Financial Planning for Business in Quebec PDF

SECTION 1 FORMS OF BUSINESS AND TAXATION CONSIDERATIONS 1 Forms of Business Entities 2 Directors’ and Officers’ Responsibilities 3 Business Income and Expenses for Tax Purposes 4 Corporate Income Tax 5 Main Considerations in Tax Planning 6 The Business and Its Employees...

SECTION 1 FORMS OF BUSINESS AND TAXATION CONSIDERATIONS 1 Forms of Business Entities 2 Directors’ and Officers’ Responsibilities 3 Business Income and Expenses for Tax Purposes 4 Corporate Income Tax 5 Main Considerations in Tax Planning 6 The Business and Its Employees © CANADIAN SECURITIES INSTITUTE  Forms of Business Entities 1 LEARNING OBJECTIVES After completing this chapter, you will be able to: 1 | Identify the basic elements of different forms of business entities. 2 | Explain at which level business entities are taxed. 3 | Describe what should be included in a partnership agreement. 4 | Describe the advantages of the utilization of the corporate form. 5 | Identify the situation in which the corporate entity may be ignored (pierce the corporate veil). CONTENT AREAS Sole Proprietorship Partnership Corporations © CANADIAN SECURITIES INSTITUTE  CHAPTER 1 | FORMS OF BUSINESS ENTITIES 1 3 INTRODUCTION A company may take any of three legal forms: Sole proprietorship Partnership Corporation Each form has specific benefits and drawbacks that financial planners must understand. Choosing which form their company will take is the client’s first important decision. A grasp of the legal characteristics of the different options and the tax considerations related to each is therefore essential for efficient financial planning. SOLE PROPRIETORSHIP A sole proprietorship is inseparable from the owner in legal and tax terms. Unlike a corporation, there is no distinction between the assets of the company and those of its owner. As its name suggests, the sole proprietorship consists of a single person managing the company. It can carry out all kinds of activities, hire staff, and operate under a company name. This is the most common form of company in Canada. The simplicity of setting up and managing a sole proprietorship is clearly what makes it so attractive. It is often used when the company has limited assets – as is frequently the case in the service sector – and relatively low revenue. MAIN CHARACTERISTICS The main characteristics of a sole proprietorship are as follows: The owner is personally liable for all the company’s debts and contractual obligations. It is simple and easy to create, manage and dissolve the company. All profits and all losses go to one single person. The company’s net business income or loss is added to other income on the owner’s personal income tax return (from a tax point of view, a sole proprietorship has no separate existence.) Net business income or loss is calculated as the business revenue minus the deductible business expenses for tax purposes. On the one hand, the owner’s tax burden increases insofar as he must pay income tax on the company’s net business income, regardless of how much he has personally taken out of the business. (For example, the business may have net business income of $15,000, and the owner has not withdrawn any money from the business.) On the other hand, the owner’s tax burden may be reduced if the business has a loss because he can deduct the net business losses against income from other sources. Financing of the company is generally limited because it depends on the owner’s resources, credit history, and ability to borrow. If the company runs into financial difficulty, it may lead to bankruptcy for the owner since, in which case creditors can seize his personal assets. Conversely, any personal financial problems on the part of the owner may jeopardize the company’s financial health. There is little scope for financial and estate planning, given the overlap, in legal and tax terms, between the sole proprietor and his business that already exists. The company may bring legal matters before the small claims court, since this tribunal is reserved for physical persons and not legal ones. © CANADIAN SECURITIES INSTITUTE 1 4 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 PARTNERSHIP A partnership is a form of business association with a very different structure than that of a corporation. A partnership resembles a sole proprietorship, except that it has more than one owner. All the income is allocated to the owners, or partners and may be shared between them in whatever way they have agreed. Although it is not a separate legal entity, the partnership nevertheless has some of the characteristics of one. For instance, a partnership can take legal action or be liable under its name. TYPES OF PARTNERSHIPS The Civil Code of Quebec recognizes only three kinds of partnerships: Undeclared partnerships (sociétés en participation) Limited partnerships (sociétés en commandite) General partnerships (sociétés en nom collectif) UNDECLARED PARTNERSHIPS (JOINT VENTURES) The undeclared partnerships apply to hidden, unorganized, or so-called de facto partnerships, and may be formed as a result of oral agreements or of simple and obvious facts showing that the individuals in question intend to form a partnership. They differ from the other forms of companies in a number of ways. It should be noted that all Quebec general and limited partnerships that are not registered are, by default, considered to be undeclared partnerships (joint ventures). LIMITED PARTNERSHIPS Limited partnerships consist of two categories of partners: one or more general partners, who are the sole persons authorized to manage the partnership, and one or more special partners, who are bound to furnish a contribution to the common stock of the partnership. In a limited partnership, the limited partners are responsible for the partnership’s debts and obligations only up to the amount of their contribution. The general partners contribute their work, expertise, and experience to the limited partnership and are authorized to administer and represent the partnership. Only the general partners may transact business and have the authority to bind it in a contract. General partners are liable for the partnership’s debts. GENERAL PARTNERSHIP A general partnership, like a limited partnership, is formed by a contract between the parties. In theory, there are no specific formalities regarding registration or other forms of publicity. The Civil Code of Quebec describes the contract of partnership, or partnership agreement, as follows: A contract of partnership is a contract by which the parties, in a spirit of cooperation, agree to carry on an activity, including the operation of an enterprise, to contribute thereto by combining property, knowledge or activities and to share any resulting pecuniary profits.” (Art. 2186 CCQ) Each partner of a general partnership is solitarily liable for the enterprise’s obligations and certain debts, independent of the respective shares of each partner in the business. A general partnership can consist of professional offices, such as a lawyer’s or dentist’s practice. A general partnership will also have its own name and head office, and it may sue or be sued in an action under civil law. NOMINAL PARTNERSHIP What is commonly known as a nominal partnership is not covered as such in the Civil Code of Quebec. A nominal partnership is an agreement whereby certain professionals operate as sole practitioners and agree to share common expenses and offices. However, letterhead or exterior signs bearing the names of the professionals in the nominal © CANADIAN SECURITIES INSTITUTE  CHAPTER 1 | FORMS OF BUSINESS ENTITIES 1 5 partnership may lead to the assumption, or even create the presumption, that a partnership exists, with all the related third-party liability consequences. Accordingly, it is important to recommend to people in such a situation that they obtain adequate legal advice, in particular concerning legal publicity. They should make it clear that they do not form a partnership, but are simply grouped together in one place of business, yet operating separately. MAIN CHARACTERISTICS OF PARTNERSHIPS Partnerships, then, have three essential characteristics: Partners’ contributions Profits to be shared among partners Willingness to work together and co-operate in pursuit of a common objective MAIN TAXATION CHARACTERISTICS OF PARTNERSHIPS For taxation purposes, the partners must report, in their individual income tax returns, their share of the income or losses of the partnership attributed to them. The income or losses are allocated to each partner on a source by source basis. The Canada Revenue Agency requires, nonetheless, that the partnership have an identification number and file a partnership information return. A partnership may have net income or losses from more than one source, – for instance, from commercial transactions, professional services, rentals, or investments. If so, the profit or loss to be attributed to each source must be determined separately. Once the net income and losses have been allocated to the partners, they retain the same characteristics in their personal tax return. For instance, dividend income earned by the partnership constitutes dividend income for the partners. A partnership normally distributes its profit, earnings, deductions, and credits among the partners according to the terms stipulated in the partnership agreement. The allocation of types of income may differ. For example, three partners may share equally in the net business income from operation, whereas only two partners participate in the taxable capital gains upon disposition of a capital property. PARTNERSHIP AGREEMENT A partnership agreement naturally requires the consent of all partners. Similarly, unless otherwise stipulated in the agreement, decisions concerning amendments to the partnership agreement must be unanimous (art. 2216 CCQ). The main issues to be considered in drawing up a partnership agreement are discussed below. PARTNERSHIP NAME AND DECLARATION The distinguishing characteristic of a partnership is that it identifies itself by a name common to the partners in its dealings with third parties. Any partnership must identify itself as such, in fact, either within or following its name, in all the acts to which it is a party. The term general partnership or société en nom collectif, or the initials G.P. or S.E.N.C., must be an integral part of the name of the partnership. This obligation is intended to protect third parties who enter into contracts with the partnership or one of its partners. It enables them to clearly identify not only the entity they are dealing with and the persons it comprises but also the applicable legal form. If the partnership is not identified as such, only the contracting partner is liable to the third party. Article 2189 of the Civil Code of Quebec requires that a general partnership identify itself by means of a name common to the partners, and the same applies to limited partnerships. For while a partnership is not a legal entity, it nevertheless has a distinctive name under which it acts. This is the reason for legal publicity in the form of a declaration of the partnership, in the same way as is done for a corporation. In Quebec, the rules relating to the contents of this declaration are set out in the Act Respecting the Legal Publicity of Enterprises. © CANADIAN SECURITIES INSTITUTE 1 6 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 INFORMATION Aside from the information prescribed by the legislation respecting the legal publicity of enterprises, the declaration of a general (or limited) partnership must state the object of the partnership and indicate that no person other than the persons named therein is a member of the partnership. In addition, the declaration of a limited partnership must indicate the name and domicile of each of the general and special partners, and their contributions to the common stock. Information on general and limited partners may vary rapidly, so the partnership will usually keep a register for this purpose. The declaration must specify the place where the register may be consulted. The declaration of general and limited partnership must be made for the partnership to exist in this form. CONTRIBUTIONS BY PARTNERS The Civil Code of Quebec contains a whole series of rules governing the relationships of the partners in a general partnership with each other and with the partnership. (Art. 2186-2197, CCQ) Of course, to avoid any misunderstandings among the future partners, it is better by far too clearly stipulate each party’s rights and obligations in the partnership agreement. One of the most important issues concerns the partners’ contributions, which is why the partnership agreement should specify as precisely as possible each party’s contribution in terms of property, knowledge or activities, including the way in which these contributions will be made. AMOUNT AND NATURE OF THE INITIAL CONTRIBUTION PROMISED Contributing to the partnership interest (hereinafter referred to as common stock) can prove very costly for a new partner, particularly if the partnership has allowed its common stock to grow over time. For this reason, some partnerships prefer to rely on bank loans, rather than requiring large contributions by partners. Another solution is not to require any contribution by a new partner, on the understanding that he will not be entitled to receive anything when he withdraws from the partnership. MEANS OF ASSESSING CONTRIBUTIONS IN KIND All partners must agree on the value to be assigned to such property. Some partnerships require that the partner purchase his own furniture and provide his own automobile; others purchase these goods and provide them for partners. There are benefits and drawbacks to each approach. We should simply note that, for tax purposes, it is the partnership itself that must deduct the depreciation on the partnership’s property, meaning that partners cannot each choose an individual amount. INCLUDING WORK IN PROGRESS AND GOODWILL Difficulties may arise if the partners decide to take the value of work in progress into account as a contribution to the capital stock. The same applies to goodwill. Unless it is possible to find a relatively simple formula for assessing each partner’s personal contribution in terms of goodwill or the goodwill of the partnership as a whole, it is preferable to ignore this aspect and assign it no value. OWNERSHIP OF CAPITAL ASSETS It may be advantageous for the partnership to simply lease the space it needs for its operations, rather than purchasing the building. The partners will thereby avoid the problems linked to the valuation of buildings, particularly in the event of a decline in value. Many general partnerships use holding companies as owners of the partnership’s capital assets, but this approach may lead to conflicts among the partners. Each partner’s interest in the holding company should be equal to his participation in the general partnership; otherwise, the result may be two categories of partners. © CANADIAN SECURITIES INSTITUTE  CHAPTER 1 | FORMS OF BUSINESS ENTITIES 1 7 MANAGING THE PARTNERSHIP Every partner is legally entitled to participate in collective decisions, and the partnership agreement may not prevent a partner from exercising that right (art. 2216 CCQ). Subject to this provision, the way in which the affairs of the partnership are managed is set out exclusively in the partnership agreement. RULES If the agreement does not stipulate the means of management, the Civil Code of Quebec provides the following rules: Unless otherwise stipulated in the contract, collective decisions are taken by a majority vote of the partners, regardless of the value of their interests in the partnership, but collective decisions to amend the contract of partnership are taken by a unanimous vote (art.2216, CCQ). Each partner may bind the partnership in the course of its activities, but the partners may oppose the transaction before it is entered into (art. 2208 CCQ). The partners are deemed to have conferred the power to manage the affairs of the partnership on one another (art. 2215 CCQ). To avoid possible disputes, it is best that the partnership agreement contain provisions outlining the partners’ respective powers in managing the affairs of the partnership. It may be preferable to provide that collective decisions will be taken in such a way as to reflect each partner’s contribution to the partnership. MANAGEMENT The partners may appoint one or more fellow partners, or even a third party, to manage the affairs of the partnership. Unless otherwise stipulated in the agreement, this manager may perform any act within his or her powers, notwithstanding the opposition of the partners (art. 2213 CCQ). This is why it is so important to specifically define the manager’s powers. For instance, a manager should not have the power to expel or admit a partner, to set the value of contributions, or to make changes to the terms of partners’ remuneration. Conversely, the partnership agreement should define the length of the mandate and grounds for revocation. Otherwise, the Civil Code of Quebec provides that the powers of management may not be revoked without serious reason during the existence of the partnership (art. 2213 CCQ). SHARING OF PROFITS AND LOSSES The focus of the partnership agreement is the sharing of the company’s profits among the partners. Accordingly, any stipulation excluding a partner from participation in the profits is without effect (art. 2203 CCQ). This participation normally entails the obligation to share in the losses (art. 2201 CCQ). Each partner’s share in the assets, profits and losses is equal unless otherwise fixed in the partnership agreement (art. 2202 CCQ). EQUITABLE REMUNERATION All methods of sharing profits have the same goal, i.e. to remunerate the partners equitably for the use of capital and services rendered. These methods range from the paternalistic system, in which a few older partners decide on the distribution of profits, to the democratic system, in which partners are elected by other partners, on the basis of age or seniority, to determine subjectively or objectively the share to go to each partner. A common approach is to divide profits on a basis reflecting each person’s efforts during the fiscal period. These efforts may be determined based on the following factors: Minimum remuneration Services billed or sales made (with a penalty for unrecoverable bad debts) Hours worked (distinguishing between hours devoted to the partnership and those devoted to community service, professional associations and others) Compliance with a minimum number of hours to be worked © CANADIAN SECURITIES INSTITUTE 1 8 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 Most partnerships adopt minimum billing and sales or service delivery objectives. The partners evaluate the annual performance of the partnership and each partner on the basis of these objectives. There is no method of sharing profits that will completely satisfy all the partners. Only time will tell whether the formula adopted is equitable. Consequently, it may be a good idea to review the profit-sharing policy every year. It is important for all partners to have a chance to express their views on this subject, for the sake of smooth relations. DISTRIBUTION OF INCOME TAX CREDITS AND CERTAIN DEDUCTIONS All allowable tax deductions in computing taxable income and income tax payable must apply to the individual partners. The partnership serves only to compute net income for tax purposes, and not taxable income. CAPITAL COST ALLOWANCE The capital cost allowance must be calculated for the partnership. The amount that can be deducted lies somewhere between zero and the allowable maximum for each asset class. Depending on their personal tax situations, the maximum deduction may be to the advantage of a given partner, while a minimal deduction may suit another. To avoid any misunderstandings in this respect, the partnership agreement should stipulate how the capital cost allowance is to be distributed. CHARITABLE DONATIONS Charitable donations give rise to non-refundable tax credits for individuals. The partnership cannot claim deductions for these donations in computing its revenue or losses for income tax purposes. The partnership’s net income will have to be adjusted accordingly, and the donations will be allocated separately to each partner. Donations made by the partnership are deemed to have been made by the partners themselves, who will add them to the donations they have made personally. FINANCIAL EXPENSES When a partnership receives interest or dividends and there are financial expenses attributable to such income, the partnership must allocate the proper share of the investment income and of the related financial expenses incurred by the partnership to each partner. OTHER OBLIGATIONS OF PARTNERS Aside from their contribution to the capital, the partnership agreement must specify exactly what is expected of each partner. WORKING CONDITIONS Working conditions must be clearly defined in terms of the availability required or the number of hours of work expected. It is recommended that the agreement include provisions outlining the amount of vacation time, leave for training and community service. The question of whether leaves can be banked or forfeited after a certain time must also be addressed. Working conditions may naturally vary from one partner to another. PARTNERS’ ACTIVITIES OUTSIDE THE PARTNERSHIP Are partners expected to devote themselves exclusively to the business of the partnership? Article 2204 of the Civil Code of Quebec specifically provides that a partner may not compete with the partnership or take part in an activity that deprives the partnership of the property, knowledge, or activity he or she is bound to contribute to it. This is why most partnerships require that a partner obtain the agreement of the other partners before undertaking activities outside the partnership, either directly or indirectly. Partners are normally forbidden to undertake professional activities on their own behalf or on behalf of a competitor. This would be the case, for instance, if a partner in an accounting firm agreed to provide the firm his commitment to work 35 hours a week, but offered his accounting services to a competing firm in his free time; © CANADIAN SECURITIES INSTITUTE  CHAPTER 1 | FORMS OF BUSINESS ENTITIES 1 9 insofar as the partner actually having worked the agreed 35 hours, he would not be depriving the partnership of the activity he was bound to contribute, although he would clearly be competing with it. VALUATING PARTNERSHIP SHARES The Civil Code of Quebec recognizes the concept of partnership shares, similar to the shares issued by corporations. These partnership shares may be transferred, hypothecated or conveyed to a third party. The partnership may also purchase its shares, by mutual agreement, or buy them back, at the discretion of the partner or of the partnership, in the same way as if they were shares of joint-stock corporations. The valuation of partnership shares may prove to be a very thorny issue, if specific procedures for doing so are not included in the partnership agreement. There are a number of options; for instance, the agreement may stipulate that the valuation will be performed by a previously selected firm of experts, submitted for arbitration or determined according to a “shotgun” clause. OTHER ISSUES In regard to partners’ rights and obligations, the partnership agreement should address the following issues, among others: Can the partnership hire the spouse or any other person of relation to a partner? Must partners undergo regular medical examinations? Who is responsible for taking out insurance? Must partners disclose their personal assets to the other partners? Who is responsible for binding the partnership in matters of charitable donations and political contributions? Croupier Agreements So-called croupier agreements allow a partner to transfer to a third party a part of his partnership share, without the consent of the other partners. The validity of such agreements is recognized in Article 2209 of the Civil Code of Quebec, which, however, prohibits any other transfer that would make this third party a member of the partnership without their consent. This same article allows any partner to exclude the third party from the partnership by reimbursing that party for the price of the share and the expenses they have paid. This right lapses one year from the acquisition of the share. This provision is intended to cover situations in which a third party has acquired the share of a partner as a result of legal seizure and sale. CORPORATIONS Many small businesses start out as sole proprietorships or general partnerships. As the company grows, or as the need for additional capital becomes more pressing, or as other persons join the upper ranks, it is almost inevitable that the enterprise will incorporate. Setting up a corporation and maintaining it from year to year admittedly involves significant, but not extravagant, costs. This is why the real question is perhaps not which legal form of a company to choose, but rather, when is it more advantageous to form a corporation? Constituting a corporation is a relatively simple operation. Some formalities must be observed, but the fact remains that any person over the age of 18 may apply to set up a corporation. © CANADIAN SECURITIES INSTITUTE 1 10 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 JURISDICTION If the company is constituted under federal jurisdiction, it is subject to the provisions and accompanying regulations of the Canada Business Corporations Act. If, on the other hand, it opts for provincial jurisdiction, the company is subject to the provisions and accompanying regulations of the legislation in effect in the province in question. For instance, companies constituted in Quebec are subject to the Quebec Business Corporations Act. The Quebec Business Corporations Act In February 2011, a new Business Corporations Act came into effect in Quebec, replacing its predecessor the Quebec Companies Act. The Quebec Business Corporations Act offers a series of simplified measures that allow sole shareholders to manage their corporations more easily. The sole shareholder may elect not to create a board of directors, not to appoint an auditor, not to adopt bylaws and not to hold shareholders’ meetings. In these circumstances, any action taken by the sole shareholder is deemed to be authorized by and binding on the corporation. If a business is active nationally or internationally, it is best to incorporate under federal legislation, merely to simplify operations; there is no legal requirement in this respect. If the corporation is constituted under provincial legislation, there may be fewer restrictions, and costs may possibly be lower. The corporation is not required to limit its operations to its province of incorporation, but if it wishes to open a branch in another province, it may have to meet additional regulatory requirements. DISTINGUISHING CHARACTERISTICS OF A CORPORATION A corporation differs from a sole proprietorship and a general partnership in several ways, as described below. SEPARATE LEGAL ENTITY The main difference from all other forms of company is that a corporation is considered a legal entity in its own right. A corporation is a legal person distinct from its shareholders. The difference between the corporation and the individuals who contribute to its capital (i.e., its shareholders) is clear. LIMITED LIABILITY OF SHAREHOLDERS Because the corporation is a legal person, shareholders are not liable for its debts and obligations. So long as a shareholder has not provided any personal guarantees to cover the corporation’s debts, no creditor has any claim to his personal property. He would, however, lose his investment in the corporation if it went bankrupt. That being said, there are some exceptions to the concept of shareholders’ limited liability (see Table 1). Table 1 | Lifting the Corporate Veil A corporation is a legal entity totally separate from its shareholders, a principle which legal authorities refer to as the corporate veil. The corporation’s obligations and commitments are not shared in any way by its shareholders. In fact, this widely known and near-absolute principle no longer applies in all cases. The corporate veil may be lifted, through a sort of legal fiction, to reach past the corporation to its shareholders. Under some circumstances, as described in article 317 of the Civil Code of Quebec, a shareholder may be held personally responsible for the debts of a corporation: In no case may a legal person set up juridical personality against a person in good faith if it is set up to dissemble fraud, abuse of right or contravention of a rule of public order. © CANADIAN SECURITIES INSTITUTE  CHAPTER 1 | FORMS OF BUSINESS ENTITIES 1 11 This article complies with legal precedents, to the effect that the juridical personality of a corporation may not be used to dissemble acts that are fraudulent, abusive or contrary to public order and that, in such cases, it is fully justifiable to lift the corporate veil. For instance, a shareholder of a joint-stock company that violates environmental, public security, communications or public utility legislation may be held responsible for the corporation’s offences and may be fined. INDEFINITE EXISTENCE A business corporation has an unlimited life. Shareholders may well sell all their shares, yet the corporation will continue to exist. Under such circumstances and unless it were specifically provided otherwise in the partnership agreement, a general partnership would be dissolved. SHAREHOLDERS ARE NOT INVOLVED IN MANAGEMENT In a corporation, it is the directors elected by the shareholders at an annual meeting who oversee the firm’s operations. Such an assembly is mandatory, even though it may be nothing more than a formality for small companies. The board of directors consists of one or more individuals, generally selected from among the shareholders. The directors may be held personally responsible for the debts and obligations of the company if they do not act prudently and diligently in the company’s best interests, or if there are legal provisions to this effect. This is the case, in particular, when it comes to directors’ liability for the recovery of unpaid income taxes and source deductions. DOUBLE TAXATION A corporation acts in its own name and on its own behalf. Unlike a sole proprietorship and other forms of companies, the corporation must pay tax on the net income it earns and so must submit its own income tax return every year. All profits and all losses go directly to the corporation itself. Consequently, the company’s profits have no effect on the shareholders’ taxable income, unless they have received wages, dividends, or some taxable benefit (e.g., the use of a car or an interest-free loan) from the corporation. REDUCING THE TAX BURDEN Some tax benefits apply only to corporations and their shareholders. Each year, by claiming the small business deduction, the corporation reduces its tax rates on the first $500,000 of net income from an active business carried on in Canada.. Similarly, shareholders of a privately owned, small business corporation can claim the lifetime capital gains exemption on capital gains realized upon the disposition of their shares. (The lifetime capital gains exemption in 2021 is $892,218 and is indexed annually for inflation.) LEGAL RESTRICTIONS Like other forms of companies, a corporation must keep accounting records and prepare annual financial statements. To protect shareholders, the company is legally obliged to have its financial statements examined by an independent auditor. Not all corporations are required to have their financial statements audited; however, most legislation on business corporations provides that, with the agreement of shareholders, small, closed companies (i.e., those whose shares are not publicly traded) may be exempt from this obligation. BETTER FINANCING OPTIONS Unlike a sole proprietorship or, to some extent, a partnership, whose ability to raise funds is limited to the individual capacity of the owner or owners, a major source of financing for a corporation is the issuance of shares. The option of issuing shares of different classes with different features makes it simpler to restructure the company’s financing and opens up many more financial planning avenues. © CANADIAN SECURITIES INSTITUTE 1 12 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 ADVANTAGES OF A INCORPORATION Business owners may choose to incorporate to take advantage of the following benefits: An unlimited life span and a legal personality separate from that of its shareholders Limited liability of shareholders (unless they have provided personal guarantees) More attractive tax planning options, such as remuneration of the majority shareholder, participation by family members, and retirement planning: Enjoyment of certain tax benefits annually and upon disposition of the shares Greater simplicity in obtaining financing or financially reorganizing the business Various ways to partially or completely liquidate the company © CANADIAN SECURITIES INSTITUTE  Directors’ and Officers’ Responsibilities 2 LEARNING OBJECTIVES After completing this chapter, you will be able to: 1 | List the conditions one must meet to serve as a director, and describe directors’ powers for fulfilling their responsibilities, as well as possible restrictions on these powers. 2 | Identify the main situations in which a director may become liable. 3 | Identify the defences that a director may invoke, and recommend protective measures. 4 | Identify the rights and responsibilities of a company’s other officers. CONTENT AREAS Directors’ Powers Directors’ Liability Means of Defence Duties and Responsibilities of Other Senior Officers Taking Facts and Circumstances Into Account © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 3 INTRODUCTION Financial planners must have fairly detailed knowledge concerning the nature, scope, and exercise of the rights and obligations of company directors and officers. Clients who own their own businesses may themselves be the directors or officers of their private companies, or they may be dealing with and learning from external directors or officers of their companies. Furthermore, larger public companies in which portfolio investments are made will all have boards of directors that help management to guide and steward the business. DIRECTORS’ POWERS Although a director’s position is often seen as a symbol of prestige, the responsibility and liability that comes with the position should make anyone think seriously before agreeing to serve. A director should have the skills, knowledge, experience, passion to learn, and time to commit to the position before taking a director’s position. Even with appropriate insurance coverage, no director wishes to see their reputation and good name besmirched because of actions by a company to which they have loaned their expertise. SHAREHOLDERS’ ROLE VERSUS THE ROLE OF DIRECTORS The law makes a very clear distinction between the roles of shareholders and directors. SHAREHOLDERS’ ROLE Shareholders are primarily investors who act in their own names and on their own behalf. Directors, on the other hand, are required to act on the company’s behalf. The role of shareholders in managing the company is quite limited. Even if they have voting shares, they have a say only in certain decisions considered the most important by lawmakers. Shareholders have virtually no say in day-to-day operations. ROLE OF THE BOARD OF DIRECTORS Strictly speaking, it is the board of directors, not the directors themselves, that is empowered to act on behalf of a corporation. Thus, a board may enter into all contracts allowed by law; acquire or sell property; hire or dismiss employees; adopt or revoke company by-laws, and so on. These powers may be limited either in the company’s articles or in a unanimous shareholder agreement, or by restrictions in loan agreements. LACK OF A BOARD OF DIRECTORS In February 2011, a new Business Corporations Act (QBCA) came into effect in Quebec. Under this new law, the sole shareholder of an owner-managed corporation governed by the QBCA may elect not to create a board of directors. The sole shareholder must first withdraw all powers from the board of directors by means of a written declaration recorded in the corporation’s records. The sole shareholder may also choose not to appoint an auditor, not to adopt by-laws and not to hold shareholders’ meetings. A corporation that was incorporated under the Quebec Business Corporations Act may continue to function under the new law without making such an election. © CANADIAN SECURITIES INSTITUTE 2 4 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 QUALIFICATIONS AND TERM OF OFFICE REQUIREMENTS Only a natural person who has attained the age of majority may serve as the director of a company. The person must be legally able to enter into contracts, i.e., must not be under tutorship or curatorship or have been declared incapable by a court in Quebec or elsewhere. Unless otherwise specified in the articles of incorporation or in a unanimous shareholders’ agreement, it is not necessary to be a shareholder of the corporation to become a director. RESTRICTIONS An individual who has not been discharged from a bankruptcy may not serve as a director, nor may a person who has been prohibited from so doing by a court. Article 329 of the Civil Code of Quebec stipulates that the court may prohibit a person from holding office as a director of a legal entity if the person has been found guilty of an indictable offence involving fraud or dishonesty. The act also focuses on individuals who have repeatedly violated the Acts relating to legal persons or failed to fulfil his obligations as a director. TERM OF A DIRECTOR Director terms can range in length if elected but unless otherwise stipulated, the term of a director elected by shareholders ends at the following annual meeting. Overlapping mandates may be arranged so as to ensure greater continuity in the administration of the company. Directors’ terms do not end automatically. Outgoing directors remain in office until their replacements have been appointed. DIRECTORS’ OBLIGATIONS The law imposes on directors the duty to act with loyalty. Unlike shareholders, they are bound to act in the exclusive interest of the company, without allowing their own interests or those of any other person or even of the shareholders (majority or not) to interfere. They must also act with care and diligence and avoid conflicts of interest. These requirements are often cited from the Peoples Department Stores Inc. (Trustee of) v. Wise case decided by the Supreme Court of Canada. DUTIES OF HONESTY AND LOYALTY Directors are duty-bound to act with honesty and loyalty in the company’s interest. They must not be subject to any pressure or interest, avoid placing themselves in conflicts of interest, and report any profits they earn as a result of their position. All directors may, even in the exercise of their duties, acquire rights, directly or indirectly, in the property they are administering. They may also enter into contracts with the company. If so, they must immediately notify the company and have this fact recorded in the minutes of the board of directors’ meeting. They must abstain from deliberations and voting on this matter, except in cases concerning their remuneration or working conditions. Article 326 of the Civil Code of Quebec allows a company itself, but also its shareholders, to take legal action, within one year after learning of the acquisition or contract, against a director who fails to disclose such information; they may ask the court to annul the act or order the director to render account and to remit the profit or benefit realized to the company. DUTY TO ACT WITH CARE AND DILIGENCE Directors must act with care and diligence. The Canada Business Corporations Act requires that directors “exercise the degree of care, diligence and skill that a reasonably prudent person would have exercised in comparable © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 5 circumstances.” The Quebec Business Corporations Act stipulates that “the directors are duty-bound toward the corporation to act with prudence and diligence, honesty and loyalty and in the interest of the corporation.” Directors may be liable if they fail to attend meetings, to act, to keep themselves properly informed, to properly select and oversee people to whom powers are delegated, or if they act carelessly or negligently. DIRECTING THE COMPANY The board of directors handles the general management of the company’s operations and overseas the future direction of the company. The chief executive officer and senior executive officers play a different role from the board of directors. The board ensures that the company is well managed, approves important decisions, adopts general policies and appropriate delegations of authority, sees to it that its decisions and policies are enforced through the CEO, and ensures that management exercises its powers within established guidelines. Rather than devoting themselves to administrative matters such as finance, staffing, and purchasing, the most efficient boards of directors concentrate on drawing up policies in four areas: company performance, employee accountability, relationship between the board and employees, and administrative duties. COMPANY PERFORMANCE Performance involves the objectives that the organization has set itself, specifically, what benefits the organization is seeking, for which groups of persons, and at what price using the resources available. EMPLOYEE ACCOUNTABILITY Employee accountability, especially at the executive level, means what employees are authorized to do, taking both ethics and due care into account. RELATIONSHIP BETWEEN THE BOARD AND EMPLOYEES The relationship between the board and employees refers to how the board delegates tasks to executive level employees and how it evaluates their performance. ADMINISTRATIVE DUTIES The fourth main field of activity of the board of directors is clearly defining its own role and procedures. If the board establishes clear policies, members can more efficiently review past operations for compliance with these policies and can focus more of their energy on the future. Any effective company management process, efficiently communicated, should build investor confidence and represent a decisive factor in determining the cost of capital. Financial planners should draw their clients’ attention to the importance of effective company management and the resulting benefits. Some issues that may become areas of concern are as follows: Lack of clarity in defining the role of the board, the executive and shareholders Conflicts between board members or between the board and company management Problems with the relevance, timeliness, conciseness or accuracy of information given to the board The board’s over- or under-involvement in company operations Problems linked to relations with major shareholders or other key shareholders Difficulties in determining optimal remuneration for company executives © CANADIAN SECURITIES INSTITUTE 2 6 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 DIRECTORS’ RIGHTS The law grants directors a number of rights, so that they can meet the obligations and responsibilities imposed on them, as regards notice of and attendance at board meetings, access to the company’s books and records, resignation and recourse in the event of removal, and, finally, the right to remuneration and reimbursement of expenses. NOTICE OF AND ATTENDANCE AT MEETINGS Directors must be informed of the date, time, and location of board meetings. They may waive this notice, however, either in writing (before, during, or after the meeting), or implicitly, simply by attending the meeting (unless they are attending to object to the meeting being called). Directors may contest the validity of a meeting of which they have not been duly notified. Note, however, that directors may not require that they be informed in advance of the subjects to be dealt with during a meeting (except for federally incorporated companies, in circumstances such as the approval of financial statements). Directors are entitled to attend meetings in person. They may also attend by conference call, provided that all the other directors agree. Unlike the case at general meetings, proxies are not allowed at board meetings. Moreover, directors may not be accompanied by another person, a legal advisor for instance, unless all the other directors agree. ACCESS TO BOOKS AND RECORDS Directors are entitled to be informed of the company’s business. They have access to all its books and records, including accounting records and the minutes of meetings of the board and general meetings. RESIGNATION Directors may resign at any time, and are not required to give any reason for doing so. It is best to provide some justification, however, particularly if resigning without giving reasonable notice. Directors who resign without notice and without valid reason may be held responsible for the harm caused to the company by their actions. A director who resigns must ensure that the notice of change of directors is filed in Ottawa or Quebec City because of the legal presumption that the directors identified in the most recent notice sent to the Inspector General or the Director are still holding that position. RECOURSE IN CASE OF REMOVAL A director is entitled to be informed of the date, time, and location of the general meeting at which shareholders intend to remove him or her from office. They may send shareholders a statement explaining their grounds for opposition. The removal need not be justified by shareholders, but if it is done without valid reason and without reasonable notice, the director may apply to the court for compensation for any harm suffered. REMUNERATION AND REIMBURSEMENT OF EXPENSES Directors are entitled to remuneration for their services, provided that the board of directors so decides. The position of director of a small company is normally not remunerated. In any case, directors are entitled to be reimbursed for the expenses incurred in the performance of their duties. If a director is sued, the company is obliged to defend them and to pay any damages arising from the suit (except in cases of personal wrongs or if the director has not acted in good faith and in the company’s best interest). RESTRICTIONS ON DIRECTORS’ POWERS Shareholders may assume directors’ powers and even replace directors completely. In such cases, the shareholders assume all the liability inherent in exercising these powers. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 7 WAYS OF INSERTING RESTRICTION CLAUSES Clauses to restrict directors’ powers in the articles of incorporation or in a unanimous shareholder agreement can take any of the following forms: A requirement for a special majority, greater than that stipulated by law, for adopting directors’ decisions, in general or for certain decisions (e.g., 100%, 75%, etc.) A requirement that directors take certain steps or that shareholders ratify certain decisions by the directors, which means that the general meeting of shareholders and the meeting of the board of directors must be held concurrently A transfer of certain specific powers from the directors to shareholders RESTRICTIONS AS PER LOAN AGREEMENTS Moreover, most loan agreements contain clauses intended to restrict the powers of shareholders and directors. The most frequent restrictions prohibit the company from the following actions without the lender’s written agreement: Declaring dividends Making changes to shareholders’ rights Granting loans or guaranteeing commitments by a third party Purchasing all or part of other companies Setting up a subsidiary Merging or combining activities with those of another person/company Liquidating assets or assigning them as collateral Such restrictions by the lender are intended to ensure that the value of the assets given as collateral is maintained. The goal is not so much to intervene in the company’s management as to exercise control over certain operations that could have a major financial impact. DIRECTORS’ LIABILITY What directors do not themselves manage, they must supervise, given that they are responsible to shareholders for the company’s affairs and, increasingly to third parties, in particular the State. Where directors’ liability is concerned, the law does not always take common management practices into account. For instance, directors may often be held liable for a company’s actions, even in cases in which they are far removed from decision-making. This may seem unfair, but for the sake of public interest, the persons who are liable must be easily identifiable so as to ensure respect for the law. The main situations in which a director may be held liable relate to unpaid wages, source deductions, reduction of the company’s capital, environmental obligations, and the dissolution of the company. UNPAID WAGES Both the Quebec Business Corporations Act and the Canada Business Corporations Act contain provisions making directors liable for wages unpaid by a company. This liability has nothing to do with any concept of fault or negligence by the directors. It is a strict liability. The scope of the liability differs, however, from one Act to the other. © CANADIAN SECURITIES INSTITUTE 2 8 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 UNDER THE QUEBEC BUSINESS CORPORATIONS ACT Section 154 of the Quebec Business Corporations Act reads as follows: Directors of a corporation are solidarily liable to the employees of a corporation for all debts not exceeding six months’ wages payable to each such employee for services performed for the corporation while they are directors of the corporation respectively. CONDITIONS Either of two conditions must be met, however, for directors to be held liable: The company must have been sued within one year after the debt became due and the employee must have been unable to execute the judgment against the company. The company must have declared bankruptcy or been put into liquidation in the year following the date on which the wages became due and the employee must have filed a claim for the debt with the trustee or the liquidator. RULES Aside from these conditions, the following rules must be kept in mind: An employee is a person who works under the orders and the control of the company. Their duties must not give them the opportunity to analyze the company’s true position. Wages include all remuneration due to employees in return for their work, including commissions and the reimbursement of expenses, as well as vacation pay and fringe benefits. The gross amount, not the net amount, is considered for purposes of assessing the debt. Union dues and vacation pay may therefore be included. The six months’ wages mentioned in the Act do not refer to a given period of work but rather are used to place a limit on the amount of wages due. Directors may also be required to pay the interest on wages due, as well as the expenses incurred by employees to sue the company. The directors are jointly and severally liable in that each director may be sued for the entire debt. Directors remain liable even if they have resigned from their positions. The suit against the directors is totally separate from the suit against the company. Recourse against the directors may be collective. Similarly, in Quebec, the Commission des normes du travail (Labour Standards Board) may bring a suit against the directors, on behalf of employees in the year following the due date of the debt. A director facing a claim for wages due may nevertheless be exonerated of the liability that would otherwise fall to him if the court is of the opinion, considering all the circumstances, that this director acted reasonably and that he fought fairly to be excused. UNDER THE CANADA BUSINESS CORPORATIONS ACT Section 119 of the Canada Business Corporations Act, concerning directors’ liabilities to employees, is expressed differently from Section 154 of the Quebec Business Corporations Act. The main differences are as follows: If the corporation is not bankrupt, the suit must be undertaken within six months (rather than one year) after the wages have become due. Similarly, if the corporation has been dissolved, a claim must have been filed with the trustee within six months (rather than one year). © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 9 Directors are not liable for wages, but rather for debts related to services provided by employees for the company. Thus, directors may be held liable for certain debts that are not part of employees’ wages, strictly speaking. According to the interpretation by the courts, layoff notices and indemnities in lieu of notice are not covered by this definition. Directors may be held liable only if they are sued while in the position of director or within two years after they have ceased to be a director. Consequently, the suit must be brought within these time limits (rather than within three years of the day on which the debt originated). A director who pays a debt for which he is liable, that is proved in liquidation and dissolution or bankruptcy proceedings, is legally entitled to any preference to which the employee would have been entitled. For instance, he may be entitled to priority of payment under the Bankruptcy and Insolvency Act. TAX DEDUCTIONS Directors are being sued more and more often on the grounds that the company did not remit the tax deductions it had collected. This liability is defined in section 227.1 of the federal Income Tax Act and section 24.0.1 of the Tax Administration Act. RESPONSIBILITY Generally speaking, directors are responsible for all amounts that the company has failed to deduct, remit, withhold, or pay under a taxation act, such as source deductions, sales taxes, and contributions to health insurance plans. Unlike the liability for unpaid wages, this is not a strict liability in that directors have a means of defence under the law. A director will not be held liable if he exercised the degree of care, diligence and skill that a reasonably prudent person would have exercised in comparable circumstances, to ensure that the corporation had deducted, remitted, withheld, or paid the amounts due. POSSIBLE MEASURES Accordingly, directors may take the following measures: Establish controls to check that amounts have been withheld from employees’ wages and remittances made. Ask the corporation’s financial officers to regularly report on the implementation of the controls established. Regularly obtain confirmation that the amounts have been withheld and remittances made during all relevant periods. ADDITIONAL RESPONSIBILITIES Directors who see that a corporation is in financial difficulty have additional responsibilities. They must ensure that the bank with which the corporation deals will honour the cheques issued by the corporation. Unless they can obtain a binding commitment from the bank that it will honour the cheques, the directors must establish a separate trust account in which the gross amount of employees’ pay will be deposited, with the difference between gross and net pay to be remitted to the government on the date it is due. WITHHOLDING AND REMITTING AMOUNTS TO THE GOVERNMENT Directors must take specific steps to ensure that the amounts withheld are remitted to the government. Directors who delegate their responsibilities to employees may still be held liable. LIABILITY Finally, we should note that, despite the apparent similarities in the wording of the Acts, the Quebec legislation appears to be less stringent than the federal version. Directors’ conduct is analyzed according to their personal © CANADIAN SECURITIES INSTITUTE 2 10 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 characteristics and the circumstances in each situation. In contrast, the federal legislation compares the directors’ conduct with that of a reasonably prudent person. This subjective evaluation of a director’s actions might exonerate them, in the end. REDUCTION IN THE COMPANY’S CAPITAL A company may not declare or pay dividends, redeem its shares, or grant loans or advances to its shareholders if there are reasonable grounds to believe that it is insolvent, or if performing either of the above actions would make it unable to discharge its liabilities when due. If a dividend, stock redemption, loan, or advance is declared or authorized in violation of the above condition, the directors shall be jointly responsible for the amount involved. If appropriate, directors may obtain a court order requiring the shareholders to remit the amounts in question to them. FINANCIAL ASSISTANCE TO SHAREHOLDERS The Canada Business Corporations Act states that a company may not grant a loan, give security, or furnish any other form of financial assistance to a shareholder, a shareholder of its parent corporation, or a person to assist them in purchasing its shares if there are reasonable grounds to believe that, as a consequence, it could not discharge its liabilities when due, or if the book value of its assets would be less than the sum of its liabilities and its issued and paid-up share capital account. Directors who authorize such financial assistance are jointly and severally liable for the sums involved and not yet recovered. The Canada Business Corporations Act offers certain exceptions, however. For instance, a corporation may provide financial assistance for its parent company if the corporation is wholly owned by the parent company, as well as to a subsidiary body corporate of the corporation. This means than any corporation may give financial assistance to its subsidiary and to its parent company if the parent company holds 100% of the corporation’s shares. Such assistance can be provided at any time and without having to meet the solvency criteria provided by law. The Quebec Business Corporations Act contains no specific requirements concerning financial assistance to shareholders. DECLARING AND PAYING DIVIDENDS The Quebec Business Corporations Act provides that directors are liable if the company declares or pays a dividend when there are reasonable grounds for believing that it could not discharge its liabilities. The directors are jointly and severally liable for the sums or goods not yet recovered from the shareholders, who are required to return the dividends received. THE ENVIRONMENT Directors, and not shareholders, are liable for many different kinds of offences under federal and provincial environmental protection laws in the following circumstances: If they commit a prohibited act or allow people under their direction to commit such an act If they fail to take the necessary steps to prevent foreseeable environmental damage If they intentionally collude in an offence If they fail to ensure that the company complies with all administrative or court orders instructing it to halt polluting activities If they do not perform the duties imposed on them by law to take all reasonable steps to prevent the company from polluting © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 11 ANTI-POLLUTION PROVISIONS Most Canadian legislation contains general anti-pollution provisions prohibiting the environmental discharge of a contaminant above the regulatory quantity or concentration (or forbidding excessive discharge). It also prohibits the discharge of contaminants likely to be harmful to health or to cause other damage (or prohibit harmful discharges). In the event of a spill (i.e., an unforeseen discharge), a director (or the person in charge) must report it to the various authorities and immediately take all possible steps to restore the environment. DISCHARGE A director (or the person in charge) who causes or authorizes such a discharge, by giving express permission or failing to intervene, lays himself open to various sanctions intended to repair the harm or the damage caused. Sanctions may include confiscation of the profits generated by the polluting activities, payment of legal damages, fines, or criminal prosecution. A director (or the person in charge) may also be obliged to comply with any administrative order issued by the Quebec Department of the Environment to repair the damage or harm caused, to take preventive action or to implement control mechanisms so as to limit polluting activities. It matters little whether the value of the company’s assets is sufficient to assume these costs, since the director (or the person in charge) is personally liable. And it is also of little importance whether or not the environmental damage was caused intentionally; it is sufficient that the activities were under the director’s control and the assets in his or her keeping. IN CASE OF DISSOLUTION In principle, it is the shareholders who are liable for the debts of the corporation on its dissolution, not the directors. The decision to dissolve a corporation and liquidate its assets requires the consent of the shareholders. The shareholders are only liable to the corporation’s creditors to the extent of the amounts they receive in the division of the corporation’s assets. TAX DEBTS Tax laws contain provisions making directors responsible for tax debts if the company’s assets are liquidated. For instance, people responsible for administering the property of another person must notify Revenu Québec before proceeding with the distribution of that person’s property, and obtain a certificate stating that there are no outstanding tax debts. Anyone who proceeds with distribution without obtaining the proper certificate may be made responsible for the other person’s tax debts. This liability extends to the value of the assets distributed. It is therefore important for the director of a corporation to inform Revenu Québec before proceeding with the distribution of the corporation’s assets and to obtain the proper certificate. LIQUIDATION OF ASSETS Because liquidating a company’s assets and using the proceeds of the sale to pay creditors represents a distribution of assets, directors may be liable. Directors, because of their status and the fact that they took part in or agreed or acquiesced to the liquidation and distribution of the company’s assets, may be held liable because they are people who have control over the company’s assets. INSOLVENT CORPORATION The liquidation of an insolvent corporation’s assets and the division of the sums available among the creditors must generally comply with bankruptcy and insolvency legislation. These laws contain provisions to hold the directors liable if decisions were made or transactions carried out to the detriment of the creditors. Conversely, the bankruptcy and insolvency laws include protection mechanisms that allow directors to take part in the recovery of an insolvent business. The rules that apply in insolvency situations are examined in the chapter on bankruptcy and financial reorganization. © CANADIAN SECURITIES INSTITUTE 2 12 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 MEANS OF DEFENCE The law clearly imposes a heavy burden on directors. The wide range of the duties and responsibilities incumbent on them under the many different federal and provincial Acts is particularly evident in Quebec, given the general principles contained in the Civil Code of Quebec, among other legislation. GENERAL PRINCIPLES The basic rule concerning directors’ liabilities is set down in Article 337 of the Civil Code of Quebec: Every director is, with the other directors, liable for the decisions taken by the board of directors unless he requested that his dissent be recorded in the minutes of proceedings or the equivalent. However, a director who was absent from a meeting of the board is presumed not to have approved the decisions taken at that meeting. Directors, then, are automatically liable. It is not necessary for them to have committed a breach of duty or to have been negligent in order to be liable for decisions made by the board of directors. In theory, directors cannot invoke their good faith or their ignorance of the facts to excuse themselves. The rule in the Civil Code of Quebec is a general provision in that it applies only where it is not contradicted by any other specific legislation. However, both the Canada Business Corporations Act and the Quebec Business Corporations Act have specific rules on this matter. THE DIRECTOR DID NOT ATTEND THE MEETING A director absent from a meeting is deemed to have consented to any illegal resolution or measure adopted, unless they have recorded their dissent. They have seven days to do so, following the date on which they learned of the decision with which they disagree. The best means of proceeding under such circumstances is to send the corporation a written notice of that dissent by registered mail. THE DIRECTOR ATTENDED THE MEETING A director who attended a meeting of the board of directors is presumed to have consented to all the decisions made there. Merely abstaining from voting is not enough to escape liability. Directors must ensure that their dissent is expressly recorded in the minutes of the meeting. It is prudent for the director to send the company written notice of dissent immediately after the meeting. If a director who attended the board meeting fails to record his or her dissent, two other means of defence are available. They may remove the presumption of liability by showing that they relied on the opinion of an expert such as an accountant, legal counsel, engineer, or professional evaluator. The existence of a unanimous shareholder agreement providing that some decisions normally made by directors are instead the responsibility of shareholders may also be cited in the director’s defence. For instance, directors cannot be held responsible for the payment of dividends that have rendered the company insolvent if, under such an agreement, it is the shareholders’ responsibility to declare and issue dividends. PROTECTIVE MEASURES In the end, the only way for directors to escape liability is to show that they acted competently and diligently in performing their duties. This means that directors must take the actions described below. ACT IN GOOD FAITH AND FOR THE EXCLUSIVE GOOD OF THE COMPANY Obviously, directors must avoid conflicts of interest, act independently, and put the company’s interests ahead of their own. This does not mean that they cannot have dealings with the company, but they must not take part © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 13 in discussions on the board of directors or vote on any item that places them in a conflict of interest situation. The prudent course of action, even if they are not obliged to do so, is to withdraw and make sure that their non- participation is recorded in the minutes of the meeting. PLAY AN ACTIVE ROLE Too often, directors follow the company’s business from a distance. They should show some initiative, without interfering in the daily operations of the business. They must be well informed of the company’s business even before agreeing to sit on the board. BE SKEPTICAL At regular intervals, directors must look into the effectiveness of the systems in place. They must demand conclusive information to this effect in the form of notices, opinions, statements, and reports. They must always keep in mind the importance of compliance with contracts, the company’s ability to meet its obligations, the honesty of representations to third parties, and the care of other people’s funds entrusted to the company. Furthermore, they must not hesitate to pursue their investigation if they have any doubts in this respect. KEEP RECORDS Directors is well advised to keep records of everything they have done to ensure that the company respects its commitments, so they can prove that they have performed his duties, if necessary. ENSURE THAT HE IS COVERED IN THE EVENT OF PROSECUTION Directors should make sure that the company is bound by its by-laws to reimburse them for any financial consequences of legal proceedings arising from the exercise of their duties. The company should preferably take out liability insurance for its directors and officers. OBTAIN PROFESSIONAL ADVICE The prudent director must seek the advice of an expert when the circumstances exceed his or her field of expertise. In the case of a liability claim, the director may invoke the consultation of reports prepared by competent professionals as a means of exoneration. The Quebec Business Corporations Act explicitly encourages directors to rely on the advice of professionals. A director is assumed to have met the obligation to behave prudently and diligently if he or she relies on a report from or the opinion of an expert. LIABILITY INSURANCE The purpose of liability insurance is to protect company directors, alone or jointly with the company, but not the company itself, in the event of legal proceedings. Such insurance is also intended to reimburse the company if it is bound or entitled, by law or under an agreement or by-law, to indemnify its directors for costs and expenses incurred as a result of such proceedings. INSURANCE FOR DEFENCE COSTS Liability insurance for directors may take either of two forms: Insurance for legal costs Indemnity insurance The former is preferable, since the insurer will apply the amount of insurance to the damages to indemnify third parties and will also pay legal costs and interest on the amount of the guarantee. © CANADIAN SECURITIES INSTITUTE 2 14 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 INDEMNITY INSURANCE The latter works in the same way as insurance on goods or property in that the director is required to pay the damages and costs, and the insurer will reimburse the director up to the amount of insurance. If the premiums for the two types of insurance are the same, the choice is clear: insurance for legal costs is better than indemnity insurance. INSURANCE COVERAGE The insurance may cover so-called reprehensible acts by the director or an officer (i.e., a breach of duty, error, or omission )in the performance of their duties. The insurance may also cover any obligation as a director, such as legal claims for unpaid wages. This amounts to a form of no-fault liability insurance. If the company cannot pay its wages because of insolvency, the directors are required to do so on its behalf. They are not in the wrong, but merely liable, and cannot escape this liability. The larger the guarantee the better. In addition to legal costs arising from proceedings, the insurance coverage may be extended to pay damages if the director is convicted, fees incurred to defend directors against criminal charges because of actions in the performance of their duties, or even legal expenses should they have to testify before administrative tribunals or commissions of inquiry. RECOMMENDATION It is normally recommended that small businesses have insurance equivalent to 25% of shareholders’ equity; for large companies, the maximum insurance coverage may vary, depending on their needs and the type of business. DUTIES AND RESPONSIBILITIES OF OTHER SENIOR OFFICERS It is not only the directors of a company who may be held liable for its actions, but its senior officers and other specified company individuals as well. Article 316 of the Civil Code of Quebec stipulates that senior officers may be held liable for any damage suffered by the company, as follows: In case of fraud with regard to the legal person, the court may, on the application of an interested person, hold the founders, directors, other senior officers or members of the legal person who have participated in the alleged act or derived personal profit therefrom liable, to the extent it indicates, for any damage suffered by the legal person. If they took part in the alleged act or profited from it personally, the other senior officers, along with the directors, are presumed to be liable. PERSONAL LIABILITY Senior officers may also become personally liable if they blindly rely on subordinates without supervising them and if these subordinates are negligent or incompetent. What actually constitutes a “reasonable” degree of supervision depends on many factors, including the officer’s duties, the size of the company, and the extent of the tasks delegated. Some laws provide that the officers of a company are directly liable for offences committed by the company. For example, an officer may become liable if the corporation employs people in contravention of immigration laws or commits an offence under occupational health and safety legislation. A director, the chief executive officer, an employee or agent of the company who participated in the offence may be charged. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 15 ENVIRONMENT Moreover, senior officers, just like directors, must be aware that they are increasingly likely to be held responsible, because of their acts or omissions, for the environmental repercussions of the company’s activities. The provisions of environmental protection legislation cast a fairly wide net. Under the Quebec Act, for instance, an officer or director of a corporation who, by means of an order or authorization or through their advice or encouragement, leads the corporation to refuse or neglect to comply with an order, or to emit, deposit, release, or discharge a contaminant into the environment in contravention of the Act or its regulations, thereby commits an offence and is personally liable. LOYALTY An officer, as an employee, is also required to show loyalty to the company. Essentially, officers must at all times act faithfully and honesty and in such a way that their actions do not harm the employer’s interests. They must not place themselves in a conflict of interest position with their employer. Unfair competition or untrustworthy behaviour represents an obvious failure in fulfilling the obligation of loyalty and the employment contract itself. As employees, officers are governed by the provisions of the Civil Code of Quebec relating to the employment contract. Consequently, they are required to carry out the work for which they were hired and must act in good faith at all times. The Civil Code of Quebec specifically provides that employees are bound to carry on their work with prudence and diligence. The requirement to perform the work is evaluated from various angles, which are very often intangible. One angle relates to an officer’s behaviour: attitude, conduct, respect for orders, and ability to avoid personality conflicts. A second aspect is physical in nature. Officers must report for work regularly and punctually. In addition, they must be in good physical and mental health so as to be able to perform their work properly. A third qualitative and sometimes quantitative dimension requires that officers carry out their duties competently. Some aspects of an officer’s obligation to act faithfully continue even for a certain period after termination of employment. What constitutes acceptable behaviour is a question that has been argued for years. Officers who leave a company quite often manage to convince certain key employees and some customers to follow them. This phenomenon obliges employers and officers to pay greater attention to their rights and obligations after the termination of work. It may mean that, for a certain time after leaving the company, officers may not use confidential information, make false representations concerning their ex-employer, directly solicit the ex-employer’s customers, encourage other employees to join them, or otherwise fail to meet their obligations. USE OF CONFIDENTIAL INFORMATION Article 2088 of the Civil Code of Quebec stipulates that an employee’s obligations to act faithfully and honestly “continue for a reasonable time after cessation of the contract, and permanently where the information concerns the reputation and private life of another person.” DISLOYAL CONDUCT Officers who failed to observe the confidentiality of the company’s information during their employment would certainly be guilty of disloyal conduct. After cessation of the contract of employment, the restriction on the use of such confidential information is generally linked to unfair competition. THE SPRINGBOARD EFFECT The intent of the law is to protect companies against what is known as the “springboard effect.” In other words, ex-employees must not be able to use confidential information belonging to the employer as a springboard to begin competing with their former employer. The springboard theory does not apply when the confidential information is not used as an advantage to give an ex-employee an edge in competing with their former employer. For instance, there is nothing stopping an ex-employee from using the knowledge acquired while working for the company in later competing with the company, provided that this knowledge was not derived from confidential information. © CANADIAN SECURITIES INSTITUTE 2 16 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 NON-COMPETITION CLAUSES A non-competition clause is a restrictive clause whereby the employer limits the officer’s right to compete with the company after the cessation of the employment contract. Employers frequently insist on such arrangements in cases where an officer’s departure and subsequent hiring by a competitor could make the company vulnerable, in view of the employee’s knowledge of its business or customers. LIMITS Under article 2089 of the Civil Code of Quebec, it is up to the employer to prove that the stipulation is valid. The Code expressly provides that the clause “shall be limited [...] as to time, place and type of employment, to whatever is necessary for the protection of the legitimate interests of the employer.” So the question arises: what interests must the employer protect, and what threats must it reasonably defend itself against to safeguard its interests? DURATION Although each case must be judged on its merits, the courts have generally been prepared to find that a non- competition clause of under two years is reasonable, except in exceptional circumstances. TERRITORY The territory covered by the clause must also be clearly defined. It must not be larger than is required to protect the employer’s legitimate interests; otherwise the clause will be considered invalid. For a local company, then, the restricted territory should be fairly small. NATURE OF PROHIBITED ACTIVITIES The third dimension to be examined in determining the reasonability of a non-competition clause is the nature of the prohibited activities. The restriction must not extend beyond what is required to ensure effective protection for the employer, without prejudicing the employee. For example, a research firm would be best to limit the scope of the clause to a researcher’s specific field, rather than extending it to all of the company’s interests. Needless to say, if the employee’s experience, knowledge, or skills were acquired before he or she joined the employer, this will have a decisive effect on the nature of activities that can be prohibited under a non-competition clause. When the employee’s activities have no special or unique character, and when the competition continues regardless of whether the ex-employee performs their activities for a competing company, then a non-competition clause will be difficult to justify. VALIDITY The courts normally hesitate to recognize the validity of non-competition clauses drafted to restrict access to potential, as opposed to existing, customers. Finally, an employer who has terminated a contract without a serious motive or without giving the employee a serious motive for terminating the contract cannot enforce a non-competition clause. NON-SOLICITATION CLAUSES A non-solicitation clause is intended to prevent a person from soliciting the clients, suppliers, or employees of their former employer. In determining the validity of a non-solicitation clause, the courts look at the duration of the clause and the nature of the activities prohibited as they apply to the protection of the employer’s legitimate interests. They tend to interpret such clauses less strictly because the protection sought by the employer is more limited than with that under a non-competition clause. These clauses cover only active solicitation, however. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2 | DIRECTORS’ AND OFFICERS’ RESPONSIBILITIES 2 17 Ex-employees violate the clause only if they take specific positive action to incite a person (client or employee) to act in a certain way. DURATION Non-solicitation clauses covering a period of one year or less from termination of employment have almost always been recognized as valid by Quebec courts. As is the case for non-competition clauses, the validity of a non- solicitation clause of longer than 12 months will depend on the nature of the employee’s job and their link with the company or the company’s clientele. TERRITORY On many occasions, the courts have found that the geographical dimensions of a non-solicitation clause need not be limited, given that the territory is implicitly defined as the location of the company’s clientele. DISTINCTIONS The courts have occasionally made a distinction between soliciting the clients of a former employer and accepting work from those clients. Accordingly, employers tend to draft such clauses to as to prohibit ex-employees not only from soliciting the former employers’ clients, but also from accepting work from these clients. TAKING FACTS AND CIRCUMSTANCES INTO ACCOUNT In short, to be valid, restrictive clauses such as non-competition and non-solicitation clauses must be limited, where the period of time, location, and type of work are concerned and to what is necessary to protect the employer’s legitimate interests. There is no magic formula for determining whether a restrictive clause is valid or not; each case must be judged on its own merits. The terms of the contract between the employee and employer, the nature of the job, the employee’s status, the type of company, the extent of competition in the company’s industry, and the nature of the company’s clientele are all factors that must be considered when analyzing the reasonableness of restrictions imposed on an employee. Finally, it is important to remember that, even if there is no restrictive clause, employees are bound to continue acting with loyalty toward the ex-employer for a reasonable period following termination of employment. © CANADIAN SECURITIES INSTITUTE  Business Income and Expenses for Tax Purposes 3 LEARNING OBJECTIVES After completing this chapter, you will be able to: 1 | Distinguish between business income, property income, and capital gains, given the different tax treatment for each. 2 | Identify the rules for determining the fiscal period of self-employed individuals. 3 | Identify the tax rules used in accounting for gross business income and the cost of goods sold. 4 | Discuss the specific rules applying to eligible expenses, in particular the restrictions on the use of automobiles, home office expenses, expenses incurred for personal purposes, and wages paid to a spouse or child. 5 | Explain the tax treatment of depreciable property. 6 | Explain the rules relating to the capital gains reserve. 7 | Explain the application of Quebec sales tax and the goods and services tax. CONTENT AREAS Business Income, Property Income, and Capital Gains Taxation Year Calculating Gross Profit Allowable Expenses for Tax Purposes Capital Cost Allowance Quebec Sales Tax and Goods & Services Tax © CANADIAN SECURITIES INSTITUTE  CHAPTER 3 | BUSINESS INCOME AND EXPENSES FOR TAX PURPOSES 3 3 INTRODUCTION Specific tax rules come into play in calculating a company’s net income. The same rules apply, regardless of the legal form of the company: a sole proprietorship, partnership, or corporation. The number of self-employed individuals is rising steadily, however, and for different reasons these individuals may carry on their trade or their profession through one or many service contracts. Financial planners must have detailed knowledge of the rules relating to the calculation of the net taxable income from a business or professional practice. Sole proprietorships and partnerships need not file tax returns. Corporations, on the other hand, must file their tax returns. Individuals operating sole proprietorships must attach the Income and Expenses Relating to a Business or Profession form (TP-80) with their provincial tax return. The information required on the form TP-80 is similar to business income information that would be reported on the Statement of Business and Professional Activities on the federal tax return). Members of a partnership are not obliged to complete this form; the financial statements of the partnership suffice. BUSINESS INCOME, PROPERTY INCOME, AND CAPITAL GAINS It is important to distinguish between income from a business, income from property, and capital gains because the rules governing taxation and tax benefits such as eligible expenses, deductions, and exemptions, differ in each case. DEFINITION OF A BUSINESS A business is an activity carried on to make a profit or in the reasonable expectation of making a profit. It may take any of the following forms: The practice of a profession The practice of a trade The operation of a store The operation of a manufacturing or service business Commission sales, for self-employed individuals The disposition of goods created or acquired for the sole purpose of making a profit from their sale or resale The provision of childcare services The operation of an undertaking of any other kind Transactions involving some risk and conducted for the sole purpose of making a profit BUSINESS INCOME To earn business income, one must generally invest time, care, and financial and human resources. Business income does not include income from an office or employment. PROPERTY INCOME To earn property income, it is not generally necessary to invest much time or attention because it is the return on capital invested that constitutes the income. Property income is generally passive in nature. © CANADIAN SECURITIES INSTITUTE 3 4 FINANCIAL PLANNING FOR BUSINESSES – QUEBEC | SECTION 1 The most common types of property income are: Interest Dividends Royalties Rental income This is usually revenue generated because one party is using another person’s property. This is intuitive with rental income, but it is also the fundamental attribute underlying the income, as follows: Interest income – a bond issuer pays the bondholder for the use of their capital. Dividend income – discretionary or obligatory amount paid to shareholders (as a payback for use of their capital). Royalty income – royalties are paid for the use of one’s intellectual or artistic property. Note that property income does not include gains or losses from the disposition of property, which are referred to as capital gains or losses. CAPITAL GAINS A capital gain or loss is calculated as the proceeds of disposition of a capital property minus the sum of the adjusted cost base of the capital property and the expenses incurred in its disposition. This type of income is entirely different from that resulting from taxpayers’ ordinary activities. Only 50% of the capital gain is included in one’s net income for tax purposes. CALCULATION OF BUSINESS INCOME/(LOSS) Net business income/(loss) is calculated following generally accepted accounting principles. However, there are many instances in which net income for accounting purposes must be adjusted. Under tax law, there are slightly different rules for revenue recognition and many expenses that are denied or limited for tax purposes. This gives rise to a difference between the net earnings shown in the company’s income statement and the net income for income tax purposes. Financial planners must understand the differences between these accounting principles and tax rules. Table 3.1 | Calculating Net Income for Tax Purposes Some expenses deducted on the corporation’s income statement are not allowable for income tax purposes. Also, certain revenue items included in income may not be taxable. Non-allowable Expenses Some expenses applied in calculating the corporation’s net (book) earnings are not deductible for income tax purposes. The following are some of the amounts that generally must be added back to the net income for accounting purposes to determine net income for tax purposes: Income tax payable Deferred income tax Interest and penalties on income taxes Book losses on disposal of fixed assets Political donations Taxable capital gains Book depreciation © CANADIAN SECURITIES INSTITUTE  CHAPTER 3 | BUSINESS INCOME AND EXPENSES FOR TAX PURPOSES 3 5 Table 3.1 | Calculating Net Income for Tax Purposes Accounting reserves not deductible in the current year Tax provisions deducted in the preceding year Charitable donations Donations of cultural or eco-sensitive property Restricted farm losses Limited partnership losses Non-deductible amounts related to non-arm’s-length transactions Prior-year investment tax credits on current scientific research and experimental development (SR&ED) expenditures SR&ED expenditures from the current year that were deducted on financial statements The non-deductible (50%) portion of food, beverage, and entertainment expenses Membership dues for social or sporting clubs The non-deductible portion of interest charges on a loan relating to the acquisition of an automobile The non-deductible portion of leasing expenses for an automobile The non-deductible portion of financing charges relating to a property Allowable Deductions Some income amounts included in calculating net earnings for accounting purposes may not be taxable. Similarly, some deductions may not be allowable or may differ from the amount shown in the income statement. These are a few of the amounts that must be subtracted from net income to determine net income for tax purposes: Gains on disposal of assets Non-taxable dividends from the capital dividend account Capital cost allowance Cumulative eligible capital deduction Allowable business investment losses Expenses incurred for which a reserve was established Tax reserves deducted in the current year Deduction claimed for SR&ED expenditures for the year SR&ED investment tax credit per financial statements Foreign income tax Credits not taxable in Quebec Source: T2 Guide – Corporation Income Tax. TAXATION YEAR The taxation year for a company is the same as