Canada: The Federal Court Of Appeal Clarifies The De Facto Control Test

Control is a concept that is relevant for a number of income tax rules. There are two types of control: de jure and de facto control. Determining de jure control is straightforward as it exists where a person (or group) has the power to elect a majority of the board of directors. De facto control is less concrete, requiring a determination of whether a person (or group) has direct or indirect influence that, if exercised, would result in factual control.1 While the de facto control concept is relevant for a variety of provisions in the ITA, it is particularly relevant for determining whether a corporation is a "Canadian-controlled private corporation" and whether corporations are "associated" for purposes of the ITA.

The seminal case on de facto control is Silicon Graphics Limited v. Canada,2 which established that a person or group of persons would have de facto control if such a person or group has "a clear right or ability to effect a change in the board of directors or the powers of the board of directors or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors."3 Subsequent cases4 expanded the test by introducing factors concerning operational control of the business, creating ambiguity and challenges in determining de facto control. Fortunately, the recent Federal Court of Appeal ("FCA") judgment in McGillivray Restaurant Ltd v. The Queen ("McGillivray")5 provides welcome clarification of the de facto control test, reaffirming the test in Silicon Graphics.

The issue in McGillivray was whether certain corporations were associated for purposes of sharing the small business deduction. Two of the corporations in question were wholly-owned by Mr. Howard ("HowardCo 1" and "HowardCo 2"), while the appellant corporation ("SpouseCo") was jointly held by Mr. Howard (24% of the voting shares) and his spouse (76% of the voting shares). Mr. Howard had been an employee of the Keg Restaurant (the "Keg") for twenty years prior to acquiring three Keg franchises and exclusivity rights to operate the Keg franchises in Winnipeg. Through his corporations, Mr. Howard operated three Keg restaurants in Winnipeg until late 2005. Mr. Howard decided to replace one of the restaurants that was being operated on rented premises with a new restaurant that would be located on owned real estate.

Mr. Howard was advised that he should hold the real estate for the new restaurant and the franchise in a separate corporation that would be majority-owned by his spouse (i.e., SpouseCo). Mr. Howard was elected as the sole director and officer of SpouseCo. No shareholders' agreement was entered into between Mr. and Mrs. Howard and SpouseCo was organized on the basis that Mr. Howard would not need his spouse's approval to make decisions on behalf of SpouseCo. Mr. Howard assured the franchisor that things would be run on the same basis as they had in the past and the facts showed that Mrs. Howard had limited involvement in the operations of SpouseCo.

The Tax Court of Canada judge relied on the line of interpretation in Mimetix and Plomberie in concluding that Mr. Howard had de facto control over SpouseCo such that HowardCo 1, HowardCo 2 and SpouseCo were "associated" corporations for purposes of the ITA and had to share the small business deduction. In doing so, the Tax Court of Canada considered factors such as Mr. Howard's control over the management and operation of SpouseCo and its business compared to his spouse's very limited role (for example, Mr. Howard made all business decisions without his spouse's approval and had day-to-day control over the management and operation of the business).

The FCA concluded that the trial judge had erred in applying the de facto control test, emphasizing that the test in Silicon Graphics was the appropriate test. The FCA stated that to the extent that the decisions in Mimetix and Plomberie may be taken as having prescribed a test for de facto control which was inconsistent with Silicon Graphics, those decisions ought not to be followed.

The FCA rejected the assertion that de facto control is based on "operational control" and emphasized that like de jure control, de facto control looks to factors that demonstrate control over the election of the board of directors. The FCA stated:

The difference between de facto and de jure control is limited to the breadth of factors that can be considered in determining whether a person or group of persons has effective control, by means of an ability to elect the board of directors of a corporation. That said, it remains the case that the list of factors that may be considered when applying the Silicon Graphics test is open-ended. However, in my view a factor that does not include a legally enforceable right and ability to effect a change to the board of directors or its powers, or to exercise influence over the shareholder or shareholders who have that right and ability, ought not to be considered as having the potential to establish de facto control.6

While the FCA found that the trial judge applied an incorrect test, it nevertheless found that, based on the facts, de facto control did exist based on Silicon Graphics because there was an unwritten agreement between Mr. and Mrs. Howard which effectively allowed Mr. Howard to determine the entirety of the board of directors of SpouseCo and this was the type of influence contemplated by the de facto control test. This decision provides much needed clarity regarding the scope of de facto control and should promote greater predictability in future applications of the test.


1 As defined in subsection 256(5.1) of the Income Tax Act (Canada) (the "ITA").

2 2002 FCA 260 ("Silicon Graphics").

Ibid at paragraph 35.

4 See, for example, Mimetix Pharmaceuticals Inc v The Queen, 2003 FCA 106 ("Mimetix") and Plomberie J.C. Langlois Inc v Canada, 2006 FCA 113 ("Plomberie").

5 2016 FCA 99.

Ibid at paragraph 48.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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