A unique feature of Canadian tax and corporate law is the use of the share freeze in the context of a reorganization of a corporation. This article provides a general and introductory overview of the share freeze.
A share freeze generally involves the exchange or conversion of common shares into redeemable preferred shares, the value of which will be set at the fair market value of the common shares so exchanged or converted. The value of the company will then cease to accrue on those shares (whose value becomes fixed upon freezing), and instead will begin to accrue on new common shares issued following the freeze.
For example, a sole shareholder owning 100% of the common shares of a company exchanges his shares for redeemable preferred shares for an amount equal to the fair market value (e.g. $100,000); immediately after the freeze, his son subscribes for 100 common shares for $100. Future appreciation will be reflected in the 100 new common shares issued, while the preferred shares retain a fixed value of $100,000. The holder of these preferred shares will have the right at any time to require that his shares be redeemed by the company, for a total amount of $100,000.
The share freeze is used in several situations where one wishes to integrate a new shareholder, in whole or in part. The typical case is that of the founder of a company who wishes to retire from the business and transfer the company to his child who will continue the operation. Various tax provisions mean that one cannot, without immediate tax consequences, simply give one's shares to a child, or let him subscribe for shares for a symbolic amount when the company has accumulated a significant value. The idea of the freeze is that all the value of the company is encapsulated in preferred shares, so that subscribers to common shares can buy the shares for a small amount, for example $100. The freeze is often used in the context of a business succession, but also when one or more shareholders wish to bring in a new partner.
Various provisions of the Income Tax Act (and their provincial equivalents) allow for a share freeze without any immediate tax consequences. Legally, at the corporate law level, the freeze may be effected by an exchange of shares. The share exchange is expressly provided for in the Quebec Business Corporations Act, and is one of the methods by which a corporation may acquire its own issued shares. An exchange agreement will be entered into between the corporation and the shareholder in question, whereby the shareholder sells his or her shares to the corporation (these shares will then be cancelled), and the corporation issues new freeze preference shares in return.
An alternative is to convert the common shares to freeze preferred shares; in such a case there is no transfer of shares per se but rather a "conversion" of those shares. At the federal level, the conversion will require the filing of articles of amendment with Corporations Canada, while at the provincial level the conversion can be done by resolution of directors and shareholder approval.
It should be noted that the articles of association must provide for the type of shares required to make the freeze in the authorised share capital. Otherwise, the articles of association must be amended to create a new category. For tax purposes, this will be a "reorganisation of capital".
A new subscription of ordinary shares will have to take place after the freeze, for a minimum amount. If the company is a federal company, the payment of the subscribed shares should not be forgotten, as the pre-payment of the shares prior to their issuance is mandatory for the issuance to be valid.