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New Tax Rules Challenge Corporate Status

07/01/2019


By Balaji Katlai PhD, CPA, CGA

Part One of a two-part series on how changes to tax rules can impact investment in start-ups.

New tax legislation that broadens the scope of what constitutes control over a private corporation could impact technology-based corporations and start-ups by changing how investment tax credits are accessed.

Control and Corporate Tax Structure

Control of a corporation is either via a legal shareholder agreement leading to a legal control or “de jure” control, or by virtue of factual control, leading to "de facto" control with a broader interpretation for control of a corporation.

Control is pertinent when understanding the corporation's tax structure and the tax benefits that a corporation can receive, including within group structures (association rules) and distribution of expense limits within the corporate group(s) when considering investment tax credits.

Changes to the federal Income Tax Act around control of a corporation and how the Canada Revenue Agency (CRA) interprets them can lead to unintended / unexpected and undesired results such as eliminating the original stature as a Canadian controlled private corporation (CCPC) and the associated tax benefits.

De Facto Control

A de facto control is when a corporation is directly or indirectly controlled in any manner by another corporation, person or group of persons.

The 2017 federal budget proposed new subsection 256(5.11) into  the Income Tax Act applicable to all corporations with tax years after March 21, 2017. This legislation outlined “all relevant factors” that should be considered when determining if a taxpayer had any direct or indirect influence that would result in control of a corporation.

Prior to the introduction of the new subsection, a de facto control didn’t extend to the operational aspect of the corporation. Therefore, it remained a limited test for a factual control.

Now, factors would not be limited to whether the taxpayer has a legally enforceable right or ability to effect a change in the board of directors of the corporation, or the board's powers, or to exercise influence over the shareholder or shareholders who have that right or ability.

The purpose of the new legislation was to ensure that certain CCPCs did not take advantage of the preferential tax rates and benefits otherwise allowed for a CCPC.

Impact to CCPCs

The introduction of the new legislation broadened the notional scope of factual control. Specifically, it now includes examination of actual day-to-day operations, not just determining if there was a control over the board of directors.

There are no current guidelines for how the CRA can perform such a test for de facto control. Hence, a CRA interpretation of control can (unfortunately) be a subjective approach towards determining the CCPC status.

Consequently, this can inadvertently limit or even eliminate an otherwise CCPC structure from being able to access preferential tax benefits. This can be a death blow for certain businesses, such as start-ups and technology-based corporations, which often seek heavy market capitalizations for continuous development of new technologies.

Capitalization and Tax Consequences

Both a mature technology corporation and a start-up often seek funding or capitalization to ensure functional health for the business. Most Canadian technology corporations have considered and used both refundable and non-refundable tax credits as part of cost recovery.

Such tax credits can reduce fixed costs thereby moving the costs to being more variable and a road to profitability. A preference for the shareholder (and equally for external stakeholders) is the beneficial investment tax credits when accessing these credits.

While tax credits are an important source of cash inflow, the eligibility criteria are stringent and obtaining the necessary credits is not a guarantee. However, businesses require continuous capital for various requirements, for example, operational and investment for growth.  Therefore, relying solely on tax credits is not an option in many circumstances. The required cash is often sourced via equity, debt or a combination of the two.

In simple terms, there are two types of consequences from a capitalization process:

Equity: Based on the level of equity given to the new shareholder on account of investment, there can be an acquisition of control by law or a "de jure" control – often no surprises in this case.

Debt: Structuring for debt does not lead to a "de jure" control, but can, in certain cases, result in "de facto" control under the new subsection of the Act. This can be a surprise to a corporation.

Prior to the new legislation, to elaborate debt capitalization, de facto control was realized in a very restrictive sense – i.e., the ability to influence the board of directors vis-à-vis the shareholders. There was no reference to how the corporation was conducting its operations.

However, following the new subsection, implications for a corporation which was originally a CCPC now include:

  • Losing the CCPC status and hence preferred tax treatment and tax credits that are often refundable in nature – this depends on the tax attributes of the de factocontrolling individual or corporation, and,
  • Having limited ability to fully utilize the $3-million expenditure limit, by virtue of an association (totally unforeseen), thereby limiting its ability to optimize on the refundable tax credits.

In both above, useful and critical cash inflow can become at risk, and in many circumstances (such as for start ups) can even put the corporation as a going concern risk. Clearly, without proper guidelines from the CRA, small and promising technology businesses in Canada can be severely impacted when considering capitalization options.

In summary, introduction of new cash can also bring in some unexpected tax challenges, some of which can be detrimental to the recipient corporation and even losing its CCPC status and the various tax benefits associated with being a CCPC. Introduction of the new legislation to test for de facto control can lead many CCPCs susceptible to exposure of losing their CCPC status.

In Part Two of this two-part series, author Balaji Katlai will examine how lack of CRA guidelines could muddy the investment waters even more – and what options companies raising market capitalization have.

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