Preserving SR&ED Credits and Offshoring IP

Marie-Emmanuelle Vaillancourt Brian Bloom

April 2, 2014

Preserving SR&ED Credits – Introduction

Preserving SR&ED Credits – Introduction • 2012 Federal Budget

– Rate reduced from 20% to 15% for the non-refundable tax credit – Enhanced refundable tax credit for CCPCs remains at 35% – Capital expenditures no longer eligible

• Québec program remains the same (for now) – General rate is 17.5%, increased to 37.5% for certain Canadian

controlled corporations – Always refundable – Salaries only

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Preserving SR&ED Credits – CCPC Status

Preserving SR&ED Credits – CCPC Status • For smaller businesses in need of financing, the key is to

maintain CCPC status

• CCPC is defined in subsection 125(7) ITA

• To qualify as a CCPC, a corporation must satisfy two tests: – the “control” test; – the “hypothetical person” test.

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Preserving SR&ED Credits – CCPC Status • The “Control” Test:

“(a) a corporation controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, […] public corporations, […] corporations [listed on a designated stock exchange] or by any combination of them ... ”

• Concerned with both de jure (legal) and de facto (factual) control

• Control may be by a single person or by “one or more” persons, which has been interpreted as referring to a “group” of persons with a “sufficient common connection” (voting agreement, agreement to act in concert, business or family relationship, etc.) in Silicon Graphics v. The Queen (2002 FCA)

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Preserving SR&ED Credits – CCPC Status The “hypothetical person” test:

“(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 […] or by a corporation [listed on a designated stock exchange] were owned by a particular person, be controlled by the particular person”

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Preserving SR&ED Credits – CCPC Status • The “hypothetical person” test is a two-step process:

1. First, all shares of any corporation that are owned by disqualifying persons are attributed to a single hypothetical person;

2. Second, determine whether this hypothetical person would then control the particular corporation whose status is being tested.

• Concerned with de jure control only

• Attempts to override Silicon Graphics – Was this objective achieved in light of Sedona Networks Corporation v. The Queen (2007 FCA)?

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1. De jure Control

• Buckerfield’s Ltd. v. MNR (1964 Exch. Ct.) and Duha Printers (Western) Ltd. v. The Queen (1998 SCC)

– Control rests in the ownership of such a number of shares as carries with it the right to a majority of the votes in the election of board of directors, which requires not only an examination of the share register but also any constating documents limiting the power of the shareholders to control the board or the board's power to manage the affairs of the Corporation.

• A USA is an agreement by all shareholders and, possibly, a non-shareholder that restricts the powers of the board of directors to manage the corporation

– See s. 146 CBCA and s. 213 of the QBCA

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1. De jure Control

• A USA is a “constating document”, per the SCC in Duha Printers:

[a USA] is at least as important as the “traditional” constating documents in assessing de jure control. It would be truly artificial to conclude, only on the basis of the share register, the articles of incorporation, and the by-laws, that one shareholder has de jure control over the corporation by virtue of its apparent power to elect the majority of the board of directors, if a USA exists which limits substantially the power of the board itself. (para 65)

• In addition, for CCPC purposes, legal control must be determined taking into account any right described in 251(5)(b) ITA

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2. 251(5)(b) ITA

• A person’s right of any kind to acquire shares (or voting rights) or to cause a corporation to redeem shares (or reduce voting rights) held by other shareholders is deemed exercised in evaluating whether that person has legal control of the corporation

• Sedona Networks (discussed below), applies 251(5)(b) on a “fully diluted” basis, but the CRA takes the position that it may apply 251(5)(b) on a “holder-by-holder” or selective basis to challenge avoidance schemes (see CRA Document No. 2007-0253591I7)

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2. 251(5)(b) ITA

• The main issue in Sedona Networks was whether the taxpayer was a CCPC; shares of the taxpayer were held by a subsidiary of a public corporation, and both resident and non-resident employees and consultants were granted stock options

• To determine CCPC status under the “hypothetical person” test, the FCA (i) applied 251(5)(b) and (ii) assumed that all options were exercised simultaneously

• The CRA disregards the FCA’s approach and justifies its position by claiming that the discussion on 251(5)(b) was merely obiter, but it was not

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3. De facto Control

• Defined at 256(5.1) ITA: “any direct or indirect influence that, if exercised, would result in control in fact of the corporation”

• A USA would also be relevant for these purposes • Silicon Graphics:

“clear right and ability to effect a significant change in the board of directors or the powers of the board of directors”

“power to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors” (para. 67)

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3. De facto Control

• But Taber Solids Control (1998) Ltd. et al. v. The Queen (2009 TCC) and CRA take a broader view of de facto control “potential to make board decisions […] influence on

decisions.” (para 22)

• See also Lyrtech RD Inc. v. The Queen (2013 TCC) (under appeal) in which the court concluded that a public corporation (“Pubco”) had de facto control of the appellant in part because any director of Pubco was automatically eligible to be a trustee of the sole shareholder of the appellant

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3. De facto Control • Also relevant in Lyrtech was that Pubco had a

preponderant economic influence over the appellant taking into account the following factors:

– numerous executives and personnel in common (overlap) – same physical space – without a lease – unreasonable allocation of expenses (life insurance, accounting fees,

board fees) – economic dependence (only source of income was nominal royalty

fee from Pubco, Pubco acting as guarantor, etc.) – consolidated financial statements – a red flag?

• Bad facts make bad law • In obiter, the court also discussed the notion of

“beneficially interested” and its interaction with 251(5)(b), and concluded that the rights of a discretionary capital beneficiary were too uncertain and indirect to constitute rights under 251(5)(b) 15

4. USAs – The Control Test

• CRA’s position – Document No. 2009-0314351I7: the only provisions of a USA

that are relevant in determining de jure control are those that restrict the powers of the board; the nomination rights merely constitute a private agreement that is irrelevant for legal control purposes

– This was the basis of the assessment under review in The Queen v. PriceWaterhouseCoopers Inc., as Trustee in Bankruptcy for Bioartificial Gel Technologies (Bagtech) Inc. (2013 FCA), in which the Minister argued that a USA should be read to include only clauses that restrict the powers of the board of directors and that voting rights were not relevant to the determination of legal control (and hence could be severed from the USA and treated as a separate, private agreement)

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4. USAs – The Control Test

• However, in Duha, the SCC makes no distinction between “relevant” and “irrelevant” provisions of a USA for purposes of evaluating legal control

• In Duha, the SCC asks whether the USA leaves any way for the majority shareholder to exercise effective control over the affairs and fortunes of the tested company in a way analogous or equivalent to the power to elect the majority of the tested company’s board

– If the minority shareholder has the right to nominate the majority of the board under the provisions of a USA, how can those provisions be disregarded when evaluating legal control?

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4. USAs – The Control Test

• Our concerns with the CRA’s position are fortunately shared by the courts. In Bagtech, the FCA disagrees with the CRA’s position because it imports words into Duha

• The FCA also comments that Duha is a pragmatic and flexible decision, and that it provides clarity for taxpayers

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4. USAs – The Hypothetical Person Test • CRA’s position

– USAs cannot be taken into account because the “hypothetical person is not party to an unanimous shareholder agreement nor is that person deemed to be a party to it” (Income Tax Technical News no. 44)

– The same argument was made in Bagtech, in which the Minister maintained that the hypothetical person test only required an arithmetical exercise

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4. USAs – The Hypothetical Person Test • The CRA’s position is inconsistent with Duha Printers and

Sedona Networks

• It is also inconsistent with corporate law principles

– 146(3) CBCA and s. 218 QBCA provide that the purchaser or transferee of shares subject to USA is “deemed to be a party to the agreement”

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4.USAs – The Hypothetical Person Test • Again, our views were confirmed by the TCC in Bagtech

(this point was not pleaded before the FCA): the “hypothetical person” is deemed to have the same rights and obligations as those of the actual shareholders of the corporation, relying on subsection 146(3) CBCA and Sedona Networks

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Preserving SR&ED Credits – Other Considerations

Preserving SR&ED Credits – Other Considerations • What is happening on the ground?

– Audits of specific industries, more objections, more appeals, FPAP

• Primordial emphasis on: – Evidence (esp. documents!)

– T661

– “Canada”

• Stricter standards with respect to Bowman J’s 3 criteria” – Advancement, uncertainty, scientific method

• New TCC decisions within the next few years?

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Offshoring IP

Offshoring IP • Basic Idea

A Canadian company (“Canco”) that has incurred significant costs, e.g. research and development (R&D) expenditures, to develop “valuable” intellectual property (IP) transfers the IP to a foreign subsidiary (“Foreign OPCO”) that will commercialize the IP outside of Canada

• Applications – Generally, Canco is a high-tech or biotech company or a company with

trademarks that have not been exploited in foreign markets

– Public or private company

– Typically, Canco has tax losses or other available “tax shelter”

– Canco owns IP that is expected to be valuable but there remains uncertainty as to whether it will result in a commercially viable product

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Offshoring IP

• Benefits – Significantly lower tax rate on the profits from the

commercialization or sale of the IP compared to the Canadian corporate tax rate. This could also translate into a significantly increased sale price for Canco.

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Offshoring IP

• Timing is (Almost) Everything

1) The objective is to transfer the IP at an early enough stage to avoid (material) cash taxes but at a late enough stage to be able to reasonably predict its commercial viability

2) Thus, ideally, the transfer should occur at a time when the IP is expected to be valuable but there is enough uncertainty as to its commercial viability that the gains realized on the transfer can be offset by Canco's "tax shelter" i.e., net capital and non-capital losses, R&D expenditure pool, unused ITCs, 20(1)(e) expenditures, etc.

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Offshoring IP

• Timing is (Almost) Everything

3) Accordingly, the first step is to obtain an independent, professional valuation of the IP and to compare that valuation to Canco's tax shelter to determine if the transfer can be accomplished without any (material) cash taxes

4) N.B. The gains on the transfer of the IP are generally capital gains, only 50% of which are taxable

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1. Selecting a Jurisdiction for Foreign OPCO • Think of the 4 S

1) Safety

2) Savings

3) Certainty

4) Sales

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1. Selecting a Jurisdiction for Foreign OPCO • Ask yourself the following questions: Does the jurisdiction

have 1) political stability and robust IP laws (safety)? If yes, go to (2). If

not, look for another jurisdiction.

2) low taxes (savings)? If yes, go to (3). If not, look for another jurisdiction.

3) an extensive tax treaty network (savings and sales)? If yes, go to (4). If not, consider another jurisdiction.

4) a tax rulings process (certainty)? If yes, go to (5). If not, consider the strength of the jurisdiction's rule of law.

5) qualified people who could serve as employees (sales)? If yes, you have found a jurisdiction. If not, then consider whether Canadian employees would be willing to relocate or whether the personnel deficit can otherwise be filled.

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2. Sample Transaction Steps

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1) Canco forms a corporation in a low-tax jurisdiction with which Canada has a tax treaty or TIEA (“Foreign OPCO”)

2) Foreign OPCO hires employees with the necessary qualifications to pursue the development and/or commercialization of the IP

3) Canco contributes the IP to Foreign OPCO, minus the rights to exploit the IP in Canada, for shares of Foreign OPCO

4) Concurrently with step 3, Canco and Foreign OPCO enter into a cost sharing arrangement or service agreement ((C)SA) under which they would agree to pursue the continuing development of the IP

Canco

Foreign OPCO (e.g. Switzerland)

Shares IP

IP Employees

CAN commercialization rights

(C)SA

2. Sample Transaction Steps

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5) Canco then forms another foreign corporation in a jurisdiction that has a holding company regime, (“Holdco”). Under the selected holding company regime, dividends paid by Foreign OPCO to Holdco and gains realized by Holdco on a sale of Foreign OPCO’s shares should be exempt from tax. Also, Foreign OPCO’s jurisdiction should not levy a withholding tax (WHT) on the above-mentioned dividends

6) Canco transfers the shares of OPCO to Holdco for shares of Holdco

7) Canco forms another foreign corporation (“Finco”) in a low or no-tax jurisdiction with which Canada has a tax treaty or TIEA and capitalizes it when and as needed to finance OPCO through interest-bearing loans. Finco’s jurisdiction should not levy a WHT tax on dividends paid by Finco to Canco and Foreign OPCO’s jurisdiction should not levy a WHT on interest paid to Finco

8) Once the IP is ready to be commercialized, OPCO or Holdco can form “stripped distributors” and/or “commissionaire” companies to effect the sales in the target markets and/or sell/license directly to customers outside of Canada

Canco

Foreign OPCO (e.g. Switzerland)

OPCO Shares

Holdco Shares

IP Employees

CAN commercialization rights

(C)SA

HOLDCO (e.g. Gibraltar)

Loans FINCO (e.g.

Caymans)

Shares $

Interest

2. Sample Transaction Steps

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CANCO

• R&D • CAN Sales & Marketing • CAN Regulatory Matters • Legal & Accounting 100%

100%

HOLDCO (e.g. Gibraltar)

Foreign OPCO (e.g. Switzerland)

FINCO (e.g. Caymans)

Loans

100%

• Sales & Marketing

• Regulatory Matters

• Supervision of Clinical Trials and/or Data Compilation

• Quality control

• (Manufacturing)

• (Research)

IP

CAN commercialization rights

(C)SA $

Stripped Distributors

Sales/ Licenses

to subs

Commissionaires

Sales/ Licenses

e.g. Europe

Sales/Licenses Customers outside of

Canada Interest

small profit small profit

100%

Sales/Licenses

e.g. U.S.

Final Structure

3. Tax Objectives • Canadian tax objectives

1) Gains on sale of IP by Canco should be offset by Canco’s tax shelter, e.g. tax losses and R&D expenditure pool

2) Foreign OPCO’s earnings derived from the commercialization of the IP should not be taxable in Canada and the effective tax rate on such earnings should be significantly less than Canco’s corporate tax rate

3) The comments in 2) apply equally to gains from the sale of the IP by Foreign OPCO

4) Foreign OPCO’s earnings should be exempt surplus and thus should not be taxed in Canada when distributed to Canco

5) Canadian federal & provincial R&D tax credits should still be available to Canco due to Canco’s continued R&D function and the retention of Canadian commercialization rights

6) Interest paid by Foreign OPCO to Finco should be attributed to Finco’s exempt surplus and thus should not be taxable in Canco’s hands when distributed to it 34

3. Tax Objectives

• Foreign tax objectives 1) Low effective tax rate on Foreign OPCO’s earnings derived from the

commercialization of the IP and on gains from the sale of the IP

2) Foreign OPCO’s earnings should be able to be distributed to Canco without bearing any foreign WHT and should not be taxable to HOLDCO

3) There should be no WHT on interest paid by Foreign OPCO to FINCO and the interest received by FINCO should bear little or no tax in FINCO’s jurisdiction

4) There should be no WHT on dividends paid by FINCO to Canco

5) Depending on the selected jurisdiction, Foreign OPCO, HOLDCO and FINCO may bear modest non-income taxes

6) Under international transfer pricing principles, the foreign stripped distributors and commissionaires should earn only a small profit from their activities in the target markets, as they have very limited assets, functions and risks

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4. Tax and Other Considerations

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Canco

• Transfer price on sale of IP to OPCO → need valuation

• Sufficient tax shelter to soak up the gain on sale of IP to OPCO

• 247(2)(b)/(d) recharacterization→ consider price adjustment linked to achievement of milestones

• OECD Guidelines on business restructurings

• FAPI

• GAAR

Foreign OPCO

• Effective tax rate on income and gains

• Capital taxes, stamp duties, VAT

• Withholding taxes on interest & dividends

• Non-federal taxes

• Thin capitalization / earnings stripping rules

• Availability of loss carryovers

• Tax holidays

• Treaty network

• US LOB clause if licensing to US residents

• Availability of advanced rulings

• Foreign branch may reduce effective tax rate even further

Holdco

• Participation exemption

• Capital taxes, stamp duties

• Withholding tax on dividends

• Level of substance required to avoid withholding tax on dividends from OPCO

• Treaty with OPCO’s jurisdiction

• Benefit of EU Parent-Subsidiary Directive

• Availability of advanced rulings

Finco

• Effective tax rate on interest

• Withholding tax on dividends

Tax Considerations

4. Tax and Other Considerations

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Other Considerations

Canco

• Is IP security for Canco’s debt?

• Shareholder approval needed?

• Cost of valuation from independent, professional valuator

Foreign OPCO

• IP fully protected?

• Subordinate Finco loans to other OPCO debt?

• Identifying local directors & employees

Holdco

• Annual maintenance / substance costs and when they must be incurred

• Identifying local directors

Finco

• Identifying local directors

Thank you!

Marie-Emmanuelle Vaillancourt 514 841-6543 mevaillancourt@dwpv.com

Brian Bloom 514 841-6505 bbloom@dwpv.com