Substantive CCPCs: Is the tax deferral game over?

Allan Lanthier is a retired partner of an international accounting firm, and has been an advisor to both the Department of Finance and the Canada Revenue Agency.

MONTREAL – To maintain a level of neutrality between individuals who use private corporations for investments and those who invest personally, a “Canadian-controlled private corporation” (CCPC)[1] is subject to significantly higher corporate income tax rates on investment income than a non-CCPC. In Ontario for example, the combined federal-provincial rate on a CCPC’s investment income (excluding portfolio dividends, but including the taxable half of capital gains) is 50.17 percent, versus a rate of 26.5 percent that applies to non-CCPCs.[2]

As a result, a number of plans have been developed to convert private corporations from CCPC to non-CCPC status, and are often implemented when a corporation is about to realize a significant capital gain. For example, a private corporation might continue under the corporate laws of a tax haven jurisdiction such as the British Virgin Islands, while maintaining central management and control in Canada.[3] As an alternative, non-resident family members might invest a small amount in fixed-value, super-voting preferred shares, or be granted an option described under paragraph 251(5)(b) to acquire a sufficient number of shares to give them voting control. The federal budget of April 7 seeks to end this planning by introducing a new definition of “substantive CCPC” to which the higher rates on investment income will continue to apply. Draft legislation has not yet been released.

After reviewing the concept of “control” under the Act and the evolution of Canadian corporate income tax rates, this article discusses the budget proposals.[4]

The concept of control

Depending on the relevant provision in the Act, control of a corporation may mean legal (de jure) control, control in fact (de facto control), or both. While the meaning of legal control is relatively clear, the concept of de facto control is anything but.

In the 1964 decision in Buckerfield’s,[5] the Exchequer Court stated that legal control means ownership of a sufficient number of voting shares to elect a majority of a corporation’s board of directors. In the 1998 decision in Duha Printers,[6] the Supreme Court expanded on the Buckerfield’s decision, stating that the test of voting control “is really an attempt to ascertain who is in effective control of the affairs and fortunes of the corporation,” and addressing issues that may arise if constating documents, including a unanimous shareholder agreement, deprive the board of some or all of its authority. In short however, Duha Printers confirmed that legal control means voting control.

The meaning of de facto control is another matter altogether. I will not try to summarize all of the jurisprudence on this matter over the years (which has been far from consistent): some excellent articles have already been written.[7] Suffice it to say that, when the term “controlled, directly or indirectly, in any manner whatever” is used in the Act, then in addition to legal control, de facto control applies as defined in subsection 256(5.1). However, the results under that provision were not clear.

In Silicon Graphics[8] the court concluded that de facto control requires that a person or group of persons have the right to effect a significant change in the board of directors or a direct influence on shareholders who can do so. On the other hand, the Mimetix Pharmaceuticals[9] decision based its analysis of subsection 256(5.1) on control of day-to-day operations and the making of management decisions. It was difficult to reconcile these decisions.

The Federal Court of Appeal settled the dispute in McGillivray.[10] Rejecting any assertion that control over day-to-day operations is relevant, the court concluded that de facto control under subsection 256(5.1) is the narrow test set out in Silicon Graphics, and that there must be a legally enforceable right and ability to effect a change to the board of directors or its powers, or to exercise influence over the shareholders who have that right and ability. The government responded by enacting subsection 256(5.11) in 2017 to override McGillivray.

Subsection 256(5.11) provides that the determination of whether a taxpayer “has any direct or indirect influence that, if exercised, would result in control in fact of the corporation” as described in subsection 256(5.1), shall:

• take all relevant factors into consideration; and
• not be limited to, and the relevant factors need not include, whether the taxpayer has a legally enforceable right or ability to effect a change in the board of directors or its powers, or to exercise influence over shareholders who have that right or ability.

But what exactly does this provision mean? If the government wanted to introduce a test that includes control of day-to-day operations, it certainly went about it in a curious way. Subsection 256(5.11) refers (as does subsection 256(5.1)) to control of a corporation, not of its activities or operations, a reference that would have been simple enough to add. In the absence of jurisprudence that examines subsection 256(5.11) (and I am not aware of a single decision that does),[11] the extent to which operational control or family influence will be relevant going forward is simply not clear, a fact that may create uncertainties under the new substantive CCPC rules.

Evolution of Canadian corporate income tax rates

Until 1995, any private corporation that was thinking straight tried to maintain CCPC status. Not only did CCPCs benefit from special rates for business income and enhanced credits for research and development,[12] but their tax rate on investment income was the same as non-CCPCs with a portion being refundable. Nirvana. But then the tax rates on investment income began to change.

In 1995, section 123.3 introduced an additional refundable tax on a CCPC’s investment income and, in 2000, corporate rate reductions were introduced under section 123.4 which did not apply to a CCPC’s investment income. So we have a problem. Some corporations now prefer to be CCPCs while others do not, but the same rules in the Act apply to both.

In light of the many favourable provisions that apply to a CCPC that earns business income, the rules in the Act tend to deny CCPC status rather than preserve it — exactly the result that tax planners now want when investment income is involved. A private corporation is not a CCPC if a non-resident (or public corporation) has either legal or de facto control. For example, assume that Canco has two shareholders — an individual resident in Canada who owns 60 percent of its voting shares, and her non-resident sister who owns 40 percent and has an contingent right described in paragraph 251(5)(b) to acquire the remainder. Even though legal control of Canco is in Canada, it is a non-CCPC.

Something had to give and, on budget day, it did.

Substantive CCPCs

The budget documents state that, while the manipulation of corporate status to achieve a tax deferral on investment income can be challenged under the general anti-avoidance rule, new rules will be introduced so that “substantive CCPCs” (“SCCPCs”) will be taxed on investment income in the same manner as CCPCs. The new rules will generally apply immediately — to taxation years of a corporation that end on or after the budget date.[13]

A SCCPC will be a private corporation, other than a CCPC, that is controlled, directly or indirectly in any manner whatever, by one or more Canadian resident individuals. Also, for purposes of determining legal control of a SCCPC, the legislation will aggregate all shares owned by Canadian resident individuals, even if they deal at arm’s length with one another. Finally, a specific anti-avoidance rule will provide that a corporation will be deemed to be a SCCPC if it is reasonable to consider that one of the purposes of a transaction, arrangement or event (or series) was to cause a corporation not to be a SCCPC (more on this anti-avoidance rule below).

The three most common situations where the new rules may apply are as follows.

Corporate continuance of a CCPC under foreign law:

A continuance under foreign law will virtually always be hit by the new rules. The definition of CCPC requires that a corporation be governed by Canadian law, and a private corporation that continues under foreign law therefore ceases to be a CCPC. However, if a majority of its voting shares are owned by Canadian resident individuals, legal control will be in Canada and the corporation will be a SCCPC.

Non-residents with voting control of a private corporation:

The results under this type of planning may be less certain. Assume for example that family members own a Canadian private corporation, and that non-resident family members have invested in fixed-value, super-voting preferred shares that give them voting control. Legal control lies outside Canada, and so the corporation will only be a SCCPC if de facto control is in Canada.

As discussed above, the factors that may give rise to a finding of de facto control under subsection 256(5.11) are not clear and have yet to be tested in court. Will a court agree that de facto control is in Canada if the non-resident family members take an active role, remotely or otherwise, as officers and directors of the corporation? And in the case of a significant capital gain that is about to be realized, take an active role as well in negotiations with the third party purchaser? The task for the Canada Revenue Agency in challenging this planning may be more difficult than was anticipated.

But what about the new anti-avoidance rule? Wasn’t one of the purposes of non-resident family members acquiring the “skinny” voting shares to cause the corporation not to be a SCCPC? I think not. One of the purposes of the share acquisitions may well have been to avoid CCPC status, but that does not avoid the SCCPC rules — it puts them into play. The question becomes whether a non-resident who takes an active and independent role as an officer and director is doing so as an arrangement or event to avoid the SCCPC rules, a difficult question at best.

Given these uncertainties, the anti-avoidance rule should apply if one of the purposes of a transaction, arrangement or event is to avoid CCPC (not SCCPC) status, and thereby avoid the rules that apply to investment income.

Non-residents with options to acquire voting shares:

This one does not seem as difficult. If non-resident family members acquire options described in paragraph 251(5)(b) to acquire a sufficient number of shares to give them voting control (as in our example further above), the corporation will be deemed not to be a CCPC. However, assuming that, unless or until the option is exercised, voting control lies with family members resident in Canada, legal control will be in Canada and the SCCPC rules will apply.

Conclusion

The SCCPC rules should, for the most part (and with the possible exception of non-residents owning shares that give them voting control), close the door on planning that seeks to manipulate non-CCPC status. However, the package of rules we are left with are complex: a corporation is not a CCPC if non-residents or public corporations have either legal or de facto control, but will be a SCCPC (and taxed at the higher rates on investment income) if Canadian resident individuals have either. These are not the rules that would likely be in place had we started with a clean sheet of paper.

There may have been an easier fix: simply deny the capital dividend account to any private corporation that is not a CCPC. But it is always easy to second guess, when officials in Ottawa have to do the real work — roll up their sleeves and develop a legislative solution. I applaud their efforts. 

Footnotes

[1] A CCPC is defined in subsection 125(7) of the federal Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (the “Act”). All statutory references in this article are to the Act. In general terms, a CCPC is a private corporation that is incorporated in Canada, other than a corporation that is controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, by one or public corporations, or by any combination of them.
[2] The higher rate of 50.17 percent includes 30.67 percent that is refundable when the CCPC pays taxable dividends to its shareholders.
[3] If central management and control does not remain in Canada, the exit tax provisions in subsection 128.1(4) would apply.
[4] In addition to the substantive CCPC rules, the budget proposes changes to the tax rules for foreign accrual property income earned by a controlled foreign affiliate of a CCPC or substantive CCPC. For a discussion of these rules see “The federal budget hits private corporations with foreign affiliates”; Allan Lanthier; Canadian Accountant; April 13, 2022.
[5] Buckerfield’s Limited et al. v. MNR; 64 DTC 5301 (Exch. Ct.).
[6] Duha Printers (Western) Ltd. v. The Queen; 98 DTC 6334 (SCC).
[7] See for example “256(5.1) — De Facto Control: A Return to the Past”; Philip Friedlan and Adam Friedlan; 2017 Ontario Tax Conference; Canadian Tax Foundation. Also “Various Aspects of Control, Including De Facto Control”; Helena Plecko and Gareth Williams; 2015 British Columbia Tax Conference; Canadian Tax Foundation. Also “De Facto Control: Meaning, Implications and Planning under Subsection 256(5.1) of the Income Tax Act”; Philip Friedlan; 2010 Ontario Tax Conference; Canadian Tax Foundation.
[8] Silicon Graphics Ltd. v. The Queen; 2002 DTC 7112 (FCA).
[9] Mimetix Pharmaceuticals Inc. v. The Queen; 2001 DTC 1026 (TCC); affirmed 2003 DTC 5194 (FCA).
[10] McGillivray Restaurant Ltd. v. The Queen; 2016 DTC 5048 (FCA).
[11] Subsection 256(5.11) has been referred to in four decisions: Aeronautic Development Corporation v. The Queen, 2018 FCA 67; Damis Properties Inc. et al. v. The Queen, 2021 TCC 24; Bresse Syndics Inc. v. The Queen, 2021 FCA 115; and The Queen v. Deans Knight Income Corporation, 2021 FCA 160 (leave to appeal to the SCC granted). However, the years in dispute in those four cases predated the introduction of the new provision.
[12] There are a number of additional benefits to CCPC status:  an individual who sells shares of a CCPC may be eligible for the lifetime capital gains exemption; there is an extended balance-due date and a shorter normal reassessment period for CCPCs; an employee stock option deferral; and entitlement of shareholders to allowable business investment losses.
[13] If an arm’s length public corporation or non-resident has a right described in paragraph 251(5)(b) to acquire all or substantially all of the shares of a CCPC and the acquisition is completed before 2023, the new rules will apply to taxation years that begin (rather than end) on or after the budget date. While beyond the scope of this article, this measure targets so-called “paragraph 111(4)(e) step-up” planning, which involves deemed dispositions of goodwill (including the crystallization of a capital dividend account) by a target CCPC shortly before closing of a third-party purchase of the CCPC shares.

Allan Lanthier is a retired partner of an international accounting firm, and has been an advisor to both the Department of Finance and the Canada Revenue Agency.