1 Selected Income Tax Issues of Particular Relevance to Shareholders Agreements Charles P. Marquette Borden Ladner Gervais LLP, Montreal
2 2001, Charles P. Marquette Originally published as Selected Income Tax Issues of Particular Relevance to Shareholders Agreements: Part 1, Personal Tax Planning feature (2001), vol. 49, no. 1 Canadian Tax Journal and... Part 2, Personal Tax Planning feature (2001), vol. 49, no. 2 Canadian Tax Journal
3 Contents Abstract v PART Introduction The Income Tax Act and The Legal Framework of Shareholders Agreements Shareholders Agreements and Corporate Law The Income Tax Act Issues Involving The Concept of De Jure De Facto Concept of Related Persons/Arm s Length Extended Meaning of : Paragraph 251(5)(b) The Concept of Affiliated Person Association of Corporations When Is an Acquisition of Relevant? PART Transfer of Shares Between Shareholders Non-Arm s-length Situations Capital Gains Exemption for Qualified Small Business Corporation Shares Deemed Disposition upon Death/Carryback of Loss (Subsection 164(6) Election) Transfer to Spouse Surplus Stripping/Deemed Dividends (Section 84.1) Surplus Stripping Involving Non-Arm s-length Sales of Shares by Non-Residents Balance of Sales/Availability of Reserves Disposition by a Non-Resident (Section 116) Dividends Paid or Deemed Payable to Non-Residents (Part XIII Withholding Tax) Issues Involving the Acquisition by the Corporation of its Shares Legal Limitations Deemed Dividend Treatment Non-Arm s-length Situations Part IV Tax Recharacterization of Dividends as Capital Gains (Section 55) Stop-Loss Rules iii
4 iv CHARLES P. MARQUETTE Insurance Life Insurance Disability Lump-Sum Insurance Issues Involving Valuation Shareholders Agreement and Valuation The CCRA s Position The Position of the Courts Impact of Fair Market Value Provisions of the Act on Shareholders Agreements Impact of Corporate-Owned Life Insurance on the Value of Shares Financing Issues Deductibility of Interest and Guarantee Fees Deductibility of Capital Losses and Business Investment Losses from Guaranteeing Loans for Inadequate Consideration and from Loaning Funds at a Less Than Reasonable Rate of Interest Preferred Share Rules Summary of Conclusions
5 Abstract Shareholders agreements for privately held corporations create rights and obligations for both the corporation and the shareholders. While the focus of a shareholders agreement is generally the contractual relationship between the shareholders, their degree of influence over the corporation, and the corporation s operations themselves, a number of different provisions of the Income Tax Act come into play. While these provisions are intended to be of general application and not to apply specifically to shareholders agreements, the treatment of many transactions envisaged by a shareholders agreement will be greatly influenced by the treatment afforded by the provisions of the Act. As well, the status of a corporation for purposes of the Act will be influenced by a shareholders agreement. This article reviews the application of a number of provisions of the Act as they relate specifically to the rights and obligations created by shareholders agreements. The article also considers the degree of influence that shareholders agreements may have on the application of certain provisions of the Act. Part 1 of this article reviews the concepts of de jure and de facto control and their influence on both the status of the corporation for purposes of the Act and the relationship between the shareholders and the corporation. The tax consequences may vary, for example, where shareholders become related to or affiliated with the corporation, or where corporations become associated because of the rights and obligations created under shareholders agreements. As well, in certain situations, it is necessary to determine whether an acquisition of control of a corporation has occurred for purposes of applying provisions of the Act. Part 2 of this article reviews other provisions of the Act as they interact with shareholders agreements. In the context of a disposition of shares between shareholders, the article examines the use of the capital gains exemptions in respect of qualified small business corporation shares, issues involving transfers to spouses, the recharacterization of a portion of the purchase price as dividends, the use by vendors of reserves for capital gains when a balance of sale is owing, the withholding requirements applicable to purchasers of shares acquired from non-residents, and the corporation s obligation to withhold part XIII tax on deemed dividends created by a disposition. As well, in the context of shareholders agreements providing for a redemption of shares by the corporation, the article reviews the potential for the purchase price to give rise to deemed dividends and part IV tax, recharacterization of intercorporate dividends as capital gains, and the stop-loss rules. Other issues that are considered v
6 vi CHARLES P. MARQUETTE are the tax consequences of the interaction of life insurance and disability lump-sum insurance, the effects of a shareholders agreement on the valuation of shares, and the concept of interest deductibility in respect of amounts borrowed to invest in the corporation.
7 Selected Income Tax Issues of Particular Relevance to Shareholders Agreements Charles P. Marquette Borden Ladner Gervais LLP, Montreal PART 1 INTRODUCTION While the focus of a shareholders agreement is to regulate the departure of a shareholder, the interaction of the shareholders with the corporation, and the operations of the corporation itself, the income tax consequences for the shareholders and the corporation can vary greatly, depending on the content of the agreement. The rights or benefits afforded shareholders, and any limitations on the activities of the corporation under the terms of the agreement, can inadvertently affect the treatment of shareholders and/or the corporation s status for income tax purposes. The provisions of the Income Tax Act 1 are not necessarily designed to apply specifically to shareholders agreements but rather are intended to be of more general application. This article, while not reviewing in depth any particular provision of the Act, will highlight certain aspects of particular provisions as they relate to, and when they come into play in, situations that are commonly governed by shareholders agreements. The article will also consider the influence that shareholders agreements can have on the application of such provisions. Because of the interaction between statutory provisions and shareholders agreements, it is important to take into account the possible tax consequences when the terms of an agreement are being drafted. For example, the income tax treatment of the disposition, by a departing shareholder, of shares of the corporation (and, conversely, the treatment of the acquisition, by the remaining shareholders, of such shares) can vary greatly, depending on the way in which the disposition is planned under the shareholders agreement. The fact that the shares can be purchased directly by the remaining shareholders (or, alternatively, by the corporation) can result in the recharacterization of the proceeds of 1 Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as the Act ). Unless otherwise stated, statutory references in this article are to the Act. 1
8 2 CHARLES P. MARQUETTE the sale as dividends instead of capital gains and thus can affect all parties involved. The income tax treatment may also differ in respect of the funding of the acquisition of the departing shareholder s shares and the determination of the value of such shares. As well, the terms of a shareholders agreement setting out the rights of shareholders in relation to the operations of the corporation may cause the shareholders to control the corporation and thereby may affect the status of the corporation for purposes of the Act. Similarly, a shareholders agreement that grants shareholders the right to acquire the shares of another shareholder can give rise to unfavourable income tax consequences associated with the control of the corporation (and its classification for tax purposes) and the relationship between the parties. or the acquisition of control can be relevant for the use of business losses, for example. THE INCOME TAX ACT AND THE LEGAL FRAMEWORK OF SHAREHOLDERS AGREEMENTS Shareholders Agreements and Corporate Law Essentially, shareholders agreements are contracts entered into by parties to govern the relationship between shareholders as owners of a corporation. They can also regulate the operations of the corporation as a commercial entity by itself, as well as the interaction and the influence between the shareholders and the corporation. Shareholders agreements can regulate the following situations that arise between shareholders: Right of first refusal. In the event that a shareholder wishes to dispose of his or her shares, he or she must give a preferential right of first refusal to the remaining shareholders. Death. In the event of the death of a shareholder, the remaining shareholders (or, alternatively, the corporation) may have the right or obligation to purchase the shares of the deceased shareholder. Withdrawal from business. A shareholder who is withdrawing from the activities of the corporation may have the obligation to sell his or her shares and the remaining shareholders may have the right to purchase the shares. Reasons for a withdrawal from business can cover a broad range, including the shareholder s bankruptcy, prolonged illness, incapacity, default under the shareholders agreement, divorce, etc. Purchase and sale of shares. An agreement may include buy-sell provisions in which a shareholder who wishes to either sell shares or acquire those of the remaining shareholders can force the issue and initiate the transaction by which the remaining shareholders will either purchase the seller s shares or sell their own shares. In either case, the mechanism (usually called a shotgun clause ) is designed to yield the desired result and to prevent a stalemate situation.
9 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 3 Retirement. A shareholder who is retiring from the affairs of the corporation, or who otherwise intends to depart from the corporation, may have the right to sell his or her shares, or the remaining shareholders may have the option or the obligation to purchase the shares. Shareholders agreements can also regulate the interaction between the shareholders and the corporation in specific areas of operation, such as the following: New share issuance. The agreement may set out the terms and conditions under which new shares of the corporation will be offered, and to whom such shares will be offered. Voting. The shareholders may agree among themselves (for example) to vote their shares, to cause the election of certain persons to the board of directors, or to alter the usual percentage of votes required to enact certain decisions. Board of directors. The agreement may restrict the powers exercised by the board of directors. Financing. The agreement may specify the shareholders obligations to provide financing to, or guarantees in favour of, the corporation. The general rule at common law is that shareholders cannot interfere with the discretion of the directors, even unanimously. For this reason, corporate statutes, such as the Canada Business Corporations Act ( the CBCA ), have reversed the common law rule by specifically authorizing the use of unanimous shareholders agreements to remove or restrict the managerial powers of directors. 2 It is thus possible for shareholders to alter who is entrusted with the stewardship of the corporation and its business. Under the CBCA, for example, several provisions are expressly subject to the existence of a unanimous shareholders agreement. These provisions include 3 1) section 25 (directorial power to issue shares), 2) section 103 (directorial power to make bylaws), 3) section 121 (directorial power to appoint officers), and 4) section 125 (directorial power to determine remuneration). 2 See, for example, section 146 of the Canada Business Corporations Act, RSC 1985, c. C-44, as amended. 3 Other provisions of the CBCA related to unanimous shareholders agreements include section 18 (authority of directors, officers, and agents), section 20 (corporate records), section 28 (pre-emptive right), section 49(8) (restrictions in security certificates), section 102 (power to manage), section 119 (director liability for employment wages), and section 122 (duty of care of directors and officers).
10 4 CHARLES P. MARQUETTE This ability to restrict directorial control and alter the structure of management differentiates unanimous shareholders agreements from conventional shareholders agreements. Unanimous shareholders agreements are a hybrid of corporate law, being part contractual and part constitutional in nature, and form part of the corporation s constating documents. It should be noted that merely labelling a shareholders agreement as a unanimous shareholders agreement will not make it part of the constating documents. The agreement itself must be a unanimous shareholders agreement within the meaning of the applicable corporate law. Because a unanimous shareholders agreement is part of a corporation s constating documents, the existence of such an agreement is relevant to the issue of de jure control of the corporation (discussed below). 4 Recognition of shareholders agreements under most corporate statutes is limited to unanimous shareholders agreements (as opposed to those that are not entered into between all of the shareholders of a corporation and those that do not restrict in some way the powers of the directors). For example, corporate law will generally provide that only a unanimous shareholders agreement is binding on successor shareholders (provided that its existence is noted on the share certificates of the corporation). Furthermore, corporate law will generally provide that only a unanimous shareholders agreement can restrict the exercise of the powers of the board of directors. For example, a unanimous shareholders agreement can require that certain decisions be adopted by a greater majority of directors rather than the usual simple majority. It can also (as noted above) withdraw certain powers of the board of directors and grant them instead to the shareholders. As well, a unanimous shareholders agreement can provide that decisions of the board of directors must be approved by shareholders before they are considered valid. In this case, the unanimous shareholders agreement may require the consent of a greater number of votes from the shareholders to approve a decision of the board of directors than would otherwise be the case. Provisions contained in shareholders agreements are generally contractual in nature. For example, the obligation that a shareholder s shares be sold in the event of the shareholder s death is a contractual matter. Shareholders agreements can provide for a myriad of contractual obligations, limited, of course, by public order. However, only a unanimous shareholders agreement can ensure that successor shareholders will be deemed party to the agreement or can restrict the exercise by the directors of their powers. Where directors powers are not restricted by a unanimous shareholders agreement, corporate law requires that the directors act in their fiduciary capacity as directors for the best interests of the corporation and of its shareholders as a whole, and not for the benefit of a particular shareholder. 4 Under the heading Issues Involving.
11 The Income Tax Act SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 5 Many provisions of the Act apply to situations commonly envisaged by shareholders agreements, without being specifically designed for that purpose. Consequently, it is critical to avoid the unintentional application of a provision of the Act when drafting a shareholders agreement. For example, a mandatory buy-sell provision between shareholders under given circumstances may, for income tax purposes, place the shareholder who is entitled to purchase the shares in the same position as if he or she owned the shares directly. Share ownership can affect the determination of control of the corporation; the corporation s status as a Canadian-controlled private corporation, and hence its rate of tax; and the determination of whether the corporation is associated with other corporations or related to shareholders. In other instances, shareholders agreements may influence the application of certain provisions of the Act. For example, contractual arrangements, in a shareholders agreement, that determine the price at which shares will be sold to the remaining shareholders in the event of the death of a shareholder can be determinative in fixing the fair market value of those shares for income tax purposes. ISSUES INVOLVING CONTROL The Concept of De Jure Case Law is not defined in the Act. The courts have held that control of a corporation means de jure control and not de facto control. De jure control has been held to mean the ability, by virtue of one s shareholdings, to elect the majority of the board of directors. The often-cited definition comes from the Buckerfield s case: Many approaches might conceivably be adopted in applying the word control in a statute such as the Income Tax Act to a corporation. It might, for example, refer to control by management, when management and the Board of Directors are separate, or it might refer to control by the Board of Directors... The word control might conceivably refer to de facto control by one or more shareholders, whether or not they hold a majority of shares. I am of the view, however, that in section 39 of the Income Tax Act,  the word controlled contemplates the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the Board of Directors [emphasis added]. 6 5 The former section of the Act dealing with association. 6 Buckerfield s Ltd. et al. v. MNR, 64 DTC 5301, at 5303 (Ex. Ct.). The decision in Buckerfield s was followed in MNR v. Dworkin Furs (Pembroke) Ltd. et al., 67 DTC 5035 (SCC); The Queen v. Imperial General Properties Limited, 85 DTC 5500 (SCC); and Vina-Rug (Canada) Ltd. v. MNR, 68 DTC 5021 (SCC).
12 6 CHARLES P. MARQUETTE This definition of de jure control has been accepted by the Canada Customs and Revenue Agency ( the CCRA ). 7 In essence, while the directors manage the corporation, the shareholders are in ultimate control of the corporation through their ability to elect the majority of the board of directors. A review of the share register of the corporation should determine whether a shareholder or a group of shareholders (connected with one another in some way) owns a sufficient number of shares to elect the majority of the board of directors. There are also external agreements such as shareholders agreements (discussed above) whereby shareholders may have agreed, for example, to alter the rule of simple majority and require a greater percentage of votes to elect directors, or to restrict certain activities of the corporation. The recent Supreme Court of Canada case of Duha Printers 8 sets out which documents are relevant to determine de jure control. Duha Printers (Western) Ltd. ( Duha #1 ) was owned by the Duha family. Another company, Outdoor Leisureland of Manitoba Ltd. ( Outdoor ), was owned by a holding company, Marr s Leisure Holdings Inc. ( Marr s ), which was controlled by Mr. and Mrs. Marr. Duha #1 operated profitably as a specialty printer. Outdoor had carried on a business as a retailer of recreational vehicles and had accumulated non-capital losses. Duha #1 wished to acquire the shares of Outdoor in order to take advantage of the latter s non-capital losses. However, if Duha #1 had made an outright purchase of Outdoor s shares, the availability of the non-capital losses would have been restricted under subsection 111(5), because Duha #1 would have acquired control of Outdoor. To circumvent this limitation, the following steps were taken: 1) On February 7, 1984, Duha #1 amalgamated with Manitoba Ltd. (a wholly owned subsidiary of Duha #1) to form Duha Printers Western Ltd. ( Duha #2 ). This caused a deemed year-end for Duha #1, so that it could take advantage of the small business deduction. The shareholders of Duha #2 received the same number of shares that they previously owned in Duha #1. Immediately thereafter, on February 8, 1984, the articles of Duha #2 were amended to authorize an additional class of shares, known as the class C preferred shares, which were entitled to non-cumulative dividends, a fixed redemption price, and one vote per share (which was to cease either upon the transfer of the share or upon the death of its holder). The class C preferred shares were redeemable by Duha #2 with the consent of the holder, or without the consent of the holder in the event that the shares were transferred. On the same day, February 8, 1984, Marr s subscribed for 2,000 class C preferred shares of Duha #2 for $1 each, which then 7 Interpretation Bulletin IT-64R3, Corporations: Association and After 1988, March 9, 1992, paragraph Duha Printers (Western) Ltd. v. The Queen, 98 DTC 6334 (SCC).
13 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 7 Figure 1 Before February 7, 1984 Duha family Mr. and Mrs. Marr Duha #1 (Duha Printers (Western) Ltd.) Marr s (Marr s Leisure Holdings Inc.) Manitoba Ltd. Outdoor (Outdoor Leisureland of Manitoba Ltd.) Figure 2 On February 7, 1984 Duha family Mr. and Mrs. Marr Marr s (Marr s Leisure Holdings Inc.) Duha #2 (Duha Printers Western Ltd.) 2,000 C Pref % of votes Outdoor Marr s Leisure (Marr s Leisure Products (1977) Ltd.) Manitoba Ltd. represented percent, and thus a majority, of the voting shares in Duha #2. At the same time, on February 8, 1984, an agreement, described as a unanimous shareholder s agreement, was entered into among all the shareholders of Duha #2. The agreement provided that the affairs of Duha #2 were to be managed by a board of directors to be elected by the shareholders and composed of any three of Mr. and Mrs. Duha, Mr. Marr, and a Mr. Quinton. Although Mr. Quinton was a friend of both Mr. Marr and Mr. Duha, he had served in Duha #1 since Mr. Duha and Mr. Marr were not related to each other within the meaning of section 251 of the Act. The agreement also contained the following provisions: a) No shares could be transferred without the consent of the majority of the directors. b) The shareholders were prohibited from disposing of or encumbering their shares.
14 8 CHARLES P. MARQUETTE c) New shares could be issued only with the unanimous consent of the existing shareholders. d) Shareholder disputes were to be resolved by arbitration. 2) On February 9, 1984, Duha #2 purchased all the shares of Outdoor from Marr s for $1. However, at the same time, Manitoba Ltd., a wholly owned subsidiary of Duha #2, purchased from Marr s Leisure Products (1977) Ltd. ( Marr s Leisure ), a wholly owned subsidiary of Marr s, a receivable in the amount of $441,253 owed by Outdoor to Marr s Leisure. Half of the total purchase price for the receivable was payable on June 1, 1984, and the other half upon the redemption of the 2,000 class C preferred shares of Duha #2 held by Marr s. 3) On February 10, 1984, Duha #2 and Outdoor amalgamated to form Duha Printers (Western) Ltd. ( Duha #3 ). The shares of Outdoor were cancelled, and the shareholders of Duha #3 received the same number in class of shares as they had previously owned in Duha #2. Some time after, on March 12, 1984, the shareholders of Duha #3 elected Mr. and Mrs. Duha and Mr. Quinton as the three directors of Duha #3. Figure 3 On February 10, 1984 Duha family Mr. and Mrs. Marr Marr s Duha #3 (Duha Printers (Western) Ltd., resulting from Outdoor and Duha #2) 2,000 C Pref % of votes Manitoba Ltd. 4) Approximately one year later, Duha #3, with the consent of Marr s, redeemed the 2,000 class C preferred shares, owned by Marr s, for the redemption price of $2,000. The agreement was terminated, and Mr. Quinton resigned as director of Duha #3. This obviously had the effect of returning control of Duha #3 back to the Duha family. Duha #3 sought to deduct the noncapital losses incurred by Outdoor in previous years. As noted above, this sequence of transactions was intended to avoid an acquisition of control of Outdoor for the purposes of subsection 111(5). If control
15 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 9 of Outdoor had been acquired by Duha #3, Outdoor s non-capital losses would have been deductible by Duha #3 in a subsequent taxation year only if Outdoor s business was carried on by Duha #3 for profit or with a reasonable expectation of profit. Consequently, what the parties attempted to do was to set up Marr s as being in control of Duha #2 while also being in control of Outdoor. The minister of national revenue argued that although Marr s owned a majority of votes in Duha #2, the shareholders agreement totally neutralized its control by restricting the manner in which Marr s could vote its shares. By merely reviewing the share register of Duha #2, one could have established that the majority of the votes were held by Marr s and, hence, it had de jure control of Duha #2. The decision in Duha Printers is of great importance, because it outlines the criteria that may be taken into account to determine who has de jure control of a corporation. In fact, the court distinguished between documents that are part of the constating documents of a corporation, which should be considered in determining de jure control, and documents that are external agreements. Furthermore, the Supreme Court found this distinction to be consistent with prior judicial pronouncements on corporate control. While the Buckerfield s test was unquestioned as the general test for de jure control, the court looked to cases where it had gone beyond the bare ownership of voting shares and had considered other indicia in determining de jure control. The court noted that in those cases Oakfield Developments (Toronto) Ltd. v. MNR 9 and The Queen v. Imperial General Properties Limited 10 its investigation had been restricted to the constating documents of the corporation; there was no indication that external agreements had been considered. The Supreme Court concluded that external agreements, no matter how binding among the parties, are not to be taken into account in determining de jure control. Thus, in Duha, it was necessary to decide whether the agreement under consideration was a conventional shareholders agreement or a unanimous shareholders agreement, recognized as such under corporate law. The court then considered how much power needed to be removed from the directors by the unanimous shareholders agreement in order to affect de jure control. In Duha, while certain restrictions were placed on the powers of the board of directors, they were not sufficient to remove the de jure control of Marr s through the ownership of its voting shares. The court observed that unanimous shareholders agreements deal with major issues such as corporate structure, issuance of shares, declarations of dividends, elections of directors, appointments of officers, and the like. The court found that because the shareholders agreement in Duha restricted the powers of the directors, in preventing them from issuing further shares without the written consent of all shareholders, it was a unanimous shareholders agreement within the meaning of the corporate law. How DTC 5175 (SCC). 10 Supra note 6.
16 10 CHARLES P. MARQUETTE ever, the effect of the unanimous shareholders agreement did not go as far as to compromise the de jure control that Marr s otherwise held over the corporation. In fact, the general rule applied in that Marr s, by virtue of its ability to elect the majority of the board of directors, did enjoy de jure control over Duha #2. 1) Summary When reviewing constating documents of a corporation to determine who has control, the aspects to determine effective control are 1) the corporation s governing statutes; 2) the share register of the corporation; 3) any specific or unique limitation on either the power of the majority of the shareholders to control the election of the board of directors or the board of directors power to manage the business and affairs of the company as manifested in either a) the constating documents of the corporation or b) any unanimous shareholders agreement; and 4) any unanimous shareholders agreement. If there is any limitation, the majority shareholder may nonetheless possess de jure control, unless there remains no other way for the shareholder to exercise effective control over the affairs and the fortunes of the corporation in a manner analogous to the Buckerfield s case. Documents other than the share register, the constating documents, and any unanimous shareholders agreement are not generally to be considered for this purpose. With respect to control meaning de jure control and not de facto control, subsequent court decisions have followed Duha. 11 As to the question whether unanimous shareholders agreements that restrict the powers of the board of directors are part of the constating documents, again Duha has been followed. 12 2) Relevance of for Income Tax Purposes The determination of control of a corporation can have a direct bearing on the application of certain provisions of the Act. For example: The status of the corporation as a Canadian-controlled private corporation in essence requires that it not be controlled by one or more nonresidents or by a public corporation. 11 Bilodeau v. The Queen (S), 99 DTC 3535 (TCC); and Monquart Hardwoods Ltd. v. The Queen, 99 DTC 818 (TCC). 12 Sportscope Television Network Ltd. v. Shaw Communications Inc. (1999), 46 BLR (2d) 87 (Ont. Gen. Div.); and Monquart Hardwoods Ltd., supra note 11.
17 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 11 For purposes of the $500,000 capital gains exemption available on qualified small business corporation shares, 13 the corporation must be a Canadian-controlled private corporation. In instances where control of a corporation is acquired by a person or a group of persons, the taxation year is deemed to have ended immediately before that time 14 and among other things the availability of the corporation s losses is restricted. 15 For purposes of the stop-loss rules, certain losses caused by the transfer of property to a corporation can be denied if the transferor is affiliated with the corporation. of a corporation is key to determining who is related to the corporation within the meaning of subsection 251(2). of a corporation is key to determining who is affiliated with the corporation within the meaning of section of corporations is key to determining whether they are associated within the meaning of section 256. De Facto While control under the Act means de jure control, the Act expands the concept for specific circumstances where the words controlled directly or indirectly in any manner whatever are used. The concept of control has been expanded by subsection 256(5.1) to include not only de jure control but also de facto control so that the controller need only have direct or indirect influence that, if exercised, would result in control in fact of the corporation. 16 The person who exercises de facto control of a corporation does not necessarily have to own shares. The CCRA states that it is a question of fact whether or not persons having close family ties exercise de facto control. 17 As well, the CCRA has outlined certain factors that will be considered to determine whether de facto control exists: a) the percentage of ownership of voting shares (when such ownership is not more than 50 per cent) in relation to the holdings of other shareholders; b) ownership of a large debt of a corporation which may become payable on demand (unless exempted by subsections 256(3) or (6)) or a substantial investment in retractable preferred shares; 13 See the definition in subsection 110.6(1). 14 Subsection 249(4). 15 Subsection 111(4). 16 Excluded are certain arrangements between arm s-length parties that govern the relationship between the controller and the corporation, such as franchise, licence, lease distribution, supply, or management agreements (subsection 256(5.1)). 17 IT-64R3, supra note 7, at paragraph 19.
18 12 CHARLES P. MARQUETTE c) shareholders agreements including the holding of a casting vote; d) commercial or contractual relationships of the corporation, for example, economic dependence on a single supplier or customer; e) possession of a unique expertise that is required to operate the business; and f) the influence that a family member, who is a shareholder, creditor, supplier, etc., of a corporation, may have over another family member who is a shareholder of the corporation [emphasis added]. 18 De facto control is relevant for the following purposes: continuation of business in the context of subsection 24(2), where an individual ceases a business that is then carried on by a corporation controlled by the individual; capital gains reserves under paragraph 40(2)(a); capital dividend account and payment of capital dividends under the definition of capital dividend account in subsection 89(1) and subsections 89(1.1), 83(2.2), and 83(2.4); the definition of Canadian-controlled private corporation in subsection 125(7), which excludes, for example, corporations that are controlled, directly or indirectly in any manner whatever, by non-residents or public corporations; refundable investment tax credits, specifically the definition of excluded corporation found in subsection 127.1(2); and association rules under section 256. Since de facto control includes influence, documents external to the constating documents of a corporation will be relevant. This will include a conventional shareholders agreement whether or not it is a unanimous shareholders agreement. Consequently, the drafter of a shareholders agreement must avoid giving one or more shareholders de facto control if this will cause prejudice to the corporation. Concept of Related Persons/Arm s Length The concept of dealing at arm s length is relevant for many purposes under the Act. 19 When unrelated persons act in concert, this may be an indication of a non-arm s-length situation. A shareholders agreement may cause the corporation to be related to its shareholders. 18 Ibid. 19 For discussion of the concept of arm s length, see Tom Stack, Arm s Length as a Question of Fact, in Report of Proceedings of the Forty-Ninth Tax Conference, 1997 Conference Report (Toronto: Canadian Tax Foundation, 1998), 16:1-15; and Interpretation Bulletin IT-419R, Meaning of Arm s Length, August 24, 1995.
19 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 13 Under the Act, persons who are related are deemed not to deal with one another at arm s length. 20 While it is a question of fact whether or not persons who are not otherwise related to one another deal with each other at arm s length, 21 the Act provides specific circumstances in which persons are related. In the case of corporations, the Act provides for certain situations in which a corporation and one or more of its shareholders are related, and other situations where two corporations will be considered to be related. These situations are illustrated below. (Note that person includes both individuals and corporations.) A corporation and a person who controls it are related if the corporation is controlled by one person. 22 Figure 4 A Corporation A corporation and a person are related where the person is a member of a related group that controls the corporation. 23 Figure 5 Group of related persons Corporation Each member of the related group is related to the corporation 20 Paragraph 251(1)(a) and IT-419R, supra note Paragraph 251(1)(b). 22 Subparagraph 251(2)(b)(i). 23 Subparagraph 251(2)(b)(ii).
20 14 CHARLES P. MARQUETTE A corporation is related to any person related to a person who controls the corporation (if it is controlled by one person) or, alternatively, a corporation is related to any person related to a member of a related group who controls the corporation. 24 Note that here the corporation becomes related to a person who owns no shares of the corporation. Figure 6 B (related to A) ling person A B (related to any member of the group) Group of related persons Corporation Corporation B is related to the corporation because he/she is related to A, who controls the corporation B is related to the corporation because he/she is related to any member of the group of related persons that controls the corporation Two corporations are related where both corporations are controlled by the same person or group of persons. 25 Figure 7 Same person or group of persons Corporation 1 Corporation 2 Two corporations are related where each corporation is controlled by one person and each controlling person is related to the person who controls the other corporation Subparagraph 251(2)(b)(iii). 25 Subparagraph 251(2)(c)(i). 26 Subparagraph 251(2)(c)(ii).
21 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 15 Figure 8 ling person A (related to B) ling person B (related to A) Corporation 1 Corporation 2 Two corporations are related where one corporation is controlled by one person and that person is related to any member of a related group of persons that controls the second corporation. 27 Figure 9 ling person A ling group of related persons (where A is related to any member of the group) Corporation 1 Corporation 2 Two corporations are related where one corporation is controlled by a person and that person is related to each member of an unrelated group of persons that controls the second corporation. 28 Figure 10 ling person A ling group of unrelated persons (each of whom is related to person A) Corporation 1 Corporation 2 Two corporations are related where one corporation is controlled by a related group and any one of its members is related to each member of an unrelated group that controls the other corporation Subparagraph 251(2)(c)(iii). 28 Subparagraph 251(2)(c)(iv). 29 Subparagraph 251(2)(c)(v).
22 16 CHARLES P. MARQUETTE Figure 11 ling group of related persons (one of whom is related to each member of the other group) ling group of unrelated persons (each of whom is related to one [and the same] member of the other group) Corporation 1 Corporation 2 Two corporations are related where one corporation is controlled by an unrelated group and the other corporation is controlled by another unrelated group, and each member of one of the unrelated groups is related to at least one member of the other unrelated group. 30 Figure 12 ling group of unrelated persons (each of whom is related to at least one member of the other group) ling group of unrelated persons Corporation 1 Corporation 2 Two corporations become related if they are each otherwise related to a common corporation. 31 Figure 13 Common corporation Related Related Corporation 1 Corporation 2 Corporations 1 and 2 become related to each other because they are each related to a common corporation 30 Subparagraph 251(2)(c)(vi). 31 Subsection 251(3).
23 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 17 Extended Meaning of : Paragraph 251(5)(b) Shareholders agreements often provide buy-sell arrangements where shares are sold either to other shareholders or back to the corporation. Any right to acquire a shareholder s shares or for the corporation to acquire the shares of a shareholder may cause paragraph 251(5)(b) to apply. Paragraph 251(5)(b) expands the concept of control. It applies only for purposes of determining whether a corporation is related 32 to (that is, controlled by) one or more of its shareholders, and for purposes of the definition of Canadiancontrolled private corporation. 33 Where a person has a right to acquire shares or to control the voting rights of shares, paragraph 251(5)(b) will treat that person as owning such shares or controlling such voting rights. These rights can exist by virtue of a contract, equity, or otherwise, and may be immediate or future, absolute or contingent. As well, if a person has a right to cause the corporation to redeem, acquire, or cancel any of its shares owned by another shareholder, that person will be treated as being in the same position in relation to control of the corporation as if such shares had been redeemed, acquired, or cancelled. Furthermore, if a person has the right to cause the reduction of voting rights of shares owned by another shareholder, that person will be treated as being in the same position in relation to control of the corporation as if those voting rights had been reduced. Consequently, a shareholder who would grant any such rights to another shareholder, where the latter does not otherwise control the corporation, may place the latter in a position of control. 34 There are a number of exceptions to the extension of control under paragraph 251(5)(b). The CCRA has taken the position that a right of first refusal is not considered to confer a right to acquire a share but rather an option in a certain future circumstance. 35 As well, the CCRA takes the view that paragraph 251(5)(b) does not normally apply to what is commonly called a shotgun arrangement in which a shareholder offers to purchase the shares of another shareholder who must either accept the offer or purchase the shares owned by the offering party. 36 Further, limited relief is provided. The deeming provision of paragraph 251(5)(b) will not apply if the right is not exercisable because its exercise is contingent upon the death, bankruptcy, or permanent disability of an individual. Shareholders agreements will typically deal with these events occurring to shareholders. What is unusual is that the exceptions of death, bankruptcy, and permanent disability relate to an individual without requiring that the individual have any connection per se with the shareholder(s) or the corporation. 32 Subsection 251(2). 33 Subsection 125(7), the definition of Canadian-controlled private corporation. 34 See Couvre-Plancher Zénith Ltée v. The Queen, 95 DTC 898 (TCC). 35 IT-419R, supra note 19, at paragraph 13; and IT-64R3, supra note 7, at paragraph 37. The concept of association is addressed below under the heading Association of Corporations. 36 Supra note 35.
24 18 CHARLES P. MARQUETTE The Concept of Affiliated Person Effective April 27, 1995, a new concept of affiliated person was introduced, mainly to deal with a new set of rules that replaced the old denial of losses rules 37 on dispositions to controlled corporations. 38 The new affiliated person concept is now used in revised stop-loss rules that deny or postpone losses generated on transfers between affiliated persons. 39 For example, where a corporation acquires any of its shares from an affiliated shareholder, any loss of the latter will be denied. While the definition of related person includes individuals connected by blood relationship, marriage, or adoption, 40 the definition of affiliated person as it relates to individuals is limited to an individual and the spouse of the individual. 41 In the case of corporations that are controlled, as noted earlier, the concept of control is extended to include de facto control (a wider notion of de jure control). 42 A shareholders agreement can influence who is considered in control of the corporation and thus who is affiliated. An individual is affiliated with himself or herself 43 and with a spouse. 44 The term spouse includes a common law spouse 45 and, as of 2001, same-sex partners. 46 The term person, under the affiliated person rule, includes not only individuals and a corporation but also a partnership. 47 A corporation will be affiliated with another person in the circumstances illustrated below. A corporation is affiliated with either a person who controls the corporation or the spouse of the person who controls the corporation Former subsection 85(4), now repealed. For example, under the old rules, a loss incurred on the disposition by a shareholder to a corporation controlled by that shareholder was denied and the loss was added to the adjusted cost base of the shares held by the shareholder in the corporation. 38 Section Subsections 13(21.2), 14(12), 18(15), 40(3.3), 40(3.4), and 40(3.6); superficial loss rules of paragraph 40(2)(g) and the definition of superficial loss in section Paragraph 251(2)(a). 41 Paragraph 251.1(1)(a). 42 See the discussion earlier under the heading The Concept of. 43 Paragraph 251.1(4)(a). 44 Paragraph 251.1(1)(a). 45 Subsection 252(4). 46 This is a result of recent amendments to the Act. There are transitional provisions for the 1998, 1999, and 2000 years. See sections 130 to 146 of the Modernization of Benefits and Obligations Act, SC 2000, c Paragraph 251.1(4)(b). 48 Subparagraphs 251.1(1)(b)(i) and (ii).
25 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 19 Figure 14 A Spouse of A Corporation Corporation is affiliated with A and his/her spouse A corporation is affiliated with either each member of an affiliated group of persons controlling the corporation or the spouses of the members of an affiliated group of persons controlling the corporation. 49 Figure 15 ling group of affiliated persons Spouse(s) Corporation Corporation is affiliated with each member (and his/her spouse) of the group Two corporations will be affiliated persons in the circumstances illustrated below. Each corporation is controlled by a person, and the person who controls one corporation is affiliated with the person who controls the other corporation. 50 Figure 16 ling person A (affiliated with B) ling person B (affiliated with A) Corporation 1 Corporation 2 49 Subparagraphs 251.1(1)(b)(ii) and (iii). 50 Subparagraph 251.1(1)(c)(i).
26 20 CHARLES P. MARQUETTE One corporation is controlled by a person, the other corporation is controlled by a group of persons, and each member of the group is affiliated with the first person. 51 Figure 17 ling person A (affiliated with each member of the group) Corporation 1 ling group of persons (each of whom is affiliated with A) Corporation 2 Each corporation is controlled by a group of persons, and each member of each group is affiliated with at least one member of the other group. 52 Figure 18 ling group of persons (each of whom is related to at least one member of the other group) Corporation 1 ling group of persons (each of whom is related to at least one member of the other group) Corporation 2 A corporation and a partnership are affiliated if the corporation is controlled by a particular group of persons each of whom is affiliated with at least one member of the majority interest group of partners of the partnership and if each member of the majority group of partners is affiliated with at least one member of the particular group. 53 Key to this definition is the concept of majority group of partners. 54 Essentially, with respect to a partnership, this term refers to a group of persons each of whom has an interest in the partnership so that (1) if one person held the interest of all members of the group, that one person would be a majority interest partner 55 of the partnership, and (2) if any member of the group 51 Subparagraph 251.1(1)(c)(ii). 52 Subparagraph 251.1(1)(c)(iii). 53 Paragraph 251.1(1)(d). 54 See the definition in subsection 251.1(3). 55 See the definition of majority interest partner under subsection 248(1).
27 SHAREHOLDERS AGREEMENTS: SELECTED INCOME TAX ISSUES 21 Figure 19 ling group of persons (each of whom is affiliated with at least one member of the majority of the group of partners) Majority group of partners (each of whom is affiliated with at least one member of the other controlling group) Other shareholders Other partners Corporation Partnership were excluded from the group, that one person would not be a majority interest partner. Affiliation of a corporation and a partnership is illustrated below. Association of Corporations The Act affords a form of assistance, through the tax system, to small businesses. An eligible Canadian-controlled private corporation 56 that carries on an active business in Canada is entitled, on an annual basis, to a reduced rate of tax on its first $200,000 of income from an active business carried on. 57 This is often referred to as the small business deduction. The 2000 federal budget has increased the threshold of $200,000 to $300,000, but the reduction of the tax rate is on a declining basis on income over $200,000 up to $300,000. Certain types of income are not eligible for the reduced rate, such as certain types of passive income and income from a personal services business. 58 In order for this form of assistance to target only a single economic group at a time, the rules of associated corporations have been developed to govern sharing of the annual limit of $200, These rules are designed to prevent a multiplication of the benefits of the small business deduction for corporations that are considered part of the same group of associated corporations. To achieve this, the Act provides an elaborate number of circumstances where two or more corporations will be considered associated, and each corporation in the group will be required to share the annual limit of income for which the low rate of tax is available. Association is also relevant for 56 See the definition in subsection 125(7). 57 See the definition of active business carried on by a corporation in subsection 125(7). 58 See the definition of personal services business in subsection 125(7). 59 See also Maureen Donnelly and Allister Young, The Associated Corporation Rules: Getting Tax Reduction Under (1998), vol. 46, no. 3 Canadian Tax Journal
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