De Facto Control 

Tax Strategy

De Facto Control

FROM: JUL-AUG 2005 ISSUE | BY FRANCINE ST-ONGE

When determining whether a corporation is associated, Canadian-controlled, or affiliated, there are two types of control that must be considered: de jure control (legal control), and de facto control (actual control).

De jure control of a company exists when a person, or group by virtue of shareholdings, has the power to elect the majority of the board of directors. De factocontrol, as defined in subsection 256(5.1) of the Income Tax Act, is less clear-cut, as it arises from questions of direct and indirect influence.

Until recently, there was little case law on de facto control, and the Canada Revenue Agency (CRA) seldom drew on this concept when determining whether corporations were associated or Canadian-controlled. Yet de facto control does have a place in the Canadian tax system, and the CRA and the courts recognize it when warranted by specific situations.

Subsection 256(5.1) of the Act stipulates that de facto control does not exist when one of the parties involved in a contract existing between parties dealing at arm's length can influence how the other operates the business. This exception applies specifically to a franchise, a licence, a lease, a contract for marketing, purchasing, or management, or any other similar contract. These types of contracts usually include clauses dictating what can or cannot occur in the operation of the business. So long as the restrictions relate solely to the operations of the business, and not to the control of the corporation, the exception applies.

In its ruling in the matter of 9044-2807 Quebec Inc. v. The Queen [2004 FCA 23], the Federal Court of Appeal (FCA) gives some indications about the process whereby de facto control may be found to exist. The court points out that it is essentially a question of fact, and that it's impossible to list all the factors that may be relevant in determining whether a corporation is subject to de facto control. What must be demonstrated, however, is that a person or group clearly has the right and the ability to change the board of directors of the corporation, or to directly influence the shareholders who have the power to elect the board of directors.

The FCA concludes, "In other words, the evidence must show that the decision-making power of the corporation in question in fact lies elsewhere than with those who have de jure control."

The CRA summarizes some of the factors it considers when determining whether there is de facto control in paragraph 23 of Interpretation Bulletin IT-64R4:

• 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;
• ownership of a large debt of a corporation that may become payable on demand [unless exempted by subsection 256(3) or (6)] or a substantial investment in retractable preferred shares;
• shareholder agreements including the holding of a casting vote;
• commercial or contractual relationships of the corporation, e.g., economic dependence on a single supplier or customer;
• possession of a unique expertise that is required to operate the business; and
• 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.

These factors have been recognized by the courts in various decisions, but a combination of factors is usually required to determine whether de facto control exists. In Quebec Inc. v. The Queen, de facto control was found to exist on the basis of three factors.

In this case, two corporations were controlled by elderly parents, while a third was controlled by their children. The parents' corporations had no employees or separate premises, and the corporation controlled by the children was the sole client of the parents' corporations. The father suffered from Alzheimer's disease and the mother's involvement was very limited. All operational decisions for the parents' corporations were made by the children and the controller of their corporation.

The children's corporation was found to have de facto control of the parents' corporations based on the following factors:

• the operational control exercised by the children's corporation;
• the economic dependence of the parents' corporations on the children's corporation; and
• the family connection between the shareholders.

The FCA concluded that the parents had relegated to the children's corporation the decision-making powers they had held as shareholders of their corporations. The judgment rendered by the court shows that before recognizing de facto control, it sought to determine whether the influence went beyond the day-to-day operations of the business.

De facto control has also been found to exist in cases where there was clear economic dependence. However, in each of those cases, in addition to the fact that the controlling entity or controller was the sole or principal client of the taxpayer, there were other indicators that led the court to conclude that decision-making power was in hands other than those of the shareholders, who had de jure control. Among these were:

• a resolution of the taxpayer's board of directors that gave an absolute right of management to the majority shareholder of the controller;
• integration of the activities of the two corporations; for example, all the employees of the taxpayer were employees of the controller;
• financing that came from the controller.

It therefore appears that de facto control does not necessarily exist when a corporation has a single major client and the loss of that client could affect the existence of the business. Rather, a combination of factors will dictate whether the economic dependence is such that the shareholders no longer control the destiny of the corporation.

It is also important to distinguish between the business operated by the corporation and the corporation itself. The loss of a major client might affect the business but not the existence of the corporation. Do the current shareholders retain control over the corporation's destiny despite its economic dependence, or have they transferred control to another entity?

De facto control may also be found to exist in camouflage operations, where the evidence shows that the organizational structure differs from what exists on paper. For example, in order to qualify as a Canadian-controlled private corporation, an entity may create an organizational structure whereby 50 per cent of the voting shares are held by Canadian residents and the other 50 per cent by non-residents. If the evidence shows that the Canadian residents actually have little or no power, or that they act only according to the directions of the non-residents, the non-residents could be found to have de facto control.

Ultimately, in order for de facto control to exist, a person or group must have enough influence to control the destiny of the corporation in place of the shareholders who control it legally.

And finally, keep in mind that de facto control applies whenever the expression "controlled, directly or indirectly, in any manner whatever," is used in the Act. This concept applies to many provisions of the Act in addition to those referred to at the beginning of this column.

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Francine St-Onge, BBA, BCL, LLB, FCGA, practises tax and corporate law in Sutton, Quebec. She is co-author of the CGA-Canada course Taxation 2.

"Tax Strategy" is co-ordinated by J. ThomasMcCallum, CBV, FCGA, a business valuation and income tax consultant based in Whitby, Ontario, and author of several CGA-Canada professional development courses. E-mail jtmc@jthomasmccallum.com.

The information appearing in "Tax Strategy" is provided for the interest of the readers. Neither CGA Magazinenor the column authors and co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.