Preferred Shares in a Private Corporation

Preferred shares trade growth for priority. They are paid before the common shares in whatever respect their terms say, and in exchange many are capped at a fixed value.

Ontario's Business Corporations Act (OBCA) does not define a preferred share. The label is a market term, and the text of the articles is what counts. Under section 22, a corporation with more than one class of shares must set out the rights, privileges, restrictions and conditions of each class in its articles of incorporation or later amendments. At least one class must carry the right to vote and at least one the right to the remaining property on dissolution, though not necessarily the same class. Every share of a class must be the same as every other share of that class, unless the class is issued in series.

Two corporations' Class A Preferred Shares can have almost nothing in common, so read the share conditions, not the name. Our guide to share structure for a new Ontario corporation explains how to design the classes at incorporation; this entry covers what the preferences themselves do.

• Dividend preference. A right to a dividend at a fixed rate or amount before any dividend on junior shares. A cumulative dividend that is not paid keeps accruing and must be caught up before junior shares receive dividends; a non-cumulative dividend not declared for a period is lost. Either way the directors must declare it, and section 38 of the OBCA bars a dividend if there are reasonable grounds to believe the corporation would fail the liquidity or balance-sheet test.
• Liquidation preference. A priority to a fixed amount, often the redemption price or a multiple of the issue price, on a dissolution or winding-up and often on a sale of the company. Our entry on liquidation preference explains the waterfall.
• Redemption and retraction. A redeemable share can be bought back at the corporation's option; a retractable share at the holder's. The OBCA's definition of a redeemable share covers both. The price cannot exceed the redemption price stated in the articles or calculated by a formula in them, and section 32 bars payment if the corporation would fail its solvency tests. See redeemable vs. retractable shares for the mechanics.
• Conversion. A right to convert into common shares, standard for venture investors and rare for freeze shares.
• Voting. Under section 102 each share has one vote unless the articles say otherwise, so a non-voting class must be drafted that way. Even non-voting shares vote separately as a class under section 170 on amendments to the articles that affect them, such as removing a redemption right or reducing a dividend or liquidation preference.

A class can also be issued in series under section 25, but no series may have priority for dividends or return of capital over another series of the same class.

Many preferred shares in Ontario private corporations are built for one of two jobs:

Freeze shares. In an estate freeze, the owner exchanges common shares for preferred shares worth the company's current value, normally on a tax-deferred basis under section 86 or section 85 of the Income Tax Act, and new common shares take the future growth. The value stays fixed only because the share conditions lock it in: freeze shares are redeemable and retractable at the freeze value and usually carry a price adjustment clause.

Investor preferred shares. In a priced round, investors buy a new class of convertible preferred shares on terms negotiated in a venture capital term sheet, often based on the CVCA model documents. Canadian articles usually call them Class A or Class B Preferred rather than Series A because of the series rule described above.

Other uses. Preferred shares can give a holding company or family member a fixed entitlement without growth, or fund a staged buyout of a retiring owner through redemptions over time. Dividends to family members can attract tax on split income, so get tax advice before issuing shares.

Dividends on preferred shares paid to an individual are taxed as dividends, eligible or non-eligible depending on the corporation's income and its designation. They are not deductible to the corporation.

When a corporation redeems or retracts its own shares, subsection 84(3) of the Income Tax Act treats the amount paid above the shares' paid-up capital as a deemed dividend, not a capital gain. Freeze shares usually have little paid-up capital, so most of each redemption payment is taxed as a dividend; shares an investor bought for cash usually have paid-up capital close to the price paid, so redeeming them at that price mostly returns capital. A sale of preferred shares to an arm's length buyer generally produces a capital gain or loss instead.

Directors who approve a redemption or dividend that breaches the solvency tests are jointly and severally liable under section 130 of the OBCA to restore the amount to the corporation.

A corporation can issue preferred shares only if its articles authorize the class, and many Ontario corporations were set up with one class of common shares. Adding a preferred class takes four steps:

1. Design the terms. The share conditions are drafted with the accountant where tax is involved, and with the investors' counsel in a financing.
2. Approval. The shareholders pass a special resolution under section 168 of the OBCA. Where the new class will be equal or superior to an existing class, that class also votes separately under section 170 unless the articles excluded that particular vote.
3. Filing. The corporation files articles of amendment, effective on the date shown on the certificate of amendment.
4. Issue and record. The board issues the shares only once they are fully paid, determining the value of any property received instead of money under section 23, and records them in the securities register and minute book.

If the articles already authorize a class issuable in series and let the directors set series terms, the directors fix the terms but must file articles of amendment designating the series before issuing any of its shares. Lamba Law's incorporation and structuring practice drafts share conditions and the amendments that create them.

In 2022 Giovanna Moretti, a retired pharmacist, invested $300,000 in Ricci Fine Foods Inc., a Richmond Hill fresh-pasta producer owned by Paolo Ricci, and received 300,000 Class B Preferred Shares at $1 each. She expected 6% a year. The share conditions in the articles say something narrower: a non-cumulative preferential dividend of up to 6% a year, payable only if declared; priority on a wind-up up to $1 a share; redeemable by the corporation at $1 a share; and no vote.

The board declared no dividends in 2024 or 2025 while the company paid for a new production line. Because the dividend is non-cumulative, those two years are lost, and because the articles remove the vote, Giovanna could not vote at the annual meetings.

In 2026 Paolo wants to issue a new class of preferred shares ranking ahead of the Class B to an investor funding a second plant. The articles do not exclude the section 170 class vote, so the Class B votes separately on the amendment, and Giovanna holds the whole class. She approves it in return for the corporation redeeming 150,000 of her shares at $1 out of the new money. The board confirms that the corporation passes the section 32 solvency tests before paying the $150,000. Because she paid $1 a share in cash, the paid-up capital of her shares equals the redemption price, so subsection 84(3) deems no dividend: she simply receives half her capital back.