Canada: Tax Court Finds Unanimous Shareholders’ Agreement Affected Legal Control Of A Corporation By Its Non-Resident Shareholders

Determining who controls a corporation is relevant to determining the availability of certain tax benefits provided by the Income Tax Act (Canada) (the "Act"). For example, specific tax incentives are available only to Canadian-controlled private corporations ("CCPCs"), such as the small business deduction which reduces the federal corporate tax rate from 28% to 11% on the first $500,000 of active business income, and the enhanced refundable investment tax credit for scientific research and experimental development ("SR&ED") expenditures. CCPC status is also necessary for a corporation to qualify as a small business corporation, which may allow individuals to claim the $750,000 lifetime capital gains exemption on dispositions of the corporation's shares. Generally, a corporation will be a CCPC as long as no non-resident or public corporation shareholders, either alone or together, own more than 50% of its voting shares.

In the recent case of Price Waterhouse Coopers Inc. Agissant Ès Qualité De Syndic À La Faillite De Bioartificial Gel Technologies (Bagtech) Inc. v. The Queen¹ ("Bagtech"), the Tax Court of Canada held in favour of Bagtech that it qualified as a CCPC during the years in question. The Court found that while Bagtech's non-resident shareholders owned, in the aggregate, more than 50% of Bagtech's voting shares, they did not legally control Bagtech because, under the provisions of a unanimous shareholders' agreement ("USA") entered into by Bagtech's shareholders, it was Bagtech's Canadian resident shareholders (and not Bagtech's non-resident shareholders) that had the power to elect a majority of the members of Bagtech's board of directors.

For a corporation concerned about qualifying for CCPC status, the most prudent course of action would be to ensure that no non-residents and public corporation shareholders, either alone or together, own more than 50% of its voting shares. In circumstances where this is not feasible, the Tax Court's decision in Bagtech may allow a corporation to qualify for (or maintain) CCPC status where its shareholders agree to be governed by a USA that provides the corporation's CCPC-qualifying shareholders with the power to elect a majority of the corporation's directors. However, some caution should be exercised in relying on this decision, as it is likely to be appealed by the Canada Revenue Agency ("CRA").

BACKGROUND TO THE CASE

Definition of CCPCA

CCPC is defined in subsection 125(7) of the Act as a corporation incorporated and resident in Canada that is a "private corporation" (i.e., not a public corporation and not controlled by one or more public corporations), but it expressly excludes any of the following corporations:

1. a corporation controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, by one or more public corporations (other than a prescribed venture capital corporation), by one or more corporations a class of the shares of which is listed on a prescribed stock exchange, or by any combination of them (this is the basic test for determining CCPC status);
2. a corporation that would, if each share of the capital stock of a corporation that is owned by a non-resident person, by a public corporation (other than a prescribed venture capital corporation), or by a corporation described in paragraph
3. below were owned by a particular person, be controlled by the particular person (this is known as the "hypothetical shareholder" test), or (c) a corporation a class of the shares of the capital stock of which is listed on a prescribed stock exchange (stock listing is one of two ways in which a corporation becomes a "public" corporation for tax purposes; the other way is by filing an election and complying with prescribed conditions under the Act).

Types of Control

There are two basic types of control, one or both of which may need to be looked at to determine tax consequences under specific rules in the Act. The first type of control is legal (i.e., voting) control. This type of control is relevant any time a provision of the Act requires one to consider who controls a corporation. For example, the control test for "private corporation" status, which is required for a corporation to qualify as a CCPC, refers only to control, so the relevant test is legal control. The classic definition of legal control, as set out by the Exchequer Court in the leading case of Buckerfield's Ltd. v. MNR², is "effective control" over the "affairs and fortunes" of the corporation as manifested in "the ownership of such number of shares as carries with it the right to a majority of the votes in the election of the Board of Directors".

The second type of control is factual control, which is relevant only where a provision of the Act specifically refers to a corporation being controlled "directly or indirectly in any manner whatever". For example, the basic test for CCPC status requires one to look not only at legal control, but also factual control since it uses the phrase "controlled, directly or indirectly in any manner whatever". Unlike legal control, factual control is defined for purposes of the Act: a corporation is controlled by another corporation, person or group of persons (a "controller") where the controller has any direct or indirect influence that, if exercised, would result in control in fact of the corporation. While the definition excludes the influence derived from contractual arrangements between a corporation and an arm's length person the main purpose of which is to govern the parties' relationship in terms of how the corporation's business is conducted, the question of what constitutes sufficient "direct or indirect influence" over a corporation has spawned numerous cases considering what factors are relevant to that determination.

With that background in mind, let's turn to the question of what role a USA plays in determining legal control of a corporation for tax purposes.

HOW A USA MAY AFFECT LEGAL CONTROL OF A CORPORATION

In Duha Printers,³ the Supreme Court of Canada provided further guidance on applying the Buckerfield's legal control test. To determine whether "effective control" of a corporation exists, the Court said that one must look at all of the following:

• the corporation's governing statute (e.g., the Canada Business Corporations Act ("CBCA");
• the share register of the corporation; and
• any specific or unique limitation on either 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 company, as manifested in either:
• the constating documents of the corporation; or
• any USA.

The Court also stated that generally only the foregoing documents are relevant to the determination of legal control of a corporation. Accordingly, if a shareholders' agreement does not constitute a USA, it has no effect on determining legal control. However, the existence of a USA by itself is not sufficient to alter the legal control of a corporation: the Court concluded that a USA will do so only if it does not leave any way for the majority shareholder to exercise effective control over the affairs of the corporation in a manner that is equivalent to the power to elect the majority of the board of directors.

The effect that a USA may have on determining legal control of a corporation is illustrated by the case of Alteco Inc. v. The Queen,⁴ in which the Tax Court of Canada confirmed that in certain circumstances the provisions of a USA might have the effect of removing legal control from a majority voting shareholder. On the facts of the case, the Court held that Alteco did not have legal control of a subsidiary corporation even though it held 51% of the voting shares of the corporation, because it had entered into a USA pursuant to which it could elect only a minority (two out of five) of the members of the corporation's board of directors. While the majority shareholder held the majority of the votes in the election of the corporations' directors according to the share register, the USA effectively shifted the majority voting power to the minority shareholder.

Questions Raised by USAs

Two general questions that have arisen with respect to USAs are:

• What shareholder agreements constitute a USA?
• Is a USA relevant in applying the hypothetical shareholder test for determining CCPC status?

A USA is not a defined term in the Act. Canadian corporate law statutes generally define a USA as an otherwise lawful written agreement among all the shareholders of a corporation, or among all the shareholders and one or more persons who are not shareholders, that restricts, in whole or in part, the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation.⁵

The CRA has taken the position that the only provisions of a USA that are relevant in determining legal control are those that either (1) restrict the directors' powers or (2) modify a rule under the corporation's governing legislation that has been explicitly made subject to a USA. Thus, in the CRA's view, a provision of a USA cannot alter a majority shareholder's voting rights to elect the corporation's directors because the relevant provision of the governing corporate legislation which requires the shareholders to elect the directors at the annual shareholders' meeting by exercising the votes attached to the shares owned by them is not made expressly subject to a USA.⁶ In support of its position, the CRA also relies on the Supreme Court's statement in Duha Printers (at paragraph 54) that "the [legal control] test neither requires nor permits an inquiry into whether a given director is the nominee of any shareholder, or any relationship or allegiance between the directors and the shareholders".

The CRA has also taken the position that a USA is not relevant in applying the hypothetical shareholder test to determine a corporation's status as a CCPC. The hypothetical shareholder test is essentially an anti-avoidance test, which requires all of the shares of a corporation held by any non-resident and public corporation shareholders to be aggregated. If that aggregate share ownership provides the hypothetical shareholder with control over the corporation, then the corporation is not a CCPC.

The CRA's rationale for excluding a USA from the hypothetical shareholder test is that since the hypothetical shareholder is a fictitious person, the hypothetical shareholder would never be a party to the USA, nor does the test itself deem the hypothetical shareholder to be a party to the USA for purposes of applying the test. In the CRA's view:

The CRA's positions on these questions were tested in Bagtech, a recent Tax Court of Canada case.

Bagtech

The facts in Bagtech are straightforward: Bagtech claimed the enhanced refundable investment tax credit for SR&ED expenditures made in its 2004 and 2005 taxation years on the basis that it was a CCPC during those years. The Minister reassessed Bagtech, concluding that it did not qualify as a CCPC under the hypothetical shareholder test.

Sedona Networks⁸ sets out a two-step approach for applying the hypothetical shareholder test:

1. Attribute all of the shares of Bagtech owned by non-resident shareholders to one hypothetical non-resident shareholder of Bagtech; and
2. Determine if the hypothetical non-resident shareholder controls Bagtech.

Bagtech had several minority shareholders who were non-resident; when their shares were aggregated, the hypothetical non-resident shareholder held a majority of the voting shares of Bagtech. However, Bagtech argued that the hypothetical non-resident shareholder did not control Bagtech because a provision of the USA gave Bagtech's Canadian resident shareholders the right to elect a majority of the members of Bagtech's board of directors. Accordingly, under the second step of the hypothetical shareholder test, while the hypothetical non-resident shareholder had sufficient voting power by virtue of the deemed ownership of all of Bagtech's nonresident shareholders' shares, it did not control Bagtech because the USA had effectively shifted that voting power into the hands of Bagtech's Canadian resident shareholders.

The Tax Court judge first considered and rejected the CRA's contention that the USA should be ignored in applying the hypothetical shareholder test. Reviewing the Department of Finance technical notes relating to the test, the trial judge concluded that the hypothetical shareholder test creates a legal fiction, i.e., that one shareholder owns all of the shares owned by the corporation's non-resident and public corporation shareholders. In La Survivance,⁹ the Federal Court of Appeal stated that where a rule effectively alters reality, its meaning and effect should be limited to what is clearly expressed. The trial judge therefore concluded that the legal fiction created by the hypothetical shareholder test requires the hypothetical shareholder to be given the same rights and obligations as the actual non-resident shareholders whose shareholdings must be aggregated under the test, which includes being bound by the USA. The contrary conclusion would go against the legal fiction created by the test itself: if all of the nonresident shareholders of Bagtech had sold their shares to one non-resident buyer, subsection 146(3) of the CBCA would have deemed the buyer to be a party to the USA.

In considering whether the shareholder voting provision of the USA was relevant in applying the hypothetical shareholder test, the Tax Court judge acknowledged that there were differing views on what constitutes a valid USA. For example, some (including the Quebec Superior Court) have taken the view that only those provisions of a USA that restrict the powers of the directors to manage the corporation are valid (and are severable from the invalid provisions), while others consider all of a USA's provisions to be valid provided that the agreement itself meets the governing corporate law definition of a USA (i.e., it is a lawful written agreement among all of the corporation's shareholders and it has provisions that restrict the powers of the directors to manage the corporation).

Contrary to the CRA's view, the trial judge concluded that all of the provisions of a USA are valid and relevant to the legal control analysis (although he did note that he personally agreed with the opposing view which he believed was more in line with fundamental principles of corporate law). The trial judge based his conclusion on the requirement in Duha Printers that all of the restrictions placed on the majority shareholder's power to elect directors by either the corporation's constating documents or a USA must be considered in determining legal control of the corporation. However, the trial judge noted that his conclusion created an unusual result in that the same voting restriction would be irrelevant if contained in a voting agreement that did not constitute a USA.

The USA in this case resulted in the hypothetical non-resident shareholder having the power to elect only a minority of the members of Bagtech's board of directors. As such, the hypothetical nonresident shareholder did not have legal control of Bagtech, and Bagtech therefore qualified as a CCPC for the years in question.

COMMENT AND IMPLICATIONS

The CRA's narrow position on the relevance of USA provisions to the legal control analysis is hard to reconcile with Duha Printers and Alteco. The CRA views the Alteco decision as having little precedential value in assessing legal control. The Alteco decision was, however, considered and then distinguished on its facts by the Supreme Court in Duha Printers. In Alteco, the majority shareholder could elect only two out of the five members of the corporation's board of directors. The decisive differentiating fact in Duha Printers appears to be that although the USA required the shareholders to elect the three-member board of directors from among four possible candidates, it did not alter the shareholders' voting power in that election, which was determined by their share ownership. While the pool of candidates for the board of directors was narrowed down to just four nominees of the shareholders, the majority shareholder still had the power to choose which three of the four possible candidates would be elected to the board by virtue of holding the majority of votes. Those facts place in proper context the Supreme Court's statement that whether or not a director is a nominee of (or otherwise has a particular relationship with) a shareholder is irrelevant to the legal control determination; it also does so in a manner consistent with the outcome in Alteco, which the Supreme Court in Duha Printers appears to have implicitly accepted.

While a USA must contain restrictions on the powers of the directors to manage the corporation to be a valid USA for corporate law purposes, corporate law legislation does not explicitly prohibit USAs from containing other provisions specifying shareholders' rights vis-à-vis each other. Although those rights may be contractual in nature only, they may still have the effect of altering control over the corporation. The more difficult question is whether they should be considered to affect legal control of the corporation, or only factual control. While there is some merit to the trial judge's observation in Bagtech that coming to different conclusions on the legal control analysis depending on whether or not a shareholder voting restriction is contained in a valid USA produces an illogical result, there are numerous instances where taxpayers receive differing tax treatment under the Act depending on whether they have entered into the necessary legal arrangements to qualify for tax-favoured treatment under specific tax rules. Why should this situation be any different? If a provision of a USA removes the ability of a majority shareholder to elect the majority of the members of the corporation's board of directors, then that alters the legal control of the corporation as defined in Buckerfield's.

Considering the consistent stance the CRA has taken on the limited relevance of USAs in this context, it is likely that the CRA will appeal the Tax Court's decision. We will continue to monitor this case and will provide an update when there are further developments.

Footnotes

^{1 2012 TCC 120 (TCC).}

^{2 64 DTC 5301 (Ex. Ct.).}

^{3 Duha Printers (Western) Ltd. v. The Queen, 98 DTC 6334 (SCC).}

^{4 [1993] 2 CTC 2087 (TCC).}

^{5 Subsection 146(1) of the CBCA. Subsection 108(2) of the Business Corporations Act (Ontario) contains a similarly worded provision.}

^{6 See, for example, CRA document no. 2009-0314351I7, January 7, 2010.}

^{7 Income Tax Technical News No. 44, April 14, 2011.}

^{8 Sedona Networks Corp. v. The Queen, 2006 DTC 2486 (TCC), at paragraph 11.}

^{9 La Survivance v. The Queen, 2007 DTC 5096 (FCA), at paragraph 55.}

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