Category Archives: 125(7)

Small Business Deduction, Specified Investment Business

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Small Business Deduction, Specified Investment Business

0742443 BC Ltd v The Queen, 2014 TCC 301

The Taxpayer’s business involved the rental of storage space.  The MNR assessed it as the business of earning rental income, and therefore  a specified investment business not eligible for the small business deduction.  The Taxpayer argued that the business was more than just a storage rental business, but included the provision of significant services.

NOTE: The analysis and analogies in this decision are less than satisfactory as the Court does not provide sufficient guidance for taxpayer’s determining the dividing line between rental income and income from a bundle of services that include/revolve around rental of property – particularly the list of core factors with reference to a motel service.  This is quite unusual for a decision by Justice Campbell J Miller.

ANALYSIS

The small business deduction applies only to income, below the small business limit,  from an active business carried on by a corporation.

The phrase “active business carried on by a corporation” is defined in the ITA, subsection 125(7) to mean “any business carried on by a corporation other than a specified investment business […]”.  The ITA, subsection 125(7), also defines “specified investment business” as “a business carried on by a corporation in the taxation year the principal purpose of which is to derive income (including interest, dividends, rents and royalties) from property”.

The question, therefore, is: What is the principal purpose of the business carried on by the corporation?

The Court referred to Weaver v HMQ,  2008 FCA 238, where it was said that:

 The definition of “specified investment business” does not ask about the general nature of the business of a corporation, or the degree of activity or passivity actually required by that business. Rather, it asks about the legal character of the income that the business is intended principally to earn. If on the relevant date the legal character of that income is rent, for example, then the business meets the definition unless one of the statutory exceptions applies […]

The court also stated that the trappings or labels used by the business are informative of intention, and in this case nothing in the advertising or invoices hinted to a bundle of services other than rental of storage space.  The Court stated that “there was only one business” and that if “one took away the storage units there would be no business, whereas one could take away the other services and there still would be a storage business” (para 18).  [NOTE: could the same argument not be made for hotels or motels? – see Interpretation Bulletin IT 73-R6The Court also held that the majority of services provided were all core to the rental of storage space business and required to support the property income, though some (shuttling customers, arranging for movers, etc) were not.

The Court examined the meaning of the phrase “principal purpose”.  As noted in Weaver v HMQ,  2008 FCA 238, the CRA considers “principal purpose” to refer to something over 50%.  In Gill v MNR, 1998 CanLII 201, reference was made to Mayon Investments Inc. et al. v MNR , [1991] 1 CTC 2245 (“the principal purpose of which is to derive income from property” is ” … when the source of revenue, the nature of the assets held and the purpose of the corporation are to derive income from property, such as interest income“) and Ed Sinclair Construction & Supplies Ltd. et al. v MNR, [1992] 1 CTC 2218 (“In determining the “principal purpose” of a business carried on by a corporation the stated object of the person who carries it on is not necessarily the only, or even the most important, criterion. Of critical importance is what the corporation in fact does and what its sources of income are.”), and in Lee v The Queen, 53 DTC 925,  where the ancillary services supporting deriving rental income did not affect the principal purpose being other than earning rental income.

The Court differentiated between the Taxpayer’s business and that of a Motel by listing several factors in Paragraph 27, saying that what is important is that the bundle of services offered by a Motel “are used by every customer” and that “every hotel customer has an expectation of a bundle of hotel services in addition to a furnished room” (para 28). [NOTE: This is debatable as many persons do not go to a hotel or a motel for the services of the motel but only to rent a room so that they can enjoy the sights, sounds, and attraction of the place the motel is located in] The Court concluded:

[29]        There is a tipping point where the provision of services overcomes the provision of property. The CRA have administratively determined that hotel/motel accommodation steps over that tipping point. I conclude that R-Xtra Co. does not: a few services to a few customers does not change the inherent nature of income from property.

[30]        In summary, all of R-Xtra Co.’s customers were buying storage space: that is what they paid for. Mr. Claeys provided services that anyone acquiring storage space would expect. He did also, however, go the extra mile and provide additional services, though has not provided sufficient evidence to in any way quantify the level of such customer service. Not every customer got loading, unloading, shuttle service or relocation advice for example. Every customer got top quality storage space. R-Xtra Co. carried on a business, the principal purpose of which was to derive income from renting storage space and that is deriving income from property.

Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

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BIOARTIFICIAL GEL TECHNOLOGIES (BAGTECH) INC v The Queen, 2012 TCC 120

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Effect of a Unanimous Shareholders’ Agreement on a Corporation’s Status as a CCPC

BIOARTIFICIAL GEL TECHNOLOGIES (BAGTECH) INC v The Queen, 2012 TCC 120

At issue was whether a Unanimous Shareholders’ Agreement that restricted the power of non-resident shareholders to elect the majority of directors, and have that power to the resident shareholders, had to be taken into account in determining the question of whether the corporation is a CCPC – ie whether a “particular person” controlled the corporation or not.

The TCC determined that a USA must be considered, that that where the resident shareholder’s elect the majority of the board, the corporation is a CCPC.  This is because the hypothetical “particular person” must be taken to have the same rights and obligations as any other non-resident or public shareholder.

FACTS

The appellant corporation (BAGTEH) incurred SR&ED expenses during the 2004 and 2005 tax years. The MNR determined that BAGTECH was not a CCPC during the relevant time (as defined in subsection 125(7)) (thus a non-qualifying corporation – subsection 125(9)) and therefore was not eligible for the refundable investment tax credit.

BAGTECH was a CBCA company that was a taxable Canadian corporation (subsection 89(1)).  There were five classes of shares, of which only Class A shares are voting and participating.  Due to some reorganizations, by 2002 45.31% of the Class A shares were held by non-residents, and on December 31, 2004, over 60% of the Class A shares were held by non-residents.  Non-residents were bound by a Unanimous Shareholders’’ Agreement (“USA”) that prevented the non-residents from electing a majority of the Board. However, the majority of the clauses in the USA could be amended or implemented by ordinary resolution.

Taxpayer’s Argument

The taxpayer’s argument was that a “particular person” doesn’t control BAGTECH simply on the basis that the person owns more than 50% o the voting shares.  The person is bound by the unanimous shareholders’ agreement, preventing him from electing a majority of the board of directors.

Minister’s Argument

The MNR argued that for purposes of the definition of CCPC, a unanimous shareholders’ agreement may not be taken into account. Alternatively, if a USA can be taken into account, this USA didn’t withdraw de jure control from the “particular person” since the majority of the clauses in the USA could be amended by ordinary resolution.  Technical interpretation 2008-0265902I7, para 21, provides a good summary:

21.      In that specific case, indeed as a general proposition, we reiterate our position that a USA has no impact on the second stage of the analysis (i.e. determination of control of a corporation by the hypothetical particular person) for the purposes of paragraph (b) of the definition of CPCC in subsection 125(7). It still seems to us that the determination provided for in the second stage of the analysis is purely arithmetical. The case law in no way rejects that approach; on the contrary, the Federal Court of Appeal unreservedly holds that mere possession of shares by a non-resident majority is sufficient to give the non-residents control for the purposes of paragraph (b) of the definition of CCPC in subsection 125(7). In any event, as stated in the Document, the hypothetical particular person is not a party to any unanimous shareholders’ agreement or deemed to be such for the purposes of paragraph (b) of the definition of CCPC in subsection 125(7).

ANALYSIS

The Definition of CCPC is found in subsection 125(7) and reads as follows:

125(7) In this section,

. . .

“Canadian-controlled private corporation” means a private corporation that is a Canadian corporation other than

(a)        a corporation controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, by one or more public corporations (other than a prescribed venture capital corporation), by one or more corporations described in paragraph (c), or by any combination of them,

(b)        a corporation that would, if each share of the capital stock of a corporation that is owned by a non-resident person, by a public corporation (other than a prescribed venture capital corporation), or by a corporation described in paragraph (c) were owned by a particular person, be controlled by the particular person,

(c)        a corporation a class of the shares of the capital stock of which is listed on a designated stock exchange, or

(d)        in applying subsection (1), paragraphs 87(2)(vv) and (ww) (including, for greater certainty, in applying those paragraphs as provided under paragraph 88(1)(e.2)), the definitions “excessive eligible dividend designation”, “general rate income pool” and “low rate income pool” in subsection 89(1) and subsections 89(4) to (6), (8) to (10) and 249(3.1), a corporation that has made an election under subsection 89(11) and that has not revoked the election under subsection 89(12);

The TCC referred to the decision in Sedona Networks Corp. v. The Queen, 2007 FCA 169, in stating that the analysis has two stages: (1) identify the non-resident and public corporation persons, assuming that their shares are owned by a particular person; and (2) determine whether the corporation is controlled by that particular person.  The second step asks whether “the “particular person” actually control[led]” BAGTECH. To answer this question, the court looked to define the word “control” for purposes of the ITA.

“Control” is not defined in the ITA, but the courts have provided a definition.  In Ltd. v. Minister of National Revenue, [1965] 1 Ex. C.R. 299, it was stated:

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”, where 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 former section dealing with associated companies], 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.] See British American Tobacco Co. v. I.R.C., [1943] 1 All E.R. 13, where Viscount Simon L. C., at page 15, says:

The owners of the majority of the voting power in a company are the persons who are in effective control of its affairs and fortunes.

The SCC has approved of the above comment on a number of occasions, including: Minister of National Revenue v. Dworkin Furs (Pembroke) Ltd., [1967] S.C.R. 223, Vina-Rug (Canada) Ltd. v. Minister of National Revenue, [1968] S.C.R. 193, R. v. Imperial General Properties Ltd., [1985] 2 S.C.R. 288, and Duha Printers (Western) Ltd. v. The Queen, [1998] 1 S.C.R. 795

The Court stated that “control” of a corporation means de jure control and not de facto control” Ask whether the majority shareholder enjoys majority control over the “affairs and fortunes” of the corporation as evinced by the “ownership of such a number of shares as carries with it the right of a majority of the votes in the election of the board of directors”.  BUT, in looking at de jure control courts are not limited to examining the rights in their immediate application, but are requires o assess the impact ‘over the long run’: Imperial Properties, para 11.  The test is not to be applied formalistically, but rather in a manner that looks at the reason for the test: Duha Printers, para 37.  The TCC then stated that the central objective of the Buckerfield’s test is to determine where the effective control of the corporation lies, though external agreements are not generally to be taken into account to determine where de jure control lies: Duha Printers, para 48-50.

A USA is not purely contractual, not is it purely constitutional, but rather it is a hybrid, but its constitutional element is more potent than its contractual element.  Thus, a USA must be taken into account when determining where de jure control lies. As stated in Duha Printers at para 70:

As I have said, the essential purpose of the Buckerfield’s test is to determine the locus of effective control of the corporation.  To my mind, it is impossible to say that a shareholder can be seen as enjoying such control simply by virtue of his or her ability to elect a majority of a board of directors, when that board may not even have the actual authority to make a single material decision on behalf of the corporation.  The de jure control of a corporation by a shareholder is dependent in a very real way on the control enjoyed by the majority of directors, whose election lies within the control of that shareholder.  When a constating document such as a USA provides that the legal authority to manage the corporation lies other than with the board, the reality of de jure control is necessarily altered and the court must acknowledge that alteration.

Once a USA has been identified, the extent to which the USA restricts the powers of directors must be examined so as to determine whether de jure control has been lost.

To summarize:

(1)        Section 111(5) of the Income Tax Act contemplates de jure, not de facto, control.

(2)        The general test for de jure control is that enunciated in Buckerfield’s, supra: whether the majority shareholder enjoys “effective control” over the “affairs and fortunes” of the corporation, as manifested 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”.

(3)        To determine whether such “effective control” exists, one must consider:

(a)        the corporation’s governing statute;

(b)        the share register of the corporation; and

(c)        any 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:

(i)         the constating documents of the corporation; or

(ii)        any unanimous shareholder agreement.

(4)        Documents other than the share register, the constating documents, and any unanimous shareholder agreement are not generally to be considered for this purpose.

(5)        If there exists any such limitation as contemplated by item 3(c), the majority shareholder may nonetheless possess de jure control, unless there remains no other way for that shareholder to exercise “effective control” over the affairs and fortunes of the corporation in a manner analogous or equivalent to the Buckerfield’s test.

The Court recalled that Parliament added paragraph (b) by SC 1998 c 19, subsection 145(2), to counter the decision of the FCA in Silicon Graphics Ltd v The Queen, [2003] 1 FC 447. The technical notes published provided:

Currently, a corporation is a CCPC if it is a private corporation and a Canadian corporation (both of which terms are defined in subsection 89(1) of the Act), and it is not controlled, directly or indirectly in any manner whatever by one or any combination of public corporations (other than prescribed venture capital corporations) or non-resident persons. This amendment ensures that two other types of corporation are not CCPCs. The first type are corporations that, if they are not actually controlled by non-residents, avoid that status only because their shares are widely held. The second type are corporations the shares of which are listed on a foreign stock exchange.

A corporation the voting shares of which are distributed among a large number of persons is usually not considered to be controlled by any group of its shareholders, provided the shareholders do not act together to exercise control. As a result, it may be argued that a private Canadian corporation that is owned by a number of non-residents or public corporations is not controlled by non-residents or public corporations, and is thus a CCPC. New paragraph (b) of the CCPC definition clarifies that this is not the case. Paragraph (b) requires non-residents’ and public corporations’ shareholdings – not only of the corporation in question, but of all corporations – to be notionally attributed to one hypothetical person. If that person would control the corporation, then the corporation is not a CCPC.

Department of Finance of Canada, Explanatory Notes Relating to Income Tax (December 8, 1997), s. 125(7), “Canadian-controlled private corporation”.

Paragraph (b) creates a legal fiction, and as with all deeming provisions that create legal fictions they must be limited to what is clearly expressed: Survivance v. Canada, 2006 FCA 129, at para. 55.  In this case, the fictitious “particular person” is to have the same rights and be subject to the same restrictions/obligations as the non-resident owners of the shares of the corporation in question.  The TCC stated:

[43]        In conclusion, I am of the opinion that the hypothetical shareholder contemplated in paragraph (b) of the definition of “Canadian-controlled private corporation” in subsection 125(7) of the ITA is bound by the Bagtech USA signed in 2003, and subsequently by the amendments made in 2005.

In looking to whether the USA removed de jure control, the TCC looked to the CBCA subsection 146(1), which deals with USAs.  A USA doesn’t just fetter the power of the directors, but it provides that shareholders may exercise powers that they have taken away from the directors.

Thus, it substitutes the shareholders for the director who would normally manage the affairs of the corporation.  The question remains controversial, however, whether the USA can contain clauses that deal with matters other than restricting director power or granting shareholder power.  The TCC notes that some authors see the USA as divisible into different provisions, some of which are USA s defined y statute while others are not. Other authors, however, believe that the USA may deal with incidental subjects.  The TCC then contrasted the Alberta USA provision with that of the CBCA, and stated that the Alberta legislation expands the concept of USA beyond that of the USA to allow for more than just restricting director power.  The court stated that the question remains to be settled.

The TCC concluded that “any restriction on the power of the majority shareholder to elect the directors, set out in the constating documents of the corporation of in a unanimous shareholders’ agreement, must be considered in the determination of de jure control.  The TCC said that this is an illogical result, but that the doctrine set out by the SCC must be followed.

However, the court, after examining the restrictions on director power in the USA, held that they are minor restrictions, and do not strip the hypothetical shareholder of control.  In examining the provision in the USA dealing with the election of directors, the TCC Concluded that notwithstanding that the “particular person” would hold more than 50% of the voting shares, it is the residents of Canada that elect the majority of directors.  Thus, the corporation is a CCPC and entitled to the refundable investment tax credit.

– Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

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