New Tax Rules Challenge Corporate Status - Part 2

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

Following changes to control as interpreted under the new subsection 256(5.1) of the federal Income Tax Act, there is now an increased risk of a corporation losing its Canadian controlled private corporation (CCPC) status and imbibing a tax structure of its creditor.

This can be a nasty surprise for an owner-managed business.

Implications for Technology and Start-Up Companies

What can the test for a de facto control determination by the Canada Revenue Agency (CRA) mean to a technology or a start-up company?

As noted in Part One of this series, control of a corporation is either via a legal shareholder agreement leading to a legal control, “de jure” control, or by virtue of factual control, leading to "de facto" control with a broader interpretation for control of a corporation.

With the expanded de facto control test, in a debt capitalization scenario the CRA can consider the following from the creditor's perspective:

• Has the creditor become involved in the daily business and operational activities of the corporation and hence can influence business decisions?
• What is the level of influence (this does not necessarily need to be confined to the board of directors or the owner of the corporation)?

Muddying the Investment Waters

Clearly, we have the following disadvantages (list is suggestive but not limiting):

• There are no CRA guidelines to limit any subjectivity that can arise when determining the level of control when understanding operational activities of a corporation.
• What would constitute influence at the operational level and the level of involvement – can a minimal but significant decision-making ability be acceptable, or would it require to be considerable or substantial? Here, do we assume the CRA's ordinarily implied notion of 50 percent or more as a test for considerable and 90 percent or more as being substantial? It is not clear which of the two would be an appropriate metric.
• Will the test for influencing an operation be on an annual (fiscal year) basis or an aggregated/cumulative test that can involve multiple fiscal years such as, for example, as in the new TOSI exclusion rules?
• In the absence of a creditor, is there an economic influence to the extent of a "going-concern" for the corporation? For example, is there a reliance on a single primary source of revenue supplier corporation?
• If you are a start-up corporation, what does level of influence imply – will it extend to an advisor who can be detrimental in how you structure and deliver the operational activities of your business?
• Instances of creditors such as angel or venture capital investments who often have powers to administer or influence operational activities without influencing the board of directors – note that such situations were excluded in the narrower definition of subsection 256(5.1) for test of de facto

New Risks and Challenges

The overall consequence of the new broadened test for de facto control can result in the CRA audit examinations to now consider operational level factors -this opens up a case for subjective interpretation. It has been evident that in many cases of the CRA audits, especially when related to investment tax credits such as in Scientific Research and Experimental (SR&ED) Tax credits, claimants have voiced the subjectivity of the CRA audits.

This has also resulted in a number of court cases and rulings trying to limit the subjectivity. In other words, it remains to be seen how the tax courts will handle the expanded new legislation for de facto control.

In respect to an owner-managed business, this imposes an additional new burden and additional due diligence when undertaking market capitalization – a task that was already not an easy one. In addition, there is also an increased level of risk for a creditor (such as in a debt financing) to not be involved in the operational level of the business.

We recommend that with the advent of the new legislation for de facto control, Canadian companies, and especially owner-managed technology corporations that are raising market capitalization, perform due diligence on the impact to their CCPC status and on their investment tax credits, especially SR&ED.

The new ruling can result in additional compliance and costs from inadvertent changes to share structures from the introduction of new investors – a de facto new Pandora's Box!

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