In allowing the government’s appeal in Canada v. Deans Knight Income Corporation, the Federal Court of Appeal (FCA) clarified the object, spirit, and purpose of subsection 111(5) of the Income Tax Act. Where control of a corporation is acquired, subsection 111(5) can limit the use of the corporation’s losses. The FCA established that the acquisition-of-control condition in this provision refers not just to de jure (legal) control, but also to actual control. Taxpayers engaged in merger and acquisition transactions should be aware of the FCA’s expansive interpretation of an acquisition of control.
Deans Knight Income Corporation was a public corporation that carried on a drug research and food additives business. Deans Knight had losses from its business and sought to monetize its losses. To do so, it underwent a reorganization that “turned the reins” over to Matco Capital Ltd., but did so in such a way that avoided Matco acquiring de jure control of Deans Knight. Matco used its expertise to arrange a takeover of Deans Knight in an IPO. Deans Knight used the funds raised from the IPO to commence a new business that earned profits and utilized the losses from the drug business to shelter the profits. An IPO was necessary so that there would not be a person or group of persons that would acquire control of Deans Knight. If there was a person or group of persons that acquired control of Deans Knight – whether Matco or another person or group of persons – subsection 111(5) would apply to prohibit Deans Knight from using the losses against its profits from the new business.
The government argued that the General Anti-Avoidance Rule (GAAR) applied because the transactions avoided subsection 111(5). Specifically, the government’s position was that, although there had not been a change in de jure control, Matco had effective control over Deans Knight, thereby constituting a change in control that frustrated the object, spirit, and purpose of subsection 111(5). The Tax Court of Canada (TCC) disagreed. The TCC determined that the object, spirit, and purpose of subsection 111(5) is “to target manipulation of losses of a corporation by a new person or group of persons, through effective control over the corporation’s actions” (paragraph 134 of the TCC decision), and that Matco did not have effective control.
The FCA overturned the TCC decision. First, the FCA “rearticulated” the object, spirit, and purpose of subsection 111(5) as restricting “the use of specified losses, including non-capital losses, if a person or group of persons has acquired actual control over the corporation’s actions, whether by way of de jure control or otherwise.” [emphasis added]. The FCA stated that the TCC’s use of the term “effective control” in the object, spirit, and purpose of subsection 111(5) resulted in the parties incorrectly interpreting it as being a synonym for de jure control. The FCA decision to replace “effective control” with “actual control” clarified that the acquisition-of-control condition in subsection 111(5) refers not just to de jure control, but to actual control (i.e., de facto control).
Second, with the object, spirit, and purpose clarified, the FCA went on to conclude that Matco had actual control of Deans Knight and, as a result, the GAAR applied because the transactions abused the object, spirit, and purpose of subsection 111(5).
This expanded interpretation of an acquisition of control could have an effect on taxpayers engaged in merger and acquisition transactions.
