Recently published in the Canadian Tax Highlights a Canadian Tax Foundation Publication and reproduced with permission here. This article can also be found at Sunita Doobay’s blog.
By: Sunita Doobay (TaxChambers LLP, Toronto) & Rajeeve Thakur (Miller Canfield Paddock & Stone LLP, Toronto)
A CCPC classification is attractive for a variety of tax reasons, including the preferential small business deduction and the heightened SRED investment tax credit (ITC) of 35 percent (rather than 20 percent). The decision in Bioartificial Gel Technologies Inc. (Bagtech) is of particular significance, because the TCC in Bagtech concluded that a unanimous shareholder agreement (USA) resulted in CCPC classification although on the facts more than 50 percent of the corporation’s shares were held by non-residents. (The TCC in Ekamant Canada Inc. concluded that there was no USA on the facts in that case.)
Bagtech was incorporated under the CBCA and in 2004 and 2005 claimed the 35-percent SR&ED ITC rate as a CCPC. Non-residents held 62.52 and 70.42 percent respectively of its voting shares, but pursuant to a USA the actual right to elect the majority of the directors was held by Canadian residents.
The concept of control is central to the CCPC definition in section 125(7) of the Income Tax Act. The term control itself is not defined in the Act and thus the courts have been left to wrestle with its meaning. For purposes of a CCPC, control is subdivided into a de jure test (control in law) and a de facto test (control in fact). Whenever the Act refers to a corporation as being controlled “directly or indirectly in any manner whatever”, the de facto test for control is triggered: otherwise the only appropriate test of control is the de jure test. Due to the foreign ownership of Bagtech’s shares, the relevant provision to determine control was paragraph (b) of the CCPC definition in 125(7), which calls for the de jure test for control.
When determining de jure control under paragraph (b) of the CCPC definition, it is important to note that that paragraph creates an important legal fiction: all the shares held by non-resident persons and public corporations are deemed to be owned by a single fictional person. If that fictional person is found to hold de jure control over the corporation, it does not qualify as a CCPC. In reality, the shareholders whose shares are held by the fictional shareholder may or may not act together to control the corporation, or even have any relationship with one another whatsoever. (See “Control Further Dissected”, Canadian Tax Highlights, April 2006.)
Generally, de jure control is “the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors.” (Buckerfield’s Limited, 64 DTC 5301,  CTC 504). Prior to the SCC decision in Duha Printers, the factors for determining whether de jure control existed included the corporation’s governing statute and its share register, and any limitation laid out in the constating documents on the majority shareholder’s power to control the election of the board or the board’s power to manage the business and affairs of the corporation.
A USA allows shareholders, by a unanimous agreement, to limit or take away all of the managerial powers of the corporation’s directors and to grant those powers to all or some shareholders (as was the case in Bagtech). A run-of-the-mill shareholders agreement, which is solely contractual in nature, is distinct from a USA, which the SCC in Duha said was “a corporate law hybrid, part contractual and part constitutional in nature.” Significantly, a USA has the power to bind current and future shareholders. Duha established that a USA should be treated as a constating document of a corporation in determining whether de jure control exists. The SCC said that in order for a majority shareholder to lose de jure control, the USA must not allow that shareholder “to exercise effective control over the affairs and fortunes of the corporation in a way analogous or equivalent to the power to elect the majority of the board of directors.”
In Bagtech the minister contended that a USA does not apply to paragraph (b) of the CCPC definition in subsection 125(7) for purposes of determining whether de jure control is present: the text and the purpose of that provision would be frustrated if the fiction of control it creates could be watered down by a USA that allocates the powers of directors to a group of shareholders that never includes the fictional shareholder. The TCC in Bagtech disagreed and concluded that that provision’s fictional shareholder is bound by a USA. The TCC reasoned that the CCPC definition is a general provision and the court’s role is to give effect to its legislative intent: the legal fiction of a hypothetical shareholder applies in all situations and thus the fictional shareholder is bound by a USA in the same way that the actual shareholders are bound.
Bagtech crystallizes what was decided in Duha: a USA should be treated as a constating document when determining de jure control and in order to conclude that a non-resident majority shareholder does not have de jure control, the USA must remove that shareholder’s ability to control the corporation in a manner equivalent to the power to elect the majority of the board of directors. In addition Bagtech specifically concludes that a USA applies to a fictional shareholder created under paragraph (b) of the subsection 125(7) CCPC definition. Will the Act be amended in light of Bagtech, as it was following the decision in Silicon Graphics? The policy behind the CCPC definition and related provisions is to afford Canadian residents preferential tax treatment under the Act. Any legislative change, however, will likely await the result of the appeal to the FCA that was filed on May 14, 2012.
TaxChambers LLP is collaborating with Andersen Global® in Canada.