18 March 2008 Internal T.I. 2007-0253591I7 - Determination of CCPC status

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Status of a corporation as a CCPC where: (i) the powers of the board of directors are limited by the terms of a unanimous shareholders agreement (ii) various rights are conferred to its shareholders (iii) a disqualifying shareholder holds a significant ownership interest that may give rise to de facto control

Position: For the taxation year under dispute, a public corporation controlled the board of directors of the corporation ("Board"), which retained the powers required to effectively control that corporation's affairs and fortunes. Being legally controlled by a disqualifying shareholder, the corporation did not qualify as a CCPC for that year. Although a selective application of the rights described in paragraph 251(5)(b) can be relied upon in specific circumstances, it was unnecessary to do so given that it had already been established that a disqualifying corporation had de jure control over that corporation. In order to support a de facto control determination, we would have needed to be provided with more information regarding the relationship existing between the disqualifying shareholder and the other Board members, and the influence of such a disqualifying shareholder that, if exercised, would have resulted in operational control of that corporation.

Reasons: The statutory law as interpreted by the jurisprudence and CRA's administrative positions

								March 18, 2008

Kevin Gibson						HEADQUARTERS
Technical Guidance Division, SR&ED Directorate	François Mathieu
50 O'Connor Street					(613) 948-2230
Ottawa ON  K1A 0L5

2007-025359

Determination of CCPC status

On September 21, 2007, you requested the assistance of the Income Tax Rulings Directorate ("Rulings") to determine whether XXXXXXXXXX qualified as a Canadian-controlled private corporation ("CCPC") throughout its taxation year ended December 31, 2005, and was entitled to claim a refundable investment tax credit ("ITC") under subsection 127.1(1) of the Income Tax Act ("ITA") in respect of the qualified expenditures it incurred for that year.

In our view, XXXXXXXXXX had de jure control over XXXXXXXXXX for the following reasons: (i) XXXXXXXXXX was entitled to control XXXXXXXXXX board of directors ("Board") for a portion of its 2005 taxation year pursuant to the terms of a shareholders agreement dated XXXXXXXXXX , and (ii) the Board retained the managerial powers required to effectively control XXXXXXXXXX affairs and fortunes until the XXXXXXXXXX was revoked on XXXXXXXXXX . Being controlled by a public corporation for that period of time, XXXXXXXXXX did not qualify as a CCPC throughout its 2005 taxation year. Therefore, XXXXXXXXXX was not entitled to claim a refundable ITC for that year.

Although that would be sufficient to dispose of the present matter, we nevertheless felt compelled to address the additional issues you raised in your request for technical assistance regarding the scope of paragraphs 125(7)(a) and (b) of the CCPC definition, the scope of the selective application of paragraph 251(5)(b) further to the release of the Federal Court of Appeal decision in Sedona Networks Corp. v. R. 2007 DTC 5359 and the circumstances that may give rise to XXXXXXXXXX de facto control over XXXXXXXXXX . For clarification purposes, you must keep in mind that we did not rely upon our understanding of the law applicable to such issues in support of our conclusion in the present matter.

Facts

General

On XXXXXXXXXX was incorporated under the Business Corporations Act XXXXXXXXXX ("BCA") with an authorized capital of an unlimited number of common shares ("CS"), and an unlimited number of XXXXXXXXXX preference shares ("PS") [Paragraph XXXXXXXXXX of the Preamble of the Shareholders Agreement dated XXXXXXXXXX ].

The composition of XXXXXXXXXX management team during its 2004 and 2005 taxation years was as follows: XXXXXXXXXX

During its 2004 and 2005 taxation years, the Board included, among others, XXXXXXXXXX . XXXXXXXXXX Board was very active providing it with strategic vision and financial advice while remaining involved in day-to-day activities surrounding XXXXXXXXXX products and sales [XXXXXXXXXX ]

XXXXXXXXXX

XXXXXXXXXX qualifies as a "public corporation", as defined in subsection 89(1) of the ITA, since its shares are traded on the XXXXXXXXXX .

We have also assumed that XXXXXXXXXX does not qualify as a "prescribed venture capital corporation" as defined in section 6700 of the Income Tax Regulations.

XXXXXXXXXX shareholders, directors and corporate officers did not own any CS (including options, XXXXXXXXXX in XXXXXXXXXX during its 2004 and 2005 taxation years [XXXXXXXXXX ].

XXXXXXXXXX did not own CS or any other participation interest in XXXXXXXXXX during XXXXXXXXXX 2004 and 2005 taxation years. Moreover, they were not related to XXXXXXXXXX shareholders, management team and directors during that period of time [XXXXXXXXXX ].

History of proceedings

Audit concluded XXXXXXXXXX could not claim refundable ITCs because it was not a CCPC throughout its 2005 taxation year. More particularly, the auditor determined XXXXXXXXXX did not qualify as such because XXXXXXXXXX , a public corporation, had legal control over XXXXXXXXXX because it owned XXXXXXXXXX % of its CS on XXXXXXXXXX . Audit primarily relied upon the definition of CCPC in paragraph 125(7)(b) of the ITA to support its views [TSO Referral to the Technical Guidance Division dated April 24, 2007].

On XXXXXXXXXX , you submitted a request for a technical interpretation to Rulings to clarify the approach to be used to determine whether the CCPC status of a corporation such as XXXXXXXXXX may be compromised when a large number of options, XXXXXXXXXX were issued to both qualifying and disqualifying shareholders, and the Board is stripped of its ability to make significant decisions affecting the future of the corporation [Technical Guidance Division Referral to Rulings dated September 21, 2007].

The Shareholders Agreement dated XXXXXXXXXX

XXXXXXXXXX acquired CS in XXXXXXXXXX from XXXXXXXXXX pursuant to a Share Purchase Agreement (Paragraph XXXXXXXXXX of the Preamble).

On XXXXXXXXXX shareholders included XXXXXXXXXX

On XXXXXXXXXX held options respectively entitling them to acquire an additional XXXXXXXXXX CS in XXXXXXXXXX

XXXXXXXXXX

On XXXXXXXXXX , the shareholders entered into XXXXXXXXXX , which was described as a "unanimous shareholder agreement" ("USA") as defined in subsection 108(2) of the OBCA (XXXXXXXXXX ).

XXXXXXXXXX superseded and restated in its entirety a previous shareholders agreement dated XXXXXXXXXX

XXXXXXXXXX specifically provided that:

Any shareholder who owned more than 50% of the issued and outstanding voting shares shall be entitled to nominate such number of additional directors so as to give such shareholder control of the Board (XXXXXXXXXX ).

Any of the following decisions had to be ratified by shareholders holding at least XXXXXXXXXX % of the issued and outstanding voting shares: (i) change in the number of directors (ii) amendment of its articles of incorporation and/or by-laws (iii) sale of all or substantially all of its assets and/or undertakings (iv) re-organization, dissolution or wind-up (v) dividend payments (vi) redemption of its share capital (vii) issuance of securities, debt and guarantees (XXXXXXXXXX ).

The XXXXXXXXXX shall not be amended except by a written agreement executed by shareholders holding at least XXXXXXXXXX % of the voting shares (XXXXXXXXXX ).

The XXXXXXXXXX also granted various pre-emptive rights to the shareholders if one of them intended to dispose of all or any part of his CS (including options XXXXXXXXXX , or was deemed to have withdrawn from XXXXXXXXXX business further to the occurrence of specific triggering events. Similar pre-emptive rights were granted to the shareholders if XXXXXXXXXX intended to issue CS (including options XXXXXXXXXX ) to third parties (XXXXXXXXXX ).

XXXXXXXXXX

On XXXXXXXXXX , the shareholders entered into a XXXXXXXXXX to specifically provide that the provisions of XXXXXXXXXX shall not be interpreted as conferring to XXXXXXXXXX de jure or de facto control over XXXXXXXXXX , and, if they did, shall be deemed not to have been written (XXXXXXXXXX ) ("Escape Clause").

XXXXXXXXXX shareholding XXXXXXXXXX on XXXXXXXXXX

On XXXXXXXXXX , the following persons held XXXXXXXXXX CS: XXXXXXXXXX

Between XXXXXXXXXX , options to acquire XXXXXXXXXX CS were granted to the following persons: XXXXXXXXXX

XXXXXXXXXX )]

As a result, the following persons held options to acquire CS in XXXXXXXXXX on XXXXXXXXXX : XXXXXXXXXX

The options were intended to attract, retain and motivate XXXXXXXXXX directors, officers, consultants and key employees by providing them with an opportunity to acquire a proprietary interest in that company. They were granted pursuant to a XXXXXXXXXX dated XXXXXXXXXX , which determined the persons eligible to be granted options, and imposed various limitations upon their exercise. The options could be exercised at prices ranging from $XXXXXXXXXX to $XXXXXXXXXX per share pursuant to the terms of an XXXXXXXXXX they entered into with XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX controlling interest in XXXXXXXXXX on XXXXXXXXXX

As of XXXXXXXXXX owned XXXXXXXXXX % of the CS in XXXXXXXXXX . That entitled XXXXXXXXXX to nominate a sufficient number of directors to control the Board.

XXXXXXXXXX would have owned XXXXXXXXXX % of the voting shares in XXXXXXXXXX if it had been the only person exercising the options XXXXXXXXXX it held on or about XXXXXXXXXX in accordance with the selective application of paragraph 251(5)(b) of the ITA [XXXXXXXXXX ].

Had all the option XXXXXXXXXX holders exercised the rights they held on or about XXXXXXXXXX would have owned XXXXXXXXXX % of the voting shares in XXXXXXXXXX (fully-diluted basis) (XXXXXXXXXX

XXXXXXXXXX

On XXXXXXXXXX , the following persons held XXXXXXXXXX CS: XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX shareholding XXXXXXXXXX on XXXXXXXXXX

The persons holding XXXXXXXXXX CS remained identical between XXXXXXXXXX with the exception of XXXXXXXXXX acquisition of XXXXXXXXXX additional CS in XXXXXXXXXX

As a result, the following persons held XXXXXXXXXX CS on XXXXXXXXXX

The persons holding options to acquire XXXXXXXXXX CS remained identical between XXXXXXXXXX

As a result, the following persons held options to acquire CS in XXXXXXXXXX on XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX controlling interest in XXXXXXXXXX on XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX held between XXXXXXXXXX % and XXXXXXXXXX % of XXXXXXXXXX CS XXXXXXXXXX , which provides the rules pertaining to the nomination of the Board. As a result, XXXXXXXXXX had control of the Board for the portion of XXXXXXXXXX 2005 taxation year preceding XXXXXXXXXX .

XXXXXXXXXX would have owned XXXXXXXXXX % of all the voting shares in XXXXXXXXXX if it had been the only person exercising the options XXXXXXXXXX it held prior to XXXXXXXXXX in accordance with the selective application of paragraph 251(5)(b) of the ITA

XXXXXXXXXX

XXXXXXXXXX no longer had the ability to control the Board for the remainder of XXXXXXXXXX 2005 taxation year pursuant to XXXXXXXXXX .

XXXXXXXXXX would have owned XXXXXXXXXX % of all the shares in XXXXXXXXXX (including any convertible option, XXXXXXXXXX ) (XXXXXXXXXX ) if we had disregarded the options, XXXXXXXXXX issued to other participants pursuant to a selective application of paragraph 251(5)(b) as of XXXXXXXXXX .

Should we rather assume that all the options, XXXXXXXXXX holders exercised their rights on or about XXXXXXXXXX would have owned XXXXXXXXXX % of all the shares in XXXXXXXXXX (including any convertible option, XXXXXXXXXX ) (XXXXXXXXXX ) on XXXXXXXXXX .

Issue

Whether XXXXXXXXXX CCPC status was compromised because XXXXXXXXXX had de jure or de facto control over that corporation during its 2005 taxation year.

Analysis

The facts of the present matter are unusually complex because: (i) a public corporation owned a significant number of shares and convertible securities in XXXXXXXXXX ; (ii) XXXXXXXXXX granted a large number of options, XXXXXXXXXX , which could trigger the application of paragraph 251(5)(b) of the ITA; and (iii) the management of XXXXXXXXXX business operations was subject to XXXXXXXXXX .

We will first identify the principles established by the Courts about the scope of paragraphs 127(5)(a) and (b) to the CCPC definition, and the anti-avoidance rule included in paragraph 251(5)(b) of the ITA. We will then determine the impact of the USAs on the ability of the Board to effectively control XXXXXXXXXX business operations before assessing the impact, if any, of the options, XXXXXXXXXX issued by XXXXXXXXXX . Finally, we will review the principal approaches that may support a de facto control determination in the present matter.

The applicable approach

According to paragraph 125(7)(a) of the ITA, a CCPC is a private corporation that is a Canadian corporation unless it is controlled, directly or indirectly in any manner whatever, by one or more non-residents or public corporations ("disqualifying shareholders").

In Silicon Graphics Ltd. v. Queen 2002 DTC 7112 (FCA), the Court stated that the determination of control under paragraph 125(7)(a) of the ITA is not merely based on the number of shares owned by disqualifying shareholders. Instead, the corporation's share register and constating documents must be reviewed in accordance with the principles stated in Duha Printers (Western) Ltd. v. Queen 98 DTC 6334 (SCC) to determine whether disqualifying shareholders had the legal ability to control the corporation's affairs and fortunes. In that regard, any right conferred on a person to acquire shares of the corporation will be relevant in making such a determination since paragraph 251(5)(b) of the ITA provides that such a person is deemed to have been in the same position in relation to the control of that corporation as if the person owned the shares at that time. The ability of disqualifying shareholders to influence the management of the corporation's affairs will also be taken into consideration in determining whether they had, pursuant to subsection 256(5.1) of the ITA, de facto control of that corporation for the purposes of paragraph 125(7)(a) of the ITA.

In order to further clarify the scope of the CCPC definition, Parliament introduced an aggregation rule in paragraph 125(7)(b) of the ITA to prevent a widely held corporation the majority of shares of which are owned by disqualifying shareholders from qualifying as a CCPC. However, it was recently established in Perfect Fry Co. v. Queen 2007 DTC 588 (TCC) that paragraph 125(7)(b) of the ITA was not intended to require the attribution of ownership to a hypothetical shareholder where the same person owns all the disqualifying shares of that corporation. In effect, the Court stated that it is unlikely that Parliament intended to apply paragraph 125(7)(b) to situations where de jure control of the corporation can otherwise be established.

In such circumstances, it is our view that the two-step analysis typically relied upon in the operation of paragraph 127(5)(b) is not applicable. Instead, a determination of control will be made pursuant to paragraph 127(5)(a) of the ITA, which requires a comprehensive assessment of the ability of disqualifying shareholders to legally or factually control that corporation.

De jure control of XXXXXXXXXX

Although it will not have an immediate impact on the de jure control determination to be made in the present matter, we will first clarify the impact of Sedona Networks on the CRA's ability to rely upon a selective application of paragraph 251(5)(b) of the ITA. We will then apply the principles established in Duha Printers to determine whether a disqualifying shareholder such as XXXXXXXXXX retained the ability to dictate the course of XXXXXXXXXX business operations in light of the powers conferred to its shareholders pursuant to XXXXXXXXXX .

The selective application of subparagraph 251(5)(b)(i) of the ITA

Despite the release of the Sedona Networks case, we believe the CRA is entitled, where appropriate, to rely upon a selective application of paragraph 251(5)(b) on the basis of a textual, contextual and purposive interpretation of that provision.

The scope of Sedona Networks

In Sedona Networks, the Court took into consideration the options granted to both qualifying and disqualifying shareholders in determining whether the taxpayer qualified as a CCPC for the taxation year under dispute. Although the Court apparently disregarded CRA's long-standing policy regarding the selective application of paragraph 251(5)(b) to the CCPC definition, we nevertheless believe it does not explicitly preclude its application when the rights listed in that provision are granted to preserve the CCPC status of a corporation otherwise controlled by a disqualifying shareholder 1 .

We note the Court had already determined that the corporation would be controlled by the hypothetical person referred to in paragraph 127(5)(b) when it proceeded to determine the impact of the options granted to non-resident/public and resident/non-public persons. Given that the decisions in Yardley Plastics of Canada v. MNR 66 DTC 5183 (Ex.Ct.) and Viking Food Products Ltd. v. MNR 67 DTC 5067 (Ex.Ct.) have clearly established that paragraph 251(5)(b) (formerly subsection 139(5d) of the Income Tax Act RSC 1952 c. 148) ("1952 ITA") was intended to enlarge rather than restrict the notion of control, we believe that the Court's comments were unnecessary to dismiss the taxpayer's claim for refundable tax credits. Therefore, we consider the Court's findings regarding the application of paragraph 251(5)(b) as obiter statements, which should not be binding on the CRA.

Although the Court in Sedona Networks appears to have implicitly considered that paragraph 251(5)(b) must be applied by simultaneously considering the rights held by all persons, it has not explicitly disregarded CRA's reliance on a selective application of that provision to challenge avoidance schemes intended to circumvent the statutory limitations applicable to the CCPC definition.

A textual, contextual and purposive interpretation of paragraph 251(5)(b)

In our view, a textual, contextual and purposive interpretation of paragraph 251(5)(b) provides sufficient grounds for applying that provision on a holder-by-holder basis where public/non-resident persons attempt to dilute their shareholding in a particular corporation to take advantage of the significant tax benefits associated with that corporation's CCPC status.

Textual

The CRA's selective application of paragraph 251(5)(b) mostly relied upon a textual approach distinguishing the wording of that provision from the one found in paragraph 256(1.4)(a) of the ITA 2 . For the purpose of determining whether a corporation is associated with another under paragraph 256(1.4)(a), it has always been CRA's view that control of a corporation must be determined on the basis that all the rights granted are exercised simultaneously since the wording of that provision states that a right holder shall be deemed to own the shares, which are deemed to be issued and outstanding at that time. According to the CRA, paragraph 251(5)(b), which states that a right holder shall be deemed to be in the same position in relation to the control of the corporation as if the person owned the shares at that time, does not specifically provide that the shares subject to the rights are deemed to be issued and outstanding at that time. For that reason, the CRA held that a selective determination of individual rights must be performed under paragraph 251(5)(b) for the purpose of the CCPC definition.

In Sedona Networks, the Court confirmed that the "legal fiction created by paragraph 251(5)(b) is directed at the concepts of ownership". The CRA has never disputed the legal validity of such an assertion, which was apparently intended to dismiss the trial judge's findings in that regard 3 . For that reason, we do not believe the Court's statement referred to above should be interpreted as an outright rejection of the textual approach relied upon by the CRA in support of a selective application of paragraph 251(5)(b) for the purpose of the CCPC definition.

In light of the above, it is reasonable to suggest that the wording of paragraph 251(5)(b) does not clearly provide whether the rights referred to in that provision shall be exercised simultaneously or separately. In such circumstances, a greater emphasis must be placed on the context and the legislative purpose underlying paragraph 251(5)(b) to resolve the latent ambiguity of that provision 4 .

Contextual and purposive

Paragraph 251(5)(b) was amended 5 to extend its application for the purpose of determining whether a corporation qualifies as a CCPC and, as a result, is eligible to claim the tax incentives provided to such corporations 6 . In order to better understand the tax policy considerations applicable to the interplay of paragraph 251(5)(b) (formerly subsection 139(5d) of the 1952 ITA) and the CCPC definition, we have to identify the legislative intent underlying the restrictions applicable to small businesses controlled by a public corporation as well as the introduction of paragraph 251(5)(b) soon after the enactment of the 1952 ITA.

The tax policy underlying the limitations introduced to the CCPC definition

In that regard, Parliament has long recognized the contribution of "small businesses" to the economic well-being of Canada, and the need to provide them with tax incentives to encourage their development. That triggered the introduction of a lower corporate tax rate applicable to "small businesses", which was meant to alleviate the difficulty they had in raising capital to enlarge the scope of their business operations. Moreover, it was intended to provide "small businesses" with the ability to retain a larger portion of their profits to fund their growth, expansion and modernization. In order to improve the effectiveness of the reduced corporate tax rate applicable to "small businesses", it was subsequently determined that "large corporations" such as public corporations and their subsidiaries should not be entitled to take advantage of such a tax incentive because they already have access to the capital markets to finance their operations 7 . The tax policy objectives stated above were subsequently embodied into the statutory definition of CCPC 8 , which specifically precludes a corporation controlled, directly or indirectly, by a public corporation from taking advantage of the various tax incentives provided to small businesses 9 .

The tax policy underlying the introduction of paragraph 251(5)(b)

Paragraph 251(5)(b) was apparently introduced in response to the Courts' reluctance to challenge schemes intended to circumvent the limitations imposed on the capital cost allowance to be claimed by a non-arm's-length transferee 10 . Prior to the amendment of the Act, a corporation and a person "directly or indirectly controlling" that corporation, and corporations "directly or indirectly controlled" by the same person were deemed not to deal with each other at arm's length 11 . In such cases, the Courts disregarded the transferor's contractual undertaking to acquire a controlling interest in the transferee 12 soon after the acquisition of the disputed property to conclude they were dealing at arm's length at the time of the transfer 13 .

The Courts' refusal to rely upon a liberal interpretation of the terms "indirectly controlled" to address what was referred to as the "stepped-up basis loophole" 14 prompted the introduction of subsection 139(5d) 15 , which was intended to prevent taxpayers having the ability to acquire legal control of a corporation from by-passing specific statutory requirements to reduce their liability to pay tax 16 . In Viking Foods Products Ltd. v. MNR 67 DTC 5067, 5070 (Ex Ct), the Court later confirmed that the legislative intent underlying provisions such as subsection 139(5d) of the 1952 ITA, which are intended to deny a tax benefit that would otherwise be available to a taxpayer in computing its tax payable, is to guard against tax avoidance.

The circumstances that may give rise to a selective application of paragraph 251(5)(b)

In light of the above contextual and purposive analysis, it appears reasonably clear that paragraph 251(5)(b) was intended to prevent taxpayers from relying upon the issuance of various rights to its shareholders to avoid compromising its CCPC status where a disqualifying person such as a public corporation has the ability to legally control the conduct of its business affairs. Despite the apparent uncertainty following the decision in Sedona Networks, it is our view that the CRA is entitled to apply paragraph 251(5)(b) selectively to disregard the rights and options issued to shareholders to circumvent the restrictions embodied in the CCPC definition.

Without limiting the generality of the above comments, we believe a selective application of paragraph 251(5)(b) would be warranted where the terms of the rights and options issued are such that it is reasonable to assume they would never be exercised, or, alternatively, where the controlling shareholder, members of the board of directors or corporate officers of a disqualifying corporation have the ability to influence, directly or indirectly, the recipient of such rights and options.

The impact of the shareholders agreements

In Duha Printers (Western) Ltd. v. Queen 98 DTC 6334 (SCC), the Court stated that the control test established in Buckerfield's Ltd. v. MNR 64 DTC 5301 (Ex Ct) is essentially an attempt to determine who is in effective control of the affairs and fortunes of the corporation:

"However, it must be recognized at the outset that this test is really an attempt to ascertain who is in effective control of the affairs and fortunes of the corporation. That is, although the directors generally have [...] the formal right to direct the management of the corporation, the majority shareholder enjoys the indirect exercise of this control through his or her ability to elect the board of directors."

Moreover, the Court held that any restrictions to the managerial powers of the board of directors included in constating documents such as a USA must be taken into consideration in making a de jure control determination:

"As I have said, the essential purpose of the Buckerfield's test is to determine the locus of effective control of the corporation [...] When a constating document such as a USA provides that the legal authority to manage the corporation lies other than with the board, the reality of de jure control is necessarily altered and the court must acknowledge that alteration."

Finally, the Court provided the following guidelines to determine when a majority shareholder no longer has de jure control over a corporation by reason of the existence of a USA:

"The appellant correctly points out that to recognize the USA as affecting de jure control begs the question of how much control must be removed from the directors before one may safely conclude that the majority voting shareholder no longer has de jure control. Certainly, the existence of a USA does not necessarily imply the loss of de jure control. [...] [T]his issue comes down to a question of fact, turning on the extent to which the powers of the directors to manage are restricted, to what extent these powers have devolved to the shareholders, and to what extent the majority shareholders are thereby able to control the exercise of the governing powers [...] As I have already said, the simple fact that the shareholders of a corporation have entered into a USA does not have the automatic effect of removing de jure control from a shareholder who enjoys the majority of the votes in the election of the board of directors [...] In my view, it is possible to determine whether de jure control has been lost as a result of a USA by asking whether the USA leaves any way for the majority 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 (as contemplated by the Buckerfield's test)."

We do not dispute that the XXXXXXXXXX qualify as a "unanimous shareholder agreement" pursuant to subsection 108(2) of the Business Corporations Act (RSO, 1990, c. B-16). However, it is our view that the fact that the Board was stripped of its ability to approve exceptional decisions intended to: (i) change the nature of XXXXXXXXXX business undertaking, (ii) alter XXXXXXXXXX organizational and capital structure, and (iii) amend or repeal XXXXXXXXXX articles of incorporation does not materially alter the de jure control determination having to be made in the present matter. More particularly, we do not believe that the powers vested with XXXXXXXXXX shareholders under the XXXXXXXXXX were significant enough to suggest that XXXXXXXXXX no longer had the ability to exercise effective control over XXXXXXXXXX business operations for the portion of its 2005 taxation year that was subject to the XXXXXXXXXX . Therefore, XXXXXXXXXX had de jure control over XXXXXXXXXX during that period of time.

Furthermore, it is our view that the Escape Clauses included in the XXXXXXXXXX will not be determinative in making such a control determination. In effect, XXXXXXXXXX cannot rely upon the Escape Clauses found in paragraphs XXXXXXXXXX of the XXXXXXXXXX to contractually re-characterize any control determination, factual or legal, arising from the application of legal principles to XXXXXXXXXX business operations. Moreover, XXXXXXXXXX cannot rely upon the Escape Clauses found in paragraphs XXXXXXXXXX of the Clarification XXXXXXXXXX to retroactively deem any provision of the USAs having unexpectedly resulted in XXXXXXXXXX legal or factual control of XXXXXXXXXX not to have been written to avoid adverse tax consequences. In both cases, it would result in an inappropriate reliance on a contractual fiction to retroactively re-characterize the facts and the law applicacle in support of a control determination for tax-motivated reasons.

Conclusion

XXXXXXXXXX can only claim a refundable ITC if it was a CCPC throughout its 2005 taxation year. In order to make such a determination, we have to determine whether XXXXXXXXXX legally controlled XXXXXXXXXX pursuant to the terms of the XXXXXXXXXX . In that regard, any control determination will be subject to the application of paragraph 251(5)(b), which may be applied selectively where it appears that the rights and options were issued to circumvent the statutory limitations applicable to the CCPC definition.

In our view, XXXXXXXXXX retained the ability to control XXXXXXXXXX Board, and, as a result, dictate the course of its business operations for the portion of its 2005 taxation year that was subject to the XXXXXXXXXX . Given that paragraph 251(5)(b) was intended to enlarge rather than restrict the notion of control, it was unnecessary to determine the impact, if any, of a selective application of the rights granted by XXXXXXXXXX prior to XXXXXXXXXX . Finally, we do not believe that the powers granted to XXXXXXXXXX shareholders pursuant to XXXXXXXXXX of the XXXXXXXXXX are significant enough to compromise XXXXXXXXXX ability to effectively control XXXXXXXXXX affairs and fortunes.

In light of the above, XXXXXXXXXX had de jure control over XXXXXXXXXX during the portion of its 2005 taxation year that preceded the introduction of the XXXXXXXXXX . Being controlled by a public corporation during that period of time, XXXXXXXXXX was not entitled to claim a refundable ITC because it did not qualify as a CCPC throughout its 2005 taxation year

Given that the terms of the XXXXXXXXXX no longer provide XXXXXXXXXX with the ability to control the Board, we have provided you with our views regarding the circumstances that may support a de facto control determination in the present matter. Although the following comments reflect our understanding of the law applicable to such circumstances, you must keep in mind that we did not rely upon such views in concluding that XXXXXXXXXX was not entitled to claim a refundable ITC for its 2005 taxation year.

De facto control of XXXXXXXXXX

According to paragraph 125(7)(a) of the ITA, a corporation will not qualify as a CCPC if it is "controlled, directly or indirectly in any manner whatever by [...] one or more public corporations". The wording of that provision specifically refers to de facto control, which is defined in subsection 256(5.1) as any direct or indirect influence that, if exercised, would result in control in fact of that corporation.

The Courts have expressed divergent views regarding the scope to be given to de facto control defined in subsection 256(5.1) of the ITA. A narrower approach was used in Silicon Graphics Ltd. where the determining factor was the ability of a given party to influence the composition of the Board of Directors, or the way the Board members exercise their powers. However, a broader approach was used in Mimetix International Inc. v. R. 2001 DTC 1026 (TCC) affirmed by 2003 DTC 5194 (FCA), and 9044-2807 Quebec Inc. v. R. 2004 DTC 6636 (FCA) where the operational control of a corporation over another was an essential consideration in determining whether de facto control existed.

In that regard, the CRA has confirmed that the circumstances giving rise to de facto control are not as narrow as those set out in Silicon Graphics 17 . Although it is the CRA's view that the broad approach 18 described in Mimetix International Inc. and 9044-2807 Quebec Inc. can be used for determining whether factual control exists for the purposes of the ITA, we will nevertheless apply the tests described above to the facts of the present matter to determine whether a disqualifying person had de facto control over XXXXXXXXXX during its 2005 taxation year.

Board control

In Silicon Graphics Ltd., the Court appears to have linked the extent of the influence required to give rise to de facto control to the Buckerfield's test, as modified by Duha Printers, which was established to determine the existence of de jure control:

"The case law suggests that in determining whether de facto control exists it is necessary to examine external agreements (Duha Printers, supra at 825); shareholder resolutions (Société Foncière d'Investissement Inc. v. Canada, [1996] TCJ No. 1568, para. 10 (TCC)); and whether any party can change the board of directors or whether any shareholder's agreement gives any party the ability to influence the composition of the board of directors (International Mercantile Factors Ltd. v. The Queen (1990), 90 DTC 6390 at 6399 (FCTD), aff'd (1994), 94 DTC 6365 (FCA); and Multiview Inc. v. The Queen (1997), 97 DTC 1489 at 1492-93 (TCC)). It is therefore my view that in order for there to be a finding of de facto control, a person or group of persons must have the clear right and ability to effect a significant 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." 19

In light of the test established in Silicon Graphics, XXXXXXXXXX could be deemed to have had de facto control over XXXXXXXXXX if it had the clear ability to influence the managerial powers vested with other Board members. The level of influence having to be established will arguably not be satisfied on the basis of circumstantial and coincidental evidence. In that regard, we have not been provided with any conclusive evidence that a disqualifying shareholder such as XXXXXXXXXX had the ability to influence the voting rights held by other Board members, and, as a result, dictate the management of XXXXXXXXXX business operations for its 2005 taxation year.

For the purpose of reviewing XXXXXXXXXX entitlement refundable ITC in respect of its 2006 and subsequent taxation years, we would recommend that the relationship existing between XXXXXXXXXX and other Board members such as XXXXXXXXXX be clarified to determine whether it had the ability to influence the exercise of their managerial and governing powers.

Operational control

As mentioned previously, recent Court decisions have relied upon a broader approach to factual control where all the circumstances pertaining to the management of a corporation are taken into consideration to determine who has the effective control over its affairs and fortunes.

In Mimetix Pharmaceuticals Inc v. R. 2001 DTC 1026 (TCC), the Court held that de facto control may arise where a person has the ability to interfere with the management responsibilities conferred on the board of directors, and actually dictate the course of its business operations on the basis of the economic influence it exerts on that corporation 20 . In 9044-2807 Quebec Inc. v. R. 2004 DTC 6636 (FCA), the Court upheld the trial judge's reliance on factors such as operational control, economic dependence and family connections to conclude the same person had de facto control over two (2) corporations, which were deemed to be associated pursuant to subsection 256(1) of the ITA.

In light of the above, it is the CRA's view that the narrower approach established in Silicon Graphics should not prevail in making a factual control determination. More particularly, we believe that the factors listed in Interpretation Bulletin IT-64R4 (paragraph 23) remain valid to determine whether de facto control exists for the purposes of the ITA

Although XXXXXXXXXX did not have de jure control over XXXXXXXXXX , we note that it held veto rights regarding most of the significant decisions pertaining to XXXXXXXXXX business. In our view, XXXXXXXXXX ability to paralyze XXXXXXXXXX business through the exercise of such veto rights is not sufficient to trigger de facto control of that corporation. More particularly, we doubt such a position can be reconciled with the principles established in Multiview Inc. v. R. 97 DTC 1489 (TCC) and Lenester Sales Ltd. v. R. 2004 DTD 6461 (FCA). In both cases, a shareholders agreement provided for an equal representation on the board of directors such that both persons had the ability to veto any decision pertaining to the corporation's business. Despite the absence of a mechanism intended to prevent the adverse consequences that may result from deadlocked voting rights, the Courts concluded the holders of such veto rights did not have de facto control over that corporation. Unless a person has the ability to determine the way a corporation's affairs are being conducted, it appears that the negative influence resulting from the exercise of veto rights would not give rise to de facto control

The foregoing appears to agree with CRA's views stated in technical interpretation 2000-0038085, which provides that de facto control will not automatically arise where a shareholder has veto rights over the occurrence of events such as: (i) the merging or dissolution of a corporation (ii) changes to its articles of incorporation or by-laws (iii) the issuing of additional shares, or (iv) the purchase of shares in a corporation.

We must say it appears somewhat counter-intuitive that a XXXXXXXXXX such as XXXXXXXXXX would relinquish operational control over the corporations XXXXXXXXXX . However, we were not provided with enough information to support a de facto control determination on the basis of the principles established in Mimetix International and 9044-2807 Quebec.

As indicated above, we would recommend that XXXXXXXXXX influence on XXXXXXXXXX business operations be closely examined if an auditor were to challenge its entitlement to refundable ITC for its 2006 and subsequent taxation years on the basis that XXXXXXXXXX had de facto control over XXXXXXXXXX .

Conclusion

XXXXXXXXXX had de jure control over XXXXXXXXXX for the portion of its 2005 taxation year it was subject to the XXXXXXXXXX . Being controlled by a public corporation for a portion of its 2005 taxation year, XXXXXXXXXX was not entitled to claim a refundable ITC for that year.

Mark Symes
Manager
Corporate Reorganizations Section I
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES

1 The preliminary reasons in support of the CRA's views regarding the impact of the Sedona Networks decision on CCPC determination were provided in response to Question 9 at the CRA Round Table (2007 Annual Conference-Canadian Tax Foundation), which were subsequently reported in technical interpretation 2007-0255501
2 CRA's long-standing views in that regard can be found in the following technical interpretations 2001-0092035, 2003-0048571C6 and 2004-0086761C6

3 Sedona Networks Corporation v. The Queen 2006 DTC 2486 (TCC) at paragraph 13

4 Placer Dome Ltd. v. Ontario (Minister of Finance) 2006 DTC 6532 (SCC) at paragraphs 22 and 23

5 SC 1984 c. 45 s. 94
6 Department of Finance, Technical Notes to a Bill Amending the Income Tax Act and Related Statutes, November 8 1984
7 Canada, Standing Senate Committee on Banking, Trade and Commerce, Report on the White Paper Proposals for Tax Reform Presented to the Senate of Canada, Ottawa, 1970, p. 80-82; Canada, Eighteenth Report of the Standing Committee on Finance, Trade and Economic Affairs Respecting the White Paper on Tax Reforms, Ottawa, 1970, p. 104, 108;

8 The concept of CCPC was first defined in paragraph 126(1)(a) of the Income Tax Act RSC 1970-71-72 c.63 as follows: "Canadian-controlled private corporation" means a private corporation that is a Canadian corporation other than a corporation controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, by one or more public corporations or by any combination thereof".

9 William J. Strain, "The Small Business Rules: O What a tangled Web", 1982 Conference Report 53, at 59-60

10 Subsection 8(3) of the Income Tax Act SC 1949 c. 25 (subsequently subsection 20(4) of the 1952 ITA) essentially deemed the undepreciated capital cost ("UCC") of a transferred property to be equal to the capital cost of that property for the transferor where the transferor and the transferee were not dealing at arm's length at the time of the transfer.

11 Paragraphs 139(5)(a) and (b) of the 1952 ITA

12 Rous & Mann Press Ltd. v. MNR 53 DTC 326, 329-330 (TAB)

13 Ballantyne Company Ltd. v. MNR 52 DTC 115, 118 (TAB); MNR v. Sheldons Engineering Ltd 54 DTC 110, 112 (Ex Ct)

14 John G. MacDonald, "The Arm's Length Concept" 1955 Canadian Tax Journal 25, 32

15 SC 1953-54 c.57 s. 31

16 Philip Vineberg, "New Arm's length Definition", 1954 Conference Report 67; Heward Stikeman, "History of Bill 467", The Canada Tax Service Letter, June 20, 1954

17 Canada Revenue Agency, Income Tax Technical News, No. 25, October 30, 2002

18 Canada Revenue Agency, Income Tax Technical News, No. 32, July 15, 2005

19 In 9044-2807 Québec Inc. v. Queen 2004 DTC 6636 (FCA), the Court reiterated that de facto control may arise, among other circumstances, where a person or a group of persons has the ability to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors.

20 In Mimetix Pharmaceuticals Inc. v. R. 2003 DTC 5194, the Federal Court of Appeal upheld the trial judge's conclusions, and dismissed the taxpayer's appeal.