Startup founders should be aware of a subtle change coming to the Income Tax Act (Canada) based on wording revealed in the recent federal budget. It could impact their tax rate or ability to participate in programs like SR&ED.

The change centres around Canadian Controlled Private Corporations, or CCPCs, and it’s important because they have much lower tax rates (by as much as half) than non-CCPCs. Other benefits of CCPCs include eligibility for refundable tax credits for research and development (through the SR&ED program) and access to equity tax credits. Therefore, CCPC status is important for startups because it allows them to minimize taxes, recover investment costs, and more easily raise investment. However, the 2017 federal budget announced a measure that may put CCPC status at risk for some companies that have foreign shareholders.

As the name suggests, there are primarily two factors that qualify a company as a CCPC. First, it must be Canadian-controlled. This is a bit misleading – technically, it just cannot be controlled by non-Canadians. Second, it must be private in the sense that its shares are not publicly listed and it is not controlled by public companies. The Canada Revenue Agency determines CCPC status and as with most tax measures there are many intricacies, but this is the general overview.

The issue arising in the budget is the definition of “control.” As with many things lawyers are involved with, the definition of “control” has been hotly debated. The result is quite a few court cases that address the issue. Two definitions have arisen. First, there is legal control—when someone has sufficient shares to elect most of a company’s directors, they legally control the company. Second, there is factual control, which has been much more controversial. The most recent case on factual control decided that a shareholder factually controls a company when he or she has any “legally enforceable right” to elect most of the company’s directors.

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As an example, let’s consider a fictional company called Wigs-n-Things, which is based in Nova Scotia. It gets an investment from an American investor, Victoria Cruz. Victoria takes 30 percent of the company’s shares and the right to elect two of five directors. Victoria does not legally control the company because she only has 30 percent of the vote. Further, although she has the right to elect two of the five directors on her own, Victoria has no legally enforceable right that lets her elect a third director on her own. The Canadian shareholders can still elect most of the board and therefore, Canadians factually control the company.

The “legally enforceable right” requirement in the definition of factual control is new, stemming from a 2016 case, and the CRA does not like it. Therefore, this year the government will legislate a definition of factual control that removes the requirement for a “legally enforceable right.” The proposed rule is not a new standard; in fact, the government’s proposal looks a lot like the way things were up until the 2016 case, so we have a good indication of how it will be interpreted. Most likely, factual control will exist when a shareholder has any power that may allow him or her to elect most the board.

Let’s go back to Wigs-n-Things. Although Victoria cannot legally choose most of the board, she owns a significant stake in the company. Furthermore, she may act as an adviser to the founders, who control operations and own most of the rest of the shares. If the founders tend to take Victoria’s advice on business matters, she may also be able to suggest whom they should elect to the board. In this case, Victoria has a soft power that allows her to fill the board. Under the new standard, this could be considered factual control, in which case Wigs-n-Things would lose its CCPC status.

So, why does this matter for startups?

The new definition of factual control means that companies with large or heavily involved foreign investors (for example, American VCs) may be at risk of losing their CCPC status if audited. Some factors to consider:

- How many directors can non-Canadian shareholders elect?
- How involved are non-Canadian shareholders in the company’s business?
- Does company management take advice from or rely on non-Canadian shareholders?
- Can non-Canadian shareholders affect operations (e.g. veto large transactions)?

None of these factors on their own or together is conclusive and it is by no means a closed list, but if many of them exist, you should consult with your advisers (ideally, a lawyer). For most companies, the change will have little effect, but for some, it may make a big difference and so should be considered by any company that currently has or is taking on substantial foreign investment.

Eric Feunekes is graduating from the University of New Brunswick this May with both law and MBA degrees. Eric has years of experience working in business with startups, which he will be bringing to McInnes Cooper, where he will be working as an articling student on his way to becoming a lawyer.