The taxpayer, Bioartificial Gel Technologies (Bagtech) Inc., was a bankrupt corporation and Pricewaterhouse Coopers Inc. was its trustee in bankruptcy.
At the relevant time, Bagtech operated in the dermo-pharmaceutical industry developing different types of dressings designed to accelerate skin healing. It conducted scientific research and experimental development (SR&ED) activities and claimed the refundable investment tax credit of 35% of qualified SR&ED expenditures.
No single non-resident held a majority of the company’s shares, but together non-residents held 62.52% and 70.42% of the outstanding voting shares in the 2004 and 2005 years, respectively. However, the USA entered into by the taxpayer and its shareholders pursuant to the Canada Business Corporations Act (CBCA) gave Canadian residents the right to elect four members of the seven-member board of directors.
The Minister reassessed the taxpayer’s 2004 and 2005 taxation years on the basis that it was not a CCPC and was therefore entitled only to the basic non-refundable SR&ED investment tax credit of 20%. The Minister claimed that the application of the “hypothetical shareholder” rule in paragraph 125(7)(b) of the Income Tax Act (the Act), which aggregates the shareholdings of non-residents and public corporations for the purposes of determining control, prevented the taxpayer from being a CCPC.
Tax Court decision
Tax Court Justice Paul Bédard first reviewed the CCPC definition in subsection 125(7), which reads as follows:
“Canadian-controlled private corporation” means a private corporation that is a Canadian corporation other than
(a) 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 described in paragraph (c), or by any combination of them,
(b) 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 (c) were owned by a particular person, be controlled by the particular person,
(c) a corporation a class of the shares of the capital stock of which is listed on a designated stock exchange...
He cited the approach set out in the Sedona Networks case (2007 FCA 169), which carried out a two-step analysis in applying paragraph 125(7)(b):
- First, determine the non-resident persons and public corporations and assume that their shareholdings belong to a “particular person,”
- Second, determine whether the corporation would be controlled by this “person.” If so, the corporation is not a CCPC.
The Tax Court judge next considered the meaning of the word “controlled” in paragraph (b) of the CCPC definition. He referred to the leading cases of Buckerfields ( 1 R.C.É. 299) and Duha Printers ( 1 S.C.R. 795) to reconfirm that “control” or “controlled” for the purposes of the Act means de jure control — the control that resides in the ownership of shares that carry the voting rights to elect the majority of directors.
The de facto control concept only comes into play when the relevant provision of the Act uses the phrase “controlled, directly or indirectly in any manner whatever” (see subsection 256(5.1)). Paragraph 125(7)(a) uses this term, but paragraph 125(7)(b) uses only the word “controlled.”
Justice Bédard emphasized that the jurisprudence dealing with de jure control is not restricted to a very formalistic and narrow interpretation of rights attaching to shares. Rather, the courts will look to whether the majority shareholder enjoys “effective control” over the “affairs and fortunes” of the company.
Unanimous shareholders agreement
Duha Printers is the leading Canadian case on de jure control. In that case, the Supreme Court of Canada held that external agreements generally should not be considered in determining de jure control. However, a USA that is a corporate law hybrid, part contractual and part constitutional in nature, is one of the corporation’s foundational documents, which also include the articles of incorporation and the by-laws. As such, the USA is relevant in determining whether the majority shareholder(s) exercise effective control over the corporation.
Justice Bédard noted that the mere fact that a corporation’s shareholders have entered into a USA does not automatically mean there will be an impact on de jure control. The court must examine to what extent the terms of the USA would restrict the ability of the majority shareholders to elect members of the board or would substantially impair the directors’ power to manage the corporation.
Under most corporate statutes, including the CBCA, a USA is an agreement that restricts, in whole or in part, the directors’ powers to manage the business and the affairs of the corporation. A valid USA binds those who become shareholders after it is signed.
Justice Bédard recognized the differing views on whether a valid USA may only include clauses restricting the powers of directors to manage. After reviewing the jurisprudence and various articles written on the subject, including Couzin Taylor LLP partner Robert Couzin’s 2005 article “Reflections on Corporate Control” (2005 CTJ 2 p.305), he concluded that provisions in a USA such as the restrictions on the shareholders’ rights to elect directors, would not invalidate the USA. Further, there is no requirement to sever such clauses from a USA, as had been done in at least one case.
Justice Bédard agreed with Mr. Couzin’s comments to the effect that the greater the restrictions a USA places on the directors’ power to manage the business, the less relevant the ownership of the shares that carry the right to elect them. However, in the Bagtech case, these restrictions were considered to be relatively minor limitations on the directors’ power.
The Crown did not take issue with the principle that a USA is one of the foundational documents of a corporation. However, it argued that the USA should not be taken into account in determining whether the hypothetical shareholder established in paragraph 125(7)(b) controls the corporation.
The basis of this argument appeared to be that the hypothetical shareholder could not be bound by the USA, since it could not be a signatory. To hold otherwise would defeat the purpose of the paragraph 125(7)(b) deeming rule, which purports to deny CCPC status when non-residents own in aggregate more than 50% of the corporation’s voting shares, even if the non-resident shareholders do not act in concert to exercise control.
Justice Bédard rejected the Crown’s argument on the basis that insofar as a legal fiction such as the deeming rule in paragraph 125(7)(b) transforms reality, its scope should be limited to what is clearly expressed, and otherwise it should not change reality (see LS c. The Queen, 2006 CAF 129, at para. 55). Therefore, the paragraph 125(7)(b) hypothetical shareholder should be deemed to have the same rights as the non-resident shareholders and would be considered to be bound by the USA.
In the end, Justice Bédard allowed the taxpayer’s appeal on the basis that the USA prevented the non-residents from controlling Bagtech under paragraph 125(7)(b).
The Minister has appealed the decision. If the decision stands, corporations that are held partially by non-residents and/or public companies may wish to consider whether altering the manner in which directors are elected would be worthwhile to permit ongoing access to the income tax benefits afforded to CCPCs.
 A tax firm allied with Ernst & Young LLP in Canada.