This article is part of a practical series written for international companies looking to establish, launch, operate or invest in a business Canada. Each article covers a major area of law in Canada — everything from employment laws to taxes. Access all the articles on the “Doing business in Canada: A practical guide from ‘Eh’ to ‘Zed’” page.
Assuming that the foreign investor will conduct operations through a Canadian corporation, financing for the Canadian business can either be sourced internally, for example through shareholder loans or equity, or financed through external sources, such as via bank lines of credit and loans or publicly issued securities.
Internally sourced funds can be advanced or contributed in a combination of debt and equity, usually dictated by the thin capitalization rules contained in the federal Income Tax Act.
In some cases, funding through shareholder loans may be chosen instead of funding through equity because in a bankruptcy or liquidation of the corporation debt is paid in priority to return of equity. Furthermore, to obtain priority over the general unsecured trade creditors, shareholder loans can be secured by the assets of the corporation. The form of security will usually be a debenture, a general security agreement or, in Québec, a hypothec, each of which would normally be subordinated by agreement to any security for senior indebtedness, such as bank debt. However, even though subordinated, bona fide shareholder loans secured in this fashion will still have priority over the claims of unsecured creditors of the corporation.
External financing
(a) Debt financing
Canada has a well-developed banking system. There are three types of banks operating in Canada under the federal Bank Act. Banks typically provide two kinds of loans: operating loans, which are usually structured as revolving lines of credit, and term loans. Revolving operating loans are generally used to finance working capital requirements and are often payable on demand. Normally, banks do not demand payment unless they are concerned about a borrower’s continuing creditworthiness. Structuring the loan as payable on demand can allow for simpler loan terms. Operating loans sometimes permit the borrower to obtain letters of credit, in addition to cash advances, and may permit borrowing of U.S. dollars in addition to Canadian dollars. The borrower may also be given a choice of interest rate options, such as a floating prime-based rate, a bankers’ acceptance rate and, in the case of larger U.S. dollar borrowings, a rate based on short-term rates in the London inter-bank market. Operating loans from Canadian banks are normally based on a floating rate of interest, although banks will sometimes offer a borrower an opportunity to fix rates for large borrowings through an interest rate swap.
Typically, banks will secure operating loans by taking a security interest in all of the borrower’s personal property or specifically in the borrower’s inventory and accounts receivable. Operating loans will often provide for a maximum amount of credit available to the borrower, but will also be limited by a borrowing base, calculated on a percentage of the value of the borrower’s inventory and receivables after deducting assets against which the bank does not wish to lend, such as receivables that are past 90 days due or ones on which recovery is otherwise doubtful, and obsolete inventory.
In addition to security on the borrower’s assets, banks may require personal guarantees from the shareholders, although this is becoming less common, particularly for well-established borrowers. Shareholder loans made to the borrower and any security for them will also have to be subordinated, postponed and assigned to the bank, although ordinary course payments may be permitted if no default under the bank loan has occurred or would result. The bank will also require that it be named as an additional insured and as loss payee in any insurance policy respecting the assets of the borrower over which the bank holds security. Key person life insurance may be required on the borrower’s principals. If the shareholder is sufficiently creditworthy, the bank may make a loan solely on the strength of that shareholder’s guarantee, or the shareholder may be able to obtain a letter of credit from its bank in favour of the Canadian bank, which would be held in place of a security interest in the borrower’s assets.
Term loans are the other kind of loans banks make. They are most often made to finance the acquisition of fixed assets by the borrower and are generally repayable over a fixed period of time pursuant to an agreed schedule. Usually, banks can only accelerate term loans if a specified event of default occurs, although some banks make term loans payable on demand in certain circumstances.
The principal security taken for a term loan is often a security interest in the fixed assets of the borrower. However, as noted above, banks frequently demand security over all of the borrower’s assets. Similarly, the methods of availability, choice of interest rates, additional security and guarantees discussed with regard to operating loans apply equally to term loans, although letters of credit are not commonly issued in connection with term loans and fixed rates of interest are more often available for such loans.
Although banks are the main providers of debt financing in Canada, debt financing is also available from other sources, such as insurance companies, trust companies, credit unions, finance companies and vendors of assets. These sources often operate within narrower market niches than banks, and some may be better sources of longer-term, fixed-rate financing than banks.
Often a company can acquire capital assets from the manufacturer on a conditional sale basis or through a conditional sale or a leasing arrangement. Such accommodation by the manufacturer eliminates the need for a substantial sum of upfront cash and allows the company to pay for the assets over their useful life from the company’s cash flow. Lease finance companies can also help a company to acquire assets by buying the assets it chooses and then leasing those assets to the company.
