Debt vs. Equity: How to Properly Document Shareholder Loans and Capital Contributions in BC
Shareholders are often the first source of funds when small corporations need financing. But before money changes hands, it’s important to determine whether the contribution will be treated as a loan or as equity. This distinction affects repayment rights, tax treatment and often the outcome of future disputes. Many problems in closely held companies arise because this decision was never made at the outset – or, most commonly, was made and never documented.
When to Use a Loan vs. Equity
A shareholder loan is preferable when the shareholder expects repayment and wants to avoid changing the company’s ownership structure. Such loans are often used for short-term capital needs and/or keeping ownership percentages intact. A capital contribution, by contrast, is most often used when the shareholder intends to permanently increase their investment, strengthen the corporation’s financial position, or adjust voting power.
Documenting a Shareholder Loan
If the contribution is intended to be a loan, proper documentation begins with a directors’ resolution approving the corporation’s authority to borrow from the shareholder and enter into a loan agreement or issue a promissory note. The core loan document should specify the principal amount, interest (or explicitly state that none is charged), repayment terms and terms of default, maturity dates or demand provisions, and whether the loan is subordinated to other creditors. It should also address security; while many shareholder loans are unsecured in BC, a shareholder can take security through a general security agreement or specific collateral. Once executed, the loan should be documented in the company’s records, and future repayments should be tracked consistently.
Documenting an Equity Contribution
In contrast, equity injections require a directors’ resolution authorizing the issuance of shares, and the shareholder will enter into a subscription agreement or share purchase agreement specifying the number and class of shares, the price paid, and any rights or restrictions attached. After the funds are received, the corporation should update its central securities register and issue a share certificate (provided it uses certificate-based ownership).
Best Practice: Decide and Document
Improperly documented contributions can create significant problems. Courts and tax authorities may disregard what the documents call the contribution and instead look at the surrounding circumstances: Was there a repayment schedule? Were interest payments made? If the answers are unclear, a loan may be recharacterized as equity or vice versa.
For anyone planning to put money into a BC corporation, the safest approach is to decide at the outset whether the funds are meant to be a loan or equity and formally document the transaction. A well-drafted agreement and clear records can prevent years of avoidable conflict.
This information is general in nature only. You should consult a lawyer before acting on any of this information. This information should not be considered as legal advice. To learn more about your legal needs, please contact our office at (250)-448-2637 or by email to info@touchstone.law