Natasha Miklaucic Stephanie Wong June 29 2012 Unanimous shareholders' agreement affects company's legal control Borden Ladner Gervais LLP | Corporate Tax - Canada Natasha Miklaucic, Stephanie Wong Corporate Tax IntroductionDefinition of CCPCTypes of controlHow a unanimous shareholders' agreement may affect legal control of a corporationQuestions raised by unanimous shareholders' agreementsFactsDecisionCommentIntroductionA Canadian corporation that is controlled by non-residents is not entitled to take advantage of certain tax benefits provided by the Income Tax Act. For example, specific tax incentives are available to Canadian-controlled private corporations (CCPCs) only, such as:the small business deduction, which reduces the federal corporate tax rate from 28% to 11% on the first C$500,000 of active business income; andthe enhanced refundable investment tax credit for scientific research and experimental development expenditures.CCPC status is also necessary for a corporation to qualify as a small business corporation, which may allow individuals to claim a C$750,000 lifetime capital gains exemption on dispositions of the corporation's shares. Generally, a corporation will be a CCPC as long as no non-resident or public corporation shareholders, either alone or together, own more than 50% of its voting shares.In the recent case of Price Waterhouse Coopers Inc Agissant Ès Qualité De Syndic À La Faillite De Bioartificial Gel Technologies (Bagtech) Inc v The Queen(1) the Tax Court held in favour of Bagtech that it had qualified as a CCPC during the years in question. The court found that while Bagtech's non-resident shareholders owned, in aggregate, more than 50% of Bagtech's voting shares, they did not legally control Bagtech because, under the provisions of a unanimous shareholders' agreement entered into by Bagtech's shareholders, it was Bagtech's Canadian resident shareholders (and not Bagtech's non-resident shareholders) that held the power to elect a majority of the members of Bagtech's board of directors.For a corporation concerned about qualifying for CCPC status, the most prudent course of action would be to ensure that no non-resident or public corporation shareholders, either alone or together, own more than 50% of its voting shares. In circumstances where this is not feasible, the Tax Court's decision in Bagtech may allow a corporation to qualify for (or maintain) CCPC status where its shareholders agree to be governed by a unanimous shareholders' agreement that provides the corporation's CCPC-qualifying shareholders with the power to elect a majority of the corporation's directors. However, some caution should be exercised in relying on this decision, as it is likely to be appealed by the Canada Revenue Agency (CRA).Definition of CCPCA 'CCPC' is defined in Section 125(7) of the Income Tax Act as a corporation incorporated and resident in Canada that is a private corporation (ie, not a public corporation and not controlled by one or more public corporations), but expressly excluding any of the following:a corporation controlled directly or indirectly in any manner by:one or more non-resident persons;one or more public corporations (other than a prescribed venture capital corporation);one or more corporations, a class of the shares of which is listed on a prescribed stock exchange; orany combination of the above (the basic test for determining CCPC status);a corporation that would, if each share of the capital stock that is owned by a non-resident person, a public corporation (other than a prescribed venture capital corporation) or a corporation described below were owned by a particular person, be controlled by the particular person (the 'hypothetical shareholder' test); ora corporation, a class of the shares of the capital stock of which is listed on a prescribed stock exchange (stock listing is the first of two ways in which a corporation becomes a public corporation for tax purposes; the other is by filing an election and complying with prescribed conditions under the Income Tax Act).Types of controlThere are two basic types of control, one or both of which may need to be examined in order to determine tax consequences under specific rules in the Income Tax Act.The first type of control is legal (ie, voting) control. This type of control is relevant any time a provision of the Income Tax Act requires consideration of who controls a corporation. For example, the control test for private corporation status, which is required for a corporation to qualify as a CCPC, refers only to control, so the relevant test is legal control. The classic definition of 'legal control', as set out by the Exchequer Court in the leading case of Buckerfield's Ltd v MNR,(2) is "effective control" over the "affairs and fortunes" of the corporation as manifested in "the ownership of such number of shares as carries with it the right to a majority of the votes in the election of the Board of Directors".The second type of control is factual control, which is relevant only where a provision of the Income Tax Act specifically refers to a corporation being controlled "directly or indirectly in any manner whatever". For example, the basic test for CCPC status requires analysis of not only legal control, but also factual control. Unlike legal control, 'factual control' is defined for purposes of the act as a corporation controlled by another corporation, person or group of persons (a 'controller') where the controller has any direct or indirect influence that, if exercised, would result in control of the corporation. While the definition excludes the influence derived from contractual arrangements between a corporation and an arm's-length party, where the main purpose is to govern the parties' relationship in terms of how the corporation's business is conducted, the question of what constitutes sufficient "direct or indirect influence" over a corporation has spawned numerous cases considering what factors are relevant to that determination.With that background in mind, it is important to examine the role that a unanimous shareholders' agreement plays in determining legal control of a corporation for tax purposes.How a unanimous shareholders' agreement may affect legal control of a corporationIn Duha Printers(3) the Supreme Court provided further guidance on applying the Buckerfield's legal control test. To determine whether "effective control" of a corporation exists, the court stated that all of the following must be examined:the corporation's governing statute (eg, the Canada Business Corporations Act);the corporation's share register; andany specific or unique limitation on either the majority shareholder's power to control the election of the board or the board's power to manage the business and affairs of the company, as manifested in either:the corporation's constating documents; orany unanimous shareholders' agreement.The court also stated that generally only the foregoing documents are relevant to the determination of a corporation's legal control. Accordingly, if a shareholders' agreement does not constitute a unanimous shareholders' agreement, it has no effect on determining legal control. However, the existence of a unanimous shareholders' agreement by itself is not sufficient to alter the legal control of a corporation: the court concluded that a unanimous shareholders' agreement will do so only if it leaves no way for the majority shareholder to exercise effective control over the affairs of the corporation in a manner that is equivalent to the power to elect the majority of the board of directors.The effect that a unanimous shareholders' agreement may have on determining legal control of a corporation is illustrated by Alteco Inc v The Queen,(4) in which the Tax Court confirmed that in certain circumstances the provisions of a unanimous shareholders' agreement might have the effect of removing legal control from a majority voting shareholder. On the facts of the case, the court held that Alteco did not have legal control of a subsidiary corporation even though it held 51% of the voting shares of the corporation, because it had entered into a unanimous shareholders' agreement pursuant to which it could elect only a minority (two out of five) of the members of the corporation's board of directors. While the majority shareholder held the majority of the votes in the election of the corporations' directors according to the share register, the unanimous shareholders' agreement effectively shifted the majority voting power to the minority shareholder.Questions raised by unanimous shareholders' agreementsTwo general questions have arisen with respect to unanimous shareholders' agreements:What shareholder agreements constitute a unanimous shareholders' agreement?Is a unanimous shareholders' agreement relevant in applying the hypothetical shareholder test for determining CCPC status?A 'unanimous shareholders' agreement' is not defined in the Income Tax Act. Canadian corporate law statutes generally define the term as an otherwise lawful written agreement among all shareholders of a corporation, or among all the shareholders and one or more parties which are not shareholders, that restricts, in whole or in part, the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation.(5)The CRA has taken the position that the only provisions of a unanimous shareholders' agreement that are relevant in determining legal control are those that either:restrict the directors' powers; ormodify a rule under the corporation's governing legislation that has been explicitly made subject to a unanimous shareholders' agreement.Thus, in the CRA's view, a provision of a unanimous shareholders' agreement cannot alter a majority shareholder's voting rights to elect the corporation's directors because the relevant provision of the governing corporate legislation which requires the shareholders to elect the directors at the annual shareholders' meeting by exercising the votes attached to the shares owned by them is not made expressly subject to a unanimous shareholders' agreement.(6) In support of its position, the CRA also relied on the Supreme Court's statement in Duha Printers (at paragraph 54) that:"The [legal control] test neither requires nor permits an inquiry into whether a given director is the nominee of any shareholder, or any relationship or allegiance between the directors and the shareholders".The CRA has also taken the position that a unanimous shareholders' agreement is not relevant in applying the hypothetical shareholder test to determine a corporation's status as a CCPC. The hypothetical shareholder test is essentially an anti-avoidance test, which requires all of the shares of a corporation held by any non-resident and public corporation shareholders to be aggregated. If that aggregate share ownership provides the hypothetical shareholder with control over the corporation, then the corporation is not a CCPC.The CRA's rationale for excluding a unanimous shareholders' agreement from the hypothetical shareholder test is that since the hypothetical shareholder is a fictitious entity, it would never be a party to the unanimous shareholders' agreement; nor does the test itself deem the hypothetical shareholder to be a party to the unanimous shareholders' agreement for purposes of applying the test. In the CRA's view:"It would be contrary to both the text and the purpose of the provision to consider that the fiction of control created by the application of paragraph (b) of the CCPC definition could be diluted by an agreement that restricts the powers of the directors of a corporation to allocate them to shareholders that would never include the hypothetical shareholder."(7)The CRA's positions on these questions were tested in Bagtech, a recent Tax Court case.FactsBagtech claimed the enhanced refundable investment tax credit for scientific research and experimental development expenditures made in its 2004 and 2005 taxation years on the basis that it was a CCPC during those years. The minister reassessed Bagtech, concluding that it did not qualify as a CCPC under the hypothetical shareholder test.Sedona Networks(8) set out a two-step approach for applying the hypothetical shareholder test:Attribute all of the shares of Bagtech owned by non-resident shareholders to one hypothetical non-resident shareholder of Bagtech; andDetermine whether the hypothetical non-resident shareholder controls Bagtech.Bagtech had several non-resident minority shareholders; when their shares were aggregated, the hypothetical non-resident shareholder held a majority of the voting shares of Bagtech. However, Bagtech argued that the hypothetical non-resident shareholder did not control Bagtech because a provision of the unanimous shareholders' agreement gave Bagtech's Canadian resident shareholders the right to elect a majority of the members of Bagtech's board of directors. Accordingly, under the second step of the hypothetical shareholder test, while the hypothetical non-resident shareholder had sufficient voting power by virtue of the deemed ownership of all of Bagtech's non-resident shareholders' shares, it did not control Bagtech because the unanimous shareholders' agreement had effectively shifted that voting power into the hands of Bagtech's Canadian resident shareholders.DecisionThe Tax Court judge first considered and rejected the CRA's contention that the unanimous shareholders' agreement should be ignored in applying the hypothetical shareholder test. Reviewing the Department of Finance technical notes relating to the test, the trial judge concluded that the hypothetical shareholder test creates a legal fiction (ie, that one shareholder owns all of the shares owned by the corporation's non-resident and public corporation shareholders).In La Survivance(9) the Federal Court of Appeal stated that where a rule effectively alters reality, its meaning and effect should be limited to what is clearly expressed. The trial judge therefore concluded that the legal fiction created by the hypothetical shareholder test requires the hypothetical shareholder to be given the same rights and obligations as the actual non-resident shareholders whose shareholdings must be aggregated under the test, which includes being bound by the unanimous shareholders' agreement.The contrary conclusion would go against the legal fiction created by the test itself: if all of Bagtech's non-resident shareholders had sold their shares to one non-resident buyer, Section 146(3) of the Canada Business Corporations Act would have deemed the buyer to be a party to the unanimous shareholders' agreement.In considering whether the shareholder voting provision of the unanimous shareholders' agreement was relevant in applying the hypothetical shareholder test, the Tax Court judge acknowledged that there are differing views on what constitutes a valid unanimous shareholders' agreement. For example, some (including the Québec Superior Court) have taken the view that only those provisions of a unanimous shareholders' agreement that restrict the powers of the directors to manage the corporation are valid (and are severable from the invalid provisions); others consider all of a unanimous shareholders' agreement's provisions to be valid provided that the agreement itself meets the governing corporate law definition of a 'unanimous shareholders' agreement' (ie, it is a lawful written agreement among all of the corporation's shareholders and it has provisions that restrict the powers of the directors to manage the corporation).Contrary to the CRA's view, the trial judge concluded that all of the provisions of a unanimous shareholders' agreement are valid and relevant to the legal control analysis (although he did note that he personally agreed with the opposing view, which he believed to be more in line with fundamental principles of corporate law). The trial judge based his conclusion on the requirement in Duha Printers that all of the restrictions placed on the majority shareholder's power to elect directors by either the corporation's constating documents or a unanimous shareholders' agreement be considered in determining legal control of the corporation. However, the trial judge noted that his conclusion created an unusual result, in that the same voting restriction would be irrelevant if contained in a voting agreement that did not constitute a unanimous shareholders' agreement.The unanimous shareholders' agreement in this case resulted in the hypothetical non-resident shareholder having the power to elect only a minority of the members of Bagtech's board of directors. As such, the hypothetical non-resident shareholder did not have legal control of Bagtech and Bagtech therefore qualified as a CCPC for the years in question.CommentThe CRA's narrow position on the relevance of unanimous shareholders' agreement provisions to the legal control analysis is hard to reconcile with Duha Printers and Alteco. The CRA views the Alteco decision as having little precedential value in assessing legal control. The Alteco decision was, however, considered and then distinguished on its facts by the Supreme Court in Duha Printers. In Alteco the majority shareholder could elect only two out of the five members of the corporation's board of directors.The decisive differentiating fact in Duha Printers appears to be that although the unanimous shareholders' agreement required the shareholders to elect the three-member board of directors from among four possible candidates, it did not alter the shareholders' voting power in that election, which was determined by their share ownership. While the pool of candidates for the board of directors was narrowed down to just four nominees of the shareholders, the majority shareholder still had the power to choose which three of the four possible candidates would be elected to the board by virtue of holding the majority of votes.Those facts place in proper context the Supreme Court's statement that whether a director is a nominee of (or otherwise has a particular relationship with) a shareholder is irrelevant to the legal control determination; it also does so in a manner consistent with the outcome in Alteco, which the Supreme Court in Duha Printers appears to have implicitly accepted.While a unanimous shareholders' agreement must contain restrictions on the powers of the directors to manage the corporation to be a valid unanimous shareholders' agreement for corporate law purposes, corporate law legislation does not explicitly prohibit unanimous shareholders' agreements from containing other provisions specifying shareholders' rights with regard to each other. Although those rights may be contractual in nature only, they may still have the effect of altering control over the corporation. The more difficult question is whether they should be considered to affect legal control of the corporation – or only factual control.While there is some merit to the trial judge's observation in Bagtech that coming to different conclusions on the legal control analysis depending on whether a shareholder voting restriction is contained in a valid unanimous shareholders' agreement produces an illogical result, there are numerous instances where taxpayers receive differing tax treatment under the Income Tax Act depending on whether they have entered into the necessary legal arrangements to qualify for tax-favoured treatment under specific tax rules. Why should this situation be any different? If a provision of a unanimous shareholders' agreement removes the ability of a majority shareholder to elect the majority of the members of the corporation's board of directors, then that alters the legal control of the corporation as defined in Buckerfield's.Considering the consistent stance that the CRA has taken on the limited relevance of unanimous shareholders' agreements in this context, it is likely that it will appeal the Tax Court's decision.For further information on this topic please contact Natasha Miklaucic or Stephanie Wong at Borden Ladner Gervais LLP by telephone (+1 416 367 6000), fax (+1 416 367 6749) or email ([email protected] or [email protected]).Endnotes(1) 2012 TCC 120 (TCC).(2) 64 DTC 5301 (Ex Ct).(3) Duha Printers (Western) Ltd v The Queen, 98 DTC 6334 (SCC).(4)  2 CTC 2087 (TCC).(5) Section 146(1) of the Canada Business Corporations Act. Section 108(2) of the Business Corporations Act (Ontario) contains a similarly worded provision.(6) See, for example, Canada Revenue Agency Document 2009-0314351I7, January 7 2010.(7) Income Tax Technical News 44, April 14 2011.(8) Sedona Networks Corp v The Queen, 2006 DTC 2486 (TCC), at paragraph 11.(9) La Survivance v The Queen, 2007 DTC 5096 (FCA), at paragraph 55.