The following article appeared in the latest edition of the Hamilton Law Association Law Journal.
Lawyers accustomed to implementing estate freezes are familiar with the very particular “suggestions” they will receive from accountants about the characteristics of the shares to be used to effect the freeze. The purpose of a freeze, of course, is to permit an existing shareholder to exchange an asset with growth potential—Common Shares of Opco, let’s say—for another asset whose value will not increase even if the value of the issued shares of Opco as a whole do. Mr. Pappas, to effect an estate freeze, might exchange his Common Shares in the capital of Opco for Special Shares with a value that is fixed at an amount equal to the value the Common Shares. Opco will issue new Common Shares to the individuals whom Mr. Pappas wishes to benefit by implementing the freeze so that any future growth will accrue to them.
The trick is to ensure that Mr. Pappas’ Special Shares will have a value equal to the value of the old Common Shares and that that value will not increase in the future. If the value of the Special Shares is less than the value of the old Common Shares, then that value might inhere in the new Common Shares, in which case Mr. Pappas will have conferred a benefit on the new Common Shareholders, which is a Bad Thing from a tax perspective. On the other hand, if Mr. Pappas’ Special Shares can increase in value or if that value can exceed the redemption amount of the Special Shares, then the freeze will have been thwarted. Growth in the value of Opco’s shares will continue to accrue in the hands of Mr. Pappas, although he doesn’t need the growth, and his tax bill on death will increase.
How, then, to ensure that the Special Shares keep the desired value? The Canada Revenue Agency (the “CRA”) requires that freeze shares be
- redeemable at the option of the issuer for a fixed amount
- redeemable at the option of the holder (‘retractable’) for a fixed amount
- entitled to dividends at a ‘reasonable’ rate
- entitled to a preference on liquidation
- freely transferable
- protected by a non-impairment clause, which ensures that shares cannot be redeemed or dividends paid that would prevent the issuer redeeming the freeze shares
Historically, the CRA has pretended indifference about whether freeze shares need have voting rights. Before addressing voting rights, however, let us consider the issue of the dividend rights that attach to freeze shares.
Freeze shares, if they are retractable (which they should be), need not be entitled to cumulative dividends. The holder of a fixed-value share that is not retractable would (or should) insist on cumulative dividends to compensate the holder for money that is tied up in the issuer’s capital. Put another way, a share would not have a value equal to its redemption amount if cumulative dividends weren’t payable. On the other hand, given that a freeze shareholder, in theory, can retract the shares and demand their value at any time, cumulative dividends should not be necessary.
The CRA has also stated that the dividend rate of a freeze share should be reasonable. Sometimes we receive instructions for incorporation that include a request to create shares with a fixed redemption amount and a right to receive unlimited dividends. Although it is possible to create a class of shares with such rights, we generally advise against it if they are to be used in a freeze. We are concerned that the fair market value of such a share will not be equal to its redemption amount, especially if the share will be held by a controlling shareholder.
In many estate freezes, the likes of Mr. Pappas will insist on retaining voting control of Opco. Mr. Pappas might wish to benefit the new Common Shareholders, but he is probably not ready to turn over control of Opco to them, especially if his comfortable retirement depends in part on protecting the value of his freeze shares (Mr. Pappas’ Special Shares). What is the position, then, if Mr. Pappas’ Special Shares are entitled to unlimited dividends, and he controls Opco?
In Winram v. M.N.R.,  D.T.C. 6187 (F.C.T.D.), Gibson J. considered the liability of an estate for estate tax where the deceased died owning nine of the 1,000 issued shares of a corporation. The issued capital of the corporation consisted of 990 Class B shares, which were participating and non-voting and 10 Class A shares, which were participating and voting. The deceased held nine of the latter shares at his death; his wife held the remaining issued shares. It appears the estate took the position that the nine Class A shares were worth only 9/1000 of the entire value of the corporation. The Minister assessed on the basis that the value of the nine Class A shares was much greater than that. The Minister contended that, because the husband could control the issuer, he could divert dividends to himself and, in effect, take all of the value of the corporation for his own benefit. As a result, the Minister argued, the value of his shares was significantly higher than the value ascribed to them by the estate.
The trial judge found in favour of the Minister. First, the judge noted the following about the governance of the corporation:
Until the date of death of the deceased and at all material times prior thereto also, the Articles of Association of the company provided at Article 3 that no share might be transferred except with the consent of the Board of Directors “who (might) . . . in their absolute discretion refuse to register the transfer of any share”; at Article 6 that the holders of non-voting shares did not have the right to vote; at Article 17 as amended that in the case of an equality vote that the Chairman had a second or casting vote; at Article 18 that “a Director interested in any contract or arrangement under consideration may be counted to make up the quorum although he shall not vote thereon”; and at Article 20 that dividends might be declared by ordinary resolution and that “dividends so declared may be equal for each class of share or not equal and dividends may be declared on one class of share without dividends being declared on another class of share”.
The judge’s decision is neatly summarized in the headnote of the case:
The wife of the deceased could not, by wilfully refusing to attend a properly called directors’ meeting, prevent the deceased from transferring the nine class A shares of which he was the owner, or from declaring dividends whereby the company would pay out 9/10 of the surplus to himself. Even if she did attend such a meeting, the deceased, because of his casting vote, could take these steps. Such action would not have been an abuse of his power in respect of the class B shareholders as they did not have an inalienable right to any part of the dividends declared, nor would it have been a breach of the deceased’s fiduciary duty as a director for he would have also been acting in his capacity as a shareholder and would therefore be free of any constructive trust. Also, any dividends declared on class A voting shares at a properly called directors’ meeting would not have been an abuse by the majority of the class A holders over the rights of the minority of class A holders.
Winram dealt with two classes of shares, both of which were fully participating. Perhaps the court would have arrived at a different conclusion if the deceased’s shares had been redeemable and retractable for a fixed amount. Moreover, the decision has been distinguished in another case involving similar circumstances (see Shepp v. The Queen,  D.T.C. 510 (T.C.C.)). Finally, one wonders whether a similar result would obtain today in respect of shares of an issuer governed by the Ontario Business Corporations Act, with its oppression remedy.
But why wonder about the status of Winram, especially given that, according to one tax commentator, some CRA valuators still believe that shares without voting control, where another class of shares with control have a right to unlimited dividends, should be considered to have nominal value? It would seem prudent simply to ensure that the freeze shares have a dividend cap. If the freezor wishes to continue to share in the value of the corporation going forward, it would be better to implement an estate “gel” or leave the freezor with some portion of the Common Shares.
Historically, the CRA has accepted that freeze shares need not have voting rights except to the extent necessary to protect the value of the shares. But, as already discussed above, the owner who implements a freeze will often wish to retain control of the issuer to protect the owner’s investment. In fact, it is not uncommon for the freezor to retain voting control through the use of “thin-voting shares”. Thin-voting shares are shares that do not participate significantly in the earnings or assets of a corporation but that confer voting rights on the holder.
If the freezor retains voting control, however, what of the dreaded “control premium”, the extra amount that a third party might pay to obtain control of a corporation? The CRA, at the 2007 Canadian Tax Foundation National Tax Conference, when asked about thin-voting shares, responded that “It is the opinion of the CRA that a hypothetical purchaser would be willing to pay some amount for the voting control of a company.” That is, it would seem that the CRA might consider taking the position that thin-voting shares, although they purport to be worth, say, only $100 in total because they are redeemable and retractable for that amount, should be valued for some (unspecified) higher amount because of their voting rights. The use of thin-voting shares could undermine an estate freeze, in other words.
The statement ought to apply to more than just thin-voting shares. The underlying principle would seem to be equally applicable to any kind of voting control. Why pick on thin-voting shares only? What if Mr. Pappas took back only Special Shares with substantial value, but they also have voting rights that give him control of Opco? Will his Special Shares be worth more than their redemption amount? And what about de facto control? Mr. Pappas’ Special Shares might not have votes, but his retraction of the shares, soon after the completion of the freeze, might render Opco insolvent, which would likely give Mr. Pappas de facto of the corporation. Does that make the Special Shares worth more than their redemption amount?
Frankly, this is deep water for a tax lawyer without any valuation training, and it is difficult to provide advice in this context. The tax lawyer might be permitted to ask some policy questions of the CRA, however, viz. just what does it think it is doing? The estate freeze is a staple of tax planning for the owner-managed business. Why make the matter more complicated and fraught than it already is, especially given that the very concept of a freeze is a dodgy one from a valuation perspective anyway? After all, it seems likely that a hypothetical purchaser would be willing to pay some amount—more than a nominal amount—for Common Shares issued in connection with a freeze. In a freeze, the Common Shares are acquired for a nominal amount, but they give one the opportunity to share in the growth of some very valuable assets. Who wouldn’t pay something for that bet, something more than the nominal amount for which the shares are issued? Why ignore that fact and then pick on thin voting shares?
In estate freezes, getting the share provisions—the dividend entitlements and the voting rights, among others—getting the provisions right counts for a lot, and so the lawyer needs to work carefully with the accountant on this task, even where the CRA’s guidance on the subject has been less than helpful.
 The dividend rate of a share is usually expressed as a percentage of the redemption amount of the share. The rate should not be expressed as a percentage of the capital, paid-up capital or stated capital of the share because all of these amounts might differ from the fair market value of the consideration for which the share is issued. A reasonable rate applied to a nominal stated capital amount will not satisfy the CRA’s requirements if the share was issued for a higher amount.
 David Louis, CCH Tax Topics, October 16, 2008.
 For this reason some lawyers prefer to insert a clause that requires the issuer of freeze shares to obtain the consent of their holder before implementing any reorganization of capital that might adversely affect the value of the shares. Query whether such a clause is necessary in light of section 170 of the OBCA (for example).