Legal risks of various family office investing scenarios

Article content

A large and growing base of family offices in Canada face multiple complex legal issues when investing. Unlike a large company with hundreds of employees that can be called on to make critical and complex decisions, a typical family office has limited in-house resources, and key people must assume a lot of the burden.

Many family offices have historically done everything themselves, especially with respect to private equity, but added complexities associated with new investment structures, and portfolios – in many cases branching into new industries – require expertise in multiple areas, including legal, accounting, tax, financial, banking, insurance, succession planning, philanthropy, and others, says Curtis Cusinato, vice-chair and partner with Bennett Jones LLP in Toronto, and co-head of the firm’s mergers and acquisitions practice.

“It goes right across the gambit. And that’s where we, as lawyers, tend to get involved with our various specialist services to make sure that their needs and objectives are addressed,” he says.

Investment structure can run afoul of regulatory authorities

The biggest legal issues for family offices centre around investment structure, Cusinato says. The family office investment structure needs to be compliant with applicable provincial securities laws, including adviser registration requirements, and myriad details need to be assessed, including whether any exemptions might apply.

“If you don’t have the right compliance structure then the securities regulatory authorities can take action which could impact the workings of the established structure of the family office. It becomes cumbersome. It could become expensive. It could require some revamping of the actual family office structure. This creates tremendous transaction uncertainties,” Cusinato warns.

A direct private equity investment in a potential takeover target company requires a full understanding of liabilities and litigation stemming from areas like operations, human resources, contracts, and environmental issues, says Wojtek Baraniak, a partner in the mergers and acquisitions and private equity and private client services groups with Fasken LLP in Toronto.

When taking a majority or minority position in a company, legal expertise is required to negotiate contractual rights for the family office over the operation and management of the target company.

This can, for example, involve power over the day-to-day decisions that businesses need to make, which might involve a say on the appointment of officers and directors of a target company or a veto over material business decisions. It can also involve rights and obligations in respect of the subsequent sale of the investment in the form of drag or forced sale provisions, or tag-along provisions in each case when requisite sale thresholds are met, explains Baraniak.

“These transactional legal issues involve sophisticated documentation and counsel,” he says.

Family offices that branch out from traditional single industry strategies in their focused core competencies, into multiple industries – perhaps including emerging industries – must be especially diligent and aware of the additional legal risks, says Cusinato.

They need to ensure that the family office members who are making the investment decisions have the requisite understanding and competencies necessary to do so. When proper legal and other due diligence is not carried out up front, as family offices migrate into more modern-day structures, they face the risk that “unfortunately sometimes they are wound down and discontinued a lot earlier than everybody had hoped,” warns Cusinato.

Risks in both direct and passive investing

With direct private equity investments, another major legal decision involves direct management and control over investments, versus passive investing, whereby a family office leaves its money to be managed by an outside fund or manager.

In a growing number of cases, family offices are opting for direct investments. “I think fundamentally it comes down to control over your investment that doesn’t exist in passive investment strategies. Ultimately you hope for a better return, and you also cut out the middle person and management fees,” explains Baraniak.

With respect to passive investments, “the ultimate legal risk is you’re engaging someone pursuant to a contract, and that contract will dictate how investment decisions are made and how your portfolio is going to be balanced. It’s a question of trust. You need to have complete trust in your outside portfolio manager to ensure that they’ll abide by the terms of that agreement,” Baraniak says.

Family offices also need to do their due diligence and be comfortable that the terms of their agreement with that portfolio manager will be fulfilled, he adds.

One potential option for parties with limited resources is to co-invest. This is a hybrid between a traditional limited partnership investment and direct investment.

“Co-investing isn’t available to everyone. Co-investment is usually a right that a family office has in an existing limited partnership fund to co-invest together with the general partner of the fund directly in an investment,” explains Baraniak. This allows investors to leverage the funds and resources in terms of the due diligence it must conduct, including legal due diligence associated with negotiation and execution of the deal, he says.

Tax and estate planning affected by investment structure

The impact of tax law on the structure of investments is another important issue for family offices. Tax law will affect the decision about whether to hold new investments in a trust, an existing holding company, or combine it with an existing operation.

For example, if an acquisition is made that will merge an existing business with a new business, a tax professional is required “at a very early stage to see how tax can impact the structure of an acquisition in a way that recognizes the unique circumstances of the family office and its existing portfolio investments,” explains Baraniak.

The buyer’s tax plan must also be co-ordinated with the seller’s tax plan to facilitate the transaction on a tax-efficient basis. For example, on a sale, a seller will want to structure the deal to take advantage of tax efficiencies such as the personal lifetime capital gains exemptions or safe income strips, if available. This will directly impact a buyer’s acquisition plan in terms of understanding the implications of pre-closing transactions and the companies to be acquired, says Baraniak.

Rhonda Rudick, a partner in the tax, private client and family office groups with Davies Ward Phillips & Vineberg LLP in Montreal, says there are several key issues that family office investors need to consider from a tax and estate planning perspective.

Geographic location and how investments affect estate tax planning

If a family office has an investment in a U.S. company or in U.S. real estate, it is necessary to structure that investment to avoid U.S. estate tax. This would typically occur through the establishment of a Canadian corporation to hold the investment, or other entity that protects against U.S. estate tax, says Rudick.

“You might also want to invest in a U.S. business through a separate Canadian entity to segregate your tax filing obligations,” she adds.

If there are U.S. citizens in the family this will also impact the way a family office structures its investments because U.S. citizens are taxed on their worldwide income even if they reside in Canada, and investing through Canadian corporations may have adverse U.S. tax consequences for such individuals. That might require, for example, establishing separate investment vehicles for family members who are subject to different tax regimes.

If another family member lives in a low- or no-tax jurisdiction, the strategy could differ even further. For example, “You don’t want them investing through an entity that’s going to be taxable in Canada, as this would eliminate some of the benefit of residing in a lower tax jurisdiction,” Rudick explains.

Estate freezes and private foundation tax considerations in investing

Estate freezes are a common element of a comprehensive tax planning strategy.

“On the estate planning side, you’ll often see estate freezes put in place where the current generation fixes their interest in a Canadian holding company, and a family trust for the next generation holds the growth shares to defer tax,” says Rudick. “So you want to keep in mind the need for tax minimization on death.”

Family offices will often establish a philanthropic arm, like a private foundation, to make investments. These are subject to specific rules, including restrictions on the types of investments or activities that can be carried on, that the family needs to understand and plan around, says Rudick.

For example, a private foundation generally cannot carry on a business. If the family office business involved, say, purchasing commercial real estate, the private foundation may not be able to participate in that business unless certain structuring is done. A private foundation is also typically barred from holding more than 20 per cent of an interest in a partnership, either alone or together with non-arm’s length parties, Rudick says.

In general, tax changes can have a significant impact on the structure of a family office in Canada, emphasizing the need to keep on top of changes in tax law and for family investment leaders to be able to adapt their structure as necessary in response.

For example, notes Rudick, the 2022 federal budget eliminated the opportunity for family offices to invest through foreign corporations that are managed in Canada, which had previously resulted in certain tax deferral opportunities.

Protection of assets is paramount

It is important for family offices to consider asset protection, such as segregating investments in different entities or using trusts for creditor protection, says Rudick.

For example, a family office shouldn’t purchase commercial real estate in a company that has a portfolio of marketable securities. That is because if the family office real estate business is sued, their other assets could also come under attack, she explains.

“I’d set up a separate entity for that investment,” Rudick advises.

More from Canadian Family Offices:

• As ‘godfather’ of family offices in Canada, Tom McCullough and his vision stand test of time
• Ten operational risks to keep an eye on at the family office
• How your business’s transfer pricing set-up can trigger CRA audits
• Family office software: ‘Time is right for Canadian families to get onboard now’
• Why UHNW and family office investors are delving into private debt

Please visit here to see information about our standards of journalistic excellence.