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De Facto Control and Enhanced Scientific Research and Experimental Development Tax Credits in Quebec

25/10/2019


This article was previously published in the Canadian Tax highlights August edition and is reproduced with permission.

This article outlines the upside for a Quebec corporation that claims scientific research and experimental development (SR&ED) tax credits in the context of the relatively untested subsection 256(5.11) for interpreting de facto control. However, there are still remaining challenges that may not have been intended by the imposition of this legislation.

The internal technical interpretation (TI) released by Revenu Québec (RQ) (17-037925-001, September 25, 2017; see also "Non-Resident Control for Quebec Enhanced SR&ED ," Canadian Tax Highlights, May 2019) seems to offer promise for Quebec corporations that are not Canadian-controlled private corporations (CCPCs) through de jure control. The TI may enable them to benefit from enhanced SR&ED tax credits at the federal rate of 35 percent and at 30 percent provincially for Quebec. Corporations other than CCPCs (as defined in subsection 125(7)) can benefit from a lower federal rate of 15 percent and a provincial rate of 14 percent for Quebec.

As we shall see, the TI from RQ is a test case wherein a de jure non-CCPC corporation can be favourably treated as a de facto CCPC for the purposes of obtaining enhanced SR&ED tax credits. This treatment is applicable only under certain circumstances, but it is important to observe that such circumstances are easily conceivable.

In its TI, RQ considered the case of Mr. X, founder of Canco, who held 40 percent of its voting shares and was a non-resident of Canada. Canco's financing arrangements required Mr. X to be continually involved with its operation. Canco was not a CCPC because more than 50 percent of its shares were held by non-residents. In this fact pattern, the RQ auditor denied enhanced tax credit treatment for Canco on the basis of its de jure control. In contrast, RQ considered the critical role of Mr. X at the operational level and applied de facto control to him; however, RQ stated that Canco was not a CCPC solely because Mr. X was a non-resident. The results of the RQ auditor and RQ were identical but the rationales were not.

The impact of this TI should be understood in the wake of McGillivray Restaurant Ltd. v. Canada (2016 FCA 99) and the challenges in applying the notion of de facto control prior to that case. The primary question was whether there should be an operational consideration or a narrower test when there is an influence over the board of directors. McGillivray reaffirmed that the narrower test of de facto control applies when there is an influence at the board of directors' level; see also the decision in Silicon Graphics Ltd. v. Canada (2002 FCA 260). Proving influence at the board of directors' level in general can be onerous, especially for small to mid-sized technology corporations, which are constantly cash flow-starved and seeking funds for development work.

The court in McGillivray ruled against using influence at the operational level as a test for de facto control:

In my view, an interpretation of de facto control as contemplated by subsection 256(5.1) that fails to include a requirement that the influence in question must be grounded in a legally enforceable right or ability runs counter to the clear admonition of the Supreme Court of Canada in Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54 (CanLII), [2005] 2 S.C.R. 601 wherein, at paragraph 12, the Chief Justice and Justice Major unequivocally stated:

The provisions of the Income Tax Act must be interpreted in order to achieve consistency, predictability and fairness so that taxpayers may manage their affairs intelligently.

McGillivray went further to state that an interpretation based on operational control will lead to a certain level of subjectivity in the de facto control analysis; this unpredictability goes against the spirit of the law (the court referred to the Canada Trustco interpretive approach to control).

RQ's approach is important to consider, because the TI offers much-needed administrative support and clarification for the new de facto control rules following McGillivray, as stated in subsection 256 (5.11). The RQ rationale now allows for the possibility that a non-resident corporation may be treated as a CCPC for the purposes of enhanced SR&ED tax credits.

The following observations may be helpful (especially in regard to the impact of the TI):

  • Other cases have considered operational-level influence as a test for de facto control, such as Mimetix Pharmaceuticals Inc. v. Canada (2003 FCA 106). Such cases demonstrate the complexity and challenges of applying tests for de facto control.
  • The spirit of McGillivray preserves a legal basis for control owing to operational-level control and influence that is not otherwise clear. (See also Philip Friedlan and Adam Friedlan, "256(5.1) —De Facto Control: A Return to the Past," 2017 Ontario Tax Conference; and "Buckerfield to McGillivray—Testing CCPC Status: Can This Now Open a Pandora's Box," Taxnetpro Tax Dispute and Resolution Centre, RP-2018-13, 2018.)

Following McGillivray, Finance widened the de facto control test in subsection 256(5.11), effective March 21, 2017. The provision now tests the legal meaning of control using a high level of subjectivity, owing to its broad scope and generality. It states, inter alia, that factors are not limited to whether the taxpayer has a legally enforceable right or ability to effect a change in the board of directors of the corporation, to change the board's powers, or to exercise influence over the shareholder(s) by using that right or ability. This is a critical change that leads to the high level of subjectivity in this new legislation.

With the above observations in mind, consider a slight change to the example provided in the TI. Mr. X is now a Canadian resident. Also, as part of a market capitalization, Canco has issued voting shares, options, or contingent rights to multiple investors. This scenario is not uncommon for many small to mid-sized technology corporations that are constantly seeking cash flow for their development activities and sustainability.

Within the Act, control commonly refers to de jure control if share ownership carries a voting right and an ability to elect the board of directors (see Duha Printers (Western) Ltd. v. Canada, [1998] 1 SCR 795). The test for control was established in the well-known case, Buckerfield's Ltd. et al. v. MNR (64 DTC 5301 (Ex. Ct.)). Subsection 251(5) sets out rules for the purposes of the CCPC definition and, depending on the residence of the investors and combined voting rights, Canco may still be a non-CCPC. In CRA document no. 2015-0565741E5 (February 4, 2015), the CRA took the position that a private corporation was not a CCPC on the basis that subparagraph 251(5)(b)(i) applied to a contingent right to acquire shares of the corporation on a default event (the right was held by a public corporation).

Notwithstanding the legal conclusions based solely on a CCPC test, it appears that as long as Mr. X is operationally involved (in a significant manner) with Canco, the RQ TI allows Canco to be treated as a CCPC and to benefit from the enhanced rates when claiming its SR&ED  tax credits. There are some important questions that follow from such a conclusion. The list below is by no means exhaustive, but it is intended to illustrate certain, perhaps unintended, consequences of the RQ TI:

  • How will RQ's conclusions be accepted by other provinces, and what if Canco is multijurisdictional? This can strain the parity of treatment regarding CCPC status between different provinces. The Act does not differentiate based on province of residence of a corporation—including where a different province or a federal authority differs from RQ in its treatment regarding CCPC status.
  • As it stands, the RQ TI is likely an annualized test for CCPC status and will depend on Mr. X's residence, among other factors. This may increase the requirements for costly and continuous compliance for Canco in future taxation years.
  • Control can affect many other sections of the Act, and how this will be handled for Canco remains to be seen. Will there be a bigger difference in how reported income is taxed at the federal level (which may not recognize Quebec's test for CCPC status) and for Quebec purposes (which may allow CCPC status)? This issue is independent of Canco's ability to benefit from SR&ED tax credits.
  • Additionally, will there be a "deemed" de facto director under common law who can be held vicariously liable for any corporate liabilities? See Information Circular IC89-2R3. This can be an unintended consequence, and liabilities may be imposed even on a de facto director (see Wheeliker v. R, [1999] 2 CTC 395 (FCA)).

The RQ TI may be welcome news for technology corporations, and its benefits may be extended to other industries, but it has raised and rekindled some important and complex questions relating to control of a corporation. There might be some beneficial planning opportunities for Quebec-based technology corporations, but the complexity of disentangling legal control from operational control still remains an unresolved consequence of subsection 256(5.11).

For more information, contact Bal Katlai, Manager, Canadian Corporate Tax, at 514.228.7858 or [email protected]