get from the OpCo, and have only what’s left to loan to the struggling OpCo.

Disadvantages:

Money. For a small business, the legal and accounting work to set it up can range from thousands to tens of thousands of dollars. It costs more to run it too – each corporation needs its own bank account, tax numbers, bookkeeping, tax return, legal work, and insurance policies, to name a few.

Also, the assets of each OpCo stay in the business, and within reach of its creditors. For businesses with lots of equipment or inventory, that could be a whole lot of value left exposed.

Typical Uses

This structure is most common in businesses where there aren’t a lot of hard assets – like services businesses – or in real estate investing, where the property is the business, and can’t be effectively separated.

HoldCo Graphic 2

Advantages

Here, OpCo1 and OpCo2 are the true operating businesses. They take on all of the business liabilities – like hiring the employees, making the products, taking customer orders, signing contracts, and so forth – but don’t actually own the valuable assets. OpCo3 owns all of the valuable assets – equipment, machinery, and sometimes inventory – and rents them to OpCo1 and OpCo2 to use.

Since OpCo3 doesn’t deal with anyone other than 1 & 2, and OpCo1 & 2 are the only ones dealing with the outside world, the valuable assets are generally out of reach of the creditors of the business. Creditors can go after the profits of 1 & 2, but they have no legal relationship with OpCo3, so have no claim against its assets.

Otherwise, it works pretty much the same way as Option 1.

Disadvantages

Again, the expense is a factor. More companies means more startup and ongoing costs.

Also, you run the risk that the money being paid from OpCo 1 & 2 to OpCo 3 for the use of the assets could be called passive income by the CRA – and taxed at a much higher rate than ordinary corporate income. This is where a good accountant earns their keep.

In some highly regulated businesses, the terms of licenses, permits, or government authorizations may prevent you from using this structure at all.

Typical Uses

This is most common where there is a lot of expensive equipment, or a great deal of inventory in the business – like resource extraction, manufacturing, transportation, or construction. A similar model can also be used by a business with multiple locations, but centralized management.

Common Failures

If you’re going to do this stuff, you’d better not half-ass it. The process of setting it all up and running it, though it may seem like overly technical, tedious legal mumbo-jumbo, is absolutely critical. This is the type of stuff that the CRA will look at in detail if you’re ever audited. Even worse than that is the possibility that you may think your assets are protected when they’re not.

There are huge benefits – tax, asset protection, and your peace of mind as a business owner foremost among them – to using these structures. If you’re going to have access to those benefits, the CRA and courts of law will require you to have done everything correctly.

A few critical factors are:

  • The paperwork must be done. Without the right legal documents and tax reporting as evidence of the intent, timing, and effect of the restructuring. You can’t pretend that you’re operating separate businesses and hope they’ll go along with it.
  • OpCos Actually Op as Separate Cos. Again, you can’t fake it. Each corporation needs its own accounts, employees, contracts… everything. If anything – employees, equipment, intellectual property, invoicing, etc – is shared between the businesses, you’ve got to have contracts in place as evidence of the separation. Any overlap between the corporations could be enough to allow a judge to ignore the structure you’ve put in place, and rule that they’re actually all just one related business.
  • HoldCo Must Not Do Business. Your HoldCo must do nothing other than own shares and be owed debt by the OpCo. If it does any active business, all of its assets – meaning all of the companies it owns – will be available to its creditors. This includes participating in the management of an OpCo through a unanimous shareholders’ agreement.
  • Solvency. If your business doesn’t have enough money to pay its expenses as they come due, then it’s illegal to restructure it unless it’s part of insolvency proceedings.
  • Current Creditors. Similarly, none of this can be used to escape creditors that you already know about – or ones you ought to know about. That’s fraud.

While it’s not rocket surgery, it’s certainly not something I recommend as a DIY project. If you’ve got a business with multiple locations, different divisions doing different things, or own pieces of a few different businesses, there’s no time like the present to square this away. If you need help along the way, I happen to know a guy…

 

Mike Hook
Intrepid Lawyer
mike@intrepidlaw.ca
@MikeHookLaw

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Duties and Liabilities of Directors and Officers of a Corporation

So, you’re the proud owner/director/president/chief-bottlewasher of a shiny new small business corporation. “President” looks sharp on your business cards. You’re primed to flex your management muscle, and power the company into the marketplace. With that power comes responsibility and risk, however. The laws of Ontario and Canada impose a lot of it on the directors and officers of a corporation. What follows are some of the basic “must-know” duties and liabilities of the people who run companies.

The legal responsibilities of directors and officers of a for-profit corporation come mainly from two laws – the Canada Business Corporations Act (CBCA) and the Business Corporations Act, Ontario (OBCA). They’re similar in most respects, so unless I mention otherwise, you can assume that the same duties and liabilities would apply for a federal or Ontario corporation. These laws have been interpreted and applied by the courts in order to determine what’s expected of those trusted with the operation and direction of a business corporation.

Limited Liability

One of the biggest advantages of a corporation is that it is a separate legal person, which assumes its own liability. If the corporation goes bankrupt, gets sued, or has some sort of accident, the directors and officers of a corporation are generally protected by the “corporate veil.” This means that the corporation is the person that may be held liable, not the people who run it. In exchange for this protection, the law expects directors and officers to fulfill certain duties. In general, more is expected of a director than of an officer. If you don’t live up to those duties, you may lose the protection of the corporate form, and face personal liability.

So What Are these Duties?

1. Management

First things first – directors and officers play different roles in the management of the company. In a startup or small corporation they may be the same people, but as the company grows you’ll need to divide up the responsibilities a little more. Many companies will bring in outside directors with business or other expertise to raise the company’s profile or influence, and guide the business.

The basic role of the board of directors is to manage or to supervise the management of the corporation. Directors are elected by the owners of the corporation – the shareholders – to protect the owners’ interests. Directors’ duties include providing oversight, questioning the reports and recommendations of the officers or committees, and retaining ultimate control and direction over the business of the corporation. Other managerial tasks the directors may do themselves, or delegate them to the officers of the corporation. Delegating duties to officers does not relieve directors of their oversight responsibilities, but absent grounds for suspicion, the directors may trust the officers to perform their duties honestly. Directors should take care not to micromanage the officers by questioning every decision.

Officers – such as the CEO, President, Vice-President, Secretary or Treasurer – are appointed by the board of directors, and are responsible to manage the day-to-day operations of the corporation honestly and in good faith. Officers are usually the “directing minds” of the corporation’s daily business.

2. Fiduciary Duty

Directors and officers are “fiduciaries” of the corporation. Fiduciary is a legal term that means that they owe the utmost loyalty and good faith to the corporation, and must act only in its best interests. They may not put themselves in an actual or potential conflict of interest with the corporation. The courts are very strict in enforcing this duty, and will continue to be so.

The fiduciary duty is designed to protect a corporation against the people who control it using the corporation for their own benefit. The most common breaches of this duty include self-dealing, self-interested actions, and bad faith actions by directors or officers. The duty doesn’t mean that a corporation can’t deal with its directors or officers. Directors and officers must simply take extra steps to ensure that the conflict is disclosed, and the transaction is reasonable and fair to the corporation. The proper procedure to follow in the event of a potential conflict of interest in dealing with a party that director or officer has an interest in will be discussed later.

A director’s fiduciary duty is owed to the corporation, not to the shareholders who nominated them as a director. The limited liability of a corporation will not protect a director who acts in the best interests of their nominator over those of the corporation.

A director can be found personally liable if they use confidential information they received in their capacity as a director or officer to steal business opportunities from the corporation. It is a breach of fiduciary duty, whether it is for their personal gain, or the gain of another entity they have an interest in.

3. Care, Diligence and Skill

Directors and officers must carry out their duties with the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. What is “reasonable” is subjective, and depends on a number of factors, including the:

  • director or officer’s qualifications
  • significance of the action to the director or officer when making the decision
  • time available to make the decision
  • alternatives available to the corporation

Directors and officers are not expected to predict the future, or to make perfect decisions – only to exercise reasonable business judgement. Courts will not intervene in honest, prudent business decisions made in good faith, even if it turns out not to be the best decision after the fact. Directors and officers must be diligent in gathering information, and make business decisions in an impartial and informed manner. This is often a matter of following the proper procedure or process, so long as that process makes sense.

Since the directors have ultimate control over the affairs of the corporation, the board of directors must be able to show that it took an active role in the decision-making process, and document its process and reasons for decisions in minutes of its meetings.

4. Complying with the Law

Directors and officers must comply with their duties under every applicable law, as well as the articles of incorporation and by-laws of the corporation, and must ensure that the corporation does too. Some of the laws that hold directors or officers liable for certain failures to comply are the:

  • Occupational Health and Safety Act (Ontario)
  • Environmental Protection Act (Canada & Ontario)
  • Consumer Packaging and Labeling Act (Canada)
  • Securities Act (Ontario)
  • Criminal Code (Canada)
  • Bankruptcy and Insolvency Act (Canada)
  • Income Tax Act (Canada)
  • Canada Pension Plan Act, Employment Insurance Act, Excise Tax Act (Canada)
  • Ontario Retail Sales Tax Act
  • Consumer Protection Act (Ontario)

5. Conflicts of Interest

As mentioned above, the CBCA and OBCA set out a specific process when a conflict of interest or potential conflict of interest arises for a director or officer.

First, you must disclose the nature and extent of any interest that you have in a material contract or transaction with the corporation, whether it’s already made or simply proposed. An interest in a transaction could be if you’re a director or officer of, or have a material interest in another party to the transaction. Notice is given to the corporation either in a registered letter, or is entered in the minutes of directors’ meetings or meetings of committees of directors.

If you’re required to make such a disclosure, you may not vote on any resolution to approve the contract or transaction, unless it relates to your remuneration, is for indemnity or insurance, or the transaction is with another company that is an affiliate of the corporation.

 So What’s the Risk?

The major liabilities of directors and officers result from failure to fulfill the duties and responsibilities discussed above. Liabilities include:

1. Misuse of Corporate Finances

Directors can be held personally liable to make up the difference if they consent to the issue of shares for consideration other than money (think goods, services, or land) if the corporation doesn’t get a fair value in return. Directors may also be personally liable for unrecovered amounts if they consent to a resolution authorizing:

  • a purchase, redemption or other acquisition of shares
  • a commission
  • payment of a dividend or an indemnity, or
  • payment to a shareholder

…in a manner that’s prohibited by corporate law, the articles of the corporation, or its bylaws.

2. Wages and Employee Payments

This is probably the biggest financial risk of taking on a directorship. In some situations, such as if a corporation is being dissolved, is bankrupt, or lost a wrongful dismissal lawsuit but doesn’t have the money to pay, its directors may be on the hook to make up the shortfall. Directors, who ought to have knowledge of the financial health of the company, can be held personally responsible for up to six months of unpaid employee wages and up to twelve months of vacation pay. This is to protect employees, by deterring directors from putting people to work when the directors know the corporation won’t be able to pay them.

Directors are also personally liable for source deductions such as income tax, EI, and CPP premiums should the corporation fail to remit them.

3. Environmental Contamination

Government officials may issue orders to corporations as well as individually to directors to rectify environmental contamination on the corporation’s land – whether it was caused by the company or not. Failure to comply may result in liability for both the company and its directors.

4. Securities Legislation

For companies that are traded publically on the stock exchange, any person or company that makes a misrepresentation in a filed securities document, commits fraud or insider trading, or manipulates the market may face substantial fines or imprisonment. Any director or officer that knew, or ought reasonably to have known of the illegal act may be personally liable.

5. Civil Liability

Directors and officers may be personally liable in civil court for actions they take that are outside of the scope of their duties – known in law as an “independent, actionable wrong.” So, if someone is suing the corporation, and a director of the company also did something to that person personally, the director may be liable for damages as well. This is common in disputes over firing of employees, oppression of minority shareholders, and sometimes in negligence. When a director is “out to get” somebody, they can’t hide behind the corporation.

A corporation may indemnify its directors and officers – as in, pay the costs of defending them – so long as they acted within their authority, honestly and in good faith, and the lawsuit isn’t the result of their gross negligence or intentionally wrongful act. The corporation may pay the indemnity itself, or take out insurance to cover it. You should speak with the corporation’s insurer, and consider having a clause in officers’ employment contracts stating what is and is not indemnified by the corporation.

 Sounds Like A Lot….

If all of this seems scary, don’t fret. Here are a few simple things that you can do to keep yourself out of hot water:

  • Stay informed about the business of the corporation by:
    • attending all directors’ meetings, or reviewing the minutes if you’re unable to attend;
    • keep your own notes, and review them before attending meetings;
    • reading the terms of the articles of incorporation and the bylaws, and know them to the point where you can verify that the corporation is doing business as it should;
    • knowing what powers have been delegated to officers by the board of directors;
    • reviewing the opinions of professional consultants – including lawyers and accountants;
    • knowing what laws regulate the business or industry, and what liabilities those laws may impose on you;
    • keeping informed about the industry and any environmental or other risks that are associated with it
    • keeping informed of the business activities of the corporation by reading reports from management;
  • If you disagree with the actions of a majority of the board of directors, ensure that:
    • your dissent is recorded in the minutes, or;
    • if you’re not at the meeting but see a resolution in the minutes that you disagree with, ensure your dissent is recorded in a registered letter to the board;
  • Avoid any conflict of interest, particularly in any share transactions that result from inside knowledge of the corporation.
  • If you hold shares of the company, do so as a long-term investment, and minimize trading in order to avoid the appearance of insider trading
  • Ensure that you’re indemnified, and that you know what is covered.

Bear in mind that what’s considered to be “reasonable” in a given situation is highly subjective. When in doubt, call a lawyer. The cost of a legal opinion up-front to clear up a grey area before making a decision is way cheaper than the potential cost of a lawsuit or government fine. I happen to know a guy…

Mike Hook
Intrepid Lawyer
Email: mike@intrepidlaw.ca
Twitter: @MikeHookLaw