The founders may prefer to loan sums to the new startup in exchange for debt securities, so that repayments of this capital may be made when the startup's operations and financial condition permit. This amounts would not be taxable as dividends if they are properly structured as debt repayments, whereas any amounts invested by the founders in exchange for common shares would be locked in as equity capital and could not be taken out without being taxed as ordinary income dividends if the startup had earnings and profits. Outside investors may prefer to advance funds in exchange for debt securities which are senior to the equity securities issued to the founders. In a high risk startup, this distinction may not be meaningful, since if the startup fails and becomes insolvent, there will not likely be sufficient assets to repay the debt. Therefore, the difference in equity securities and debt securities may not be meaningful if the startup fails. However, venture capital investors may wish to create a security interest in the assets of the startup, e.g., the intellectual property representing the technology being financed. Thus, in an insolvency situation, the startup investors may be able to recover by foreclosure the intellectual property in priority over the unsecured creditors of the startup.
For tax purposes it makes a substantial difference to an individual investor (as opposed to a corporate investor) whether he receives distributions from the startup as payment of dividends or a payment of interest, since the tax rate on qualified dividends is 15%, while the maximum rate on interest is 35%. The difference to the corporation paying the dividends, however, is also substantial. Dividends are not deductible by the corporation and thus must be paid with after-tax dollars. Interest payments, on the other hand, are deductible within limits and therefore reduce the taxable income and amount of taxes that the corporation must pay. Furthermore, repayment of a loan to an investor should be treated as a return of capital and not result in taxable income to the investor. On the other hand, repurchase by a startup of its shares may result in dividend income to the shareholder. Because of the lower rate on dividends to individual investors, the tax advantage for issuing debt rather than shares has considerably decreased. In connection with capitalizing the startup, therefore, shareholders should consider whether the startup needs additional deductions provided by interest payments on a shareholder note, since the shareholder will be foregoing the preferred 15% rate on dividends for a 35% rate on interest payments.
Because of the tax advantages of using debt, many small startups attempt to maximize the amount of debt as opposed to invested equity capital. That fact pattern may cause Revenue Canada scrutiny of the debt to determine whether, in fact, it should be treated as equity. The Revenue Canada is authorized by statute to prescribe regulations to determine whether an interest should be treated as shares or indebtedness or as a hybrid. There are currently no regulations in effect. Among the factors that the Revenue Canada may consider in the regulation are: (1) Whether the debt is supported by a written unconditional promise to pay on demand or on a specified date a sum certain in money for an adequate consideration in money or money's worth, and to pay a fixed rate of interest; (2) Whether the debt is subordinate to or preferred over any other indebtedness; (3) The ratio of debt to equity of the corporation; (4) Whether the debt is convertible into shares; and (5) Whether the debt is issued proportionately to the shareholdings in the corporation. Debt instruments of a corporation are also subject to some fairly complex provisions relating to below-market interest loans between corporations and shareholders and rules relating to original issue discount on corporate obligations.