Deans Knight wins precedent-setting "recap and restart" case

The Tax Court of Canada has ruled in favour of Deans Knight in its dispute with the Minister of National Revenue, finding that "recapitalization and restart" transactions do not offend the general anti-avoidance rule (the GAAR). The Court held that the Minister was wrong to deny the company from applying its tax losses resulting from one failed business against its income from a newly-started, successful, business.

The Deans Knight Income Corporation v. R. (Deans Knight) case confirms that the de jure control test is the critical criteria for determining when loss trading has occurred in recapitalization transactions. An acquisition of de jure control occurs when a person acquires 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.

The Court found that Parliament has deliberately chosen the acquisition of de jure control test to identify when a tax attribute is considered to be notionally transferred to an arm's length party (which, in turn, triggers certain loss streaming rules). Moreover, changes in management, business activities, assets and liabilities, name and shareholders are not markers of a change of effective control of a corporation.


In Deans Knight, a public company in the drug research and food additive business had accumulated significant tax attributes (non-capital losses, scientific research and experimental development expenditures, and investment tax credits). The company was running low on funds and decided to pursue a transaction to capitalize on the value of its tax attributes.

The company first "spun-out" its drug and food additive business into a new parent corporation (the New Parent), following which a new investor, Matco, loaned money to the company. Matco's investment required that the company search for a new corporate opportunity, with Matco's assistance. Matco's investment was in the form of a convertible debenture that was convertible into a significant portion of the equity of the company (approximately 79%), but did not acquire voting control (Matco's voting interest was approximately 35%).

Matco then assisted the company in searching for a new business opportunity. The company was introduced to the investment team at Deans Knight Capital Management (DKCM), a fund advisor that was seeking to start a bond investment business, and wanted to raise public money to finance it. The company, Matco and DKCM reached an agreement whereby the company would raise approximately $100 million dollars in an IPO offering, and would use those funds to start buying corporate bonds. The company's old management team resigned, and the DKCM team were hired to conduct the business. The board of directors was reconstituted with independent directors, DKCM nominees, and a Matco nominee (Matco also remained as a shareholder).

The company was successful in its IPO, and in its new business for several years, earning income and paying dividends to its investors. The Canada Revenue Agency reassessed the company, asserting that Matco had acquired a right (a Residual Right) to 100% of the company shares, including all of the voting shares. If Matco did not have a Residual Right to acquire all of the shares, then the Crown asserted that the GAAR applied.

The Residual Right that wasn't

If Matco had a Residual Right, then it would have acquired effective control (de jure control) over the company, and the company's tax attributes would be restricted. The Minister argued that Matco had a Residual Right under the investment agreement between Matco, the company and New Parent.

The investment agreement provided both that (1) the company would receive a cash loan; and (2) the New Parent was guaranteed to receive an additional $800,000 within a year (the Guaranteed Amount). The investment agreement aligned the interests of the company, New Parent and Matco. On the one hand, if Matco did not find a new business for the company to pursue, then it would have to pay the Guaranteed Amount to New Parent. On the other hand, if New Parent turned down a corporate opportunity, or received an opportunity to sell its company shares during the year, this would relieve Matco of its obligation to pay the Guaranteed Amount.

As a result of the IPO, there was an opportunity for New Parent to sell its company shares on the public market. However, the shares were subject to a six-month lock-up period. Matco made an offer to acquire the company shares during the IPO lock-up period. New Parent accepted the Matco offer, even though the offered price was less than the IPO price. New Parent was motivated to sell the shares quickly and did not want to wait and take the risk of selling the company shares on the open market after the lock-up period expired.

The Tax Court judge determined that the investment agreement did not give Matco a Residual Right to acquire the company shares. Instead he found that each party acted independently, and that New Parent had control over its shares (i.e. the majority of the voting shares) of the company at all times. Thus, Matco did not acquire effective control over the company at any time.


The Minister argued that if Matco did not actually acquire control, that the GAAR applied in any event. The Minister argued that the transfer of losses between the company's former business, to be applied against its new investment business, is not allowed under the general policy against loss trading in the Income Tax Act. The Court held that this position was wrong, and not supported

In all GAAR cases, the Court must first determine the object, spirit and purpose of the provisions at issue. The Tax Court judge made the following precedent-setting findings about the object, spirit and purpose of the Income Tax Act:

  1. Since the government shares in a taxpayer's income (i.e. through income tax), the object, spirit and purpose of allowing loss deductions is to provide relief to taxpayers who have suffered losses. There is no limit on the type of income against which losses can be offset, nor is a company required to carry on the same business that generated the losses, in order to deduct them.
  2. A company's ability to deduct losses becomes restricted only when an acquisition of de jure control occurs. The de jure control test is the mechanism by which Parliament has determined that losses have notionally been transferred to an unrelated party. The test is a reasonable marker between situations where a company is a free actor, versus when it is only a passive participant whose tax attributes can be manipulated for another's benefit. The test, therefore, prevents arm's length persons from manipulating corporate losses by acquiring effective control of the corporation.
  3. Finally, where a person acquires rights to shares or voting rights, with the intent of avoiding an acquisition of control, the person is deemed to have exercised those rights. This means that a person can be deemed to acquire de jure control of a company, without actually acquiring the majority of voting shares. The purpose of this rule is to prevent persons from circumventing the loss restriction provisions by acquiring control over shares or voting rights, instead of the shares themselves, to achieve effective control over a company with tax attributes.

At the end of the day, the Tax Court concluded that the Minister was attempting to read the de jure control test out of the loss streaming rules, by applying the GAAR. This was inappropriate and not allowed.

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