In the context of a sale of a business operated by a corporation, the seller and buyer typically have competing interests. Whereas sellers tend to prefer selling their shares of the corporation so that they can receive the sale proceeds directly and pay tax on any gains at preferential capital gains rates, buyers tend to prefer buying the corporation's business assets in order to step-up the cost amount of those assets and avoid acquiring unwanted assets and unknown liabilities.
While "hybrid" asset and share sale transactions have proven to be a popular tool for bridging this gap between sellers and buyers, they need to carefully planned and considered, particularly in light of the increasingly broad interpretation being given to subsection 84(2) of the Income Tax Act (Canada) (the "Tax Act"). For example, in Foix v. The King,1 the Federal Court of Appeal (the "FCA") recently concluded that subsection 84(2) of the Tax Act applied to a series of "indirect, structured and inter-related" transactions involving distributions of a corporation's cash or cash equivalents to a taxpayer when a third-party facilitator is involved. As a result of the FCA's finding, certain amounts received by the taxpayers in that case as part of a hybrid sale were deemed to be dividends instead of proceeds of disposition, which precluded the taxpayers from claiming their lifetime capital gains exemptions.
The facts at issue in Foix involved a complicated hybrid sale of the shares and assets of Watch4NetSolutions Inc. ("W4N"), which carried on the business of software development. All of the outstanding shares of W4N were directly and indirectly owned by Mr. Foix, Mr. Souty, their family trusts and their holding companies.
In November 2011, Mr. Foix and Mr. Souty entered into a letter of intent with EMC Corporation ("EMC US") and EMC Corporation of Canada ("EMC Canada") to sell the shares of W4M for a purchase price of $50 million. The letter of intent provided that W4N could distribute to its shareholders any excess cash on hand before closing, subject to maintaining an agreed upon working capital balance.
In April 2012, the parties agreed to convert the proposed W4N share sale to a hybrid sale of W4N's assets and shares for a total purchase price of $70 million. This hybrid sale involved the following steps:
- EMC Canada acquired the W4N shares held by Mr. Foix's family trust and Mr. Souty's family trust in exchange for EMC Canada issuing a $2,489,591 promissory note to each family trust (the "Trust Notes"). The Trust Notes were paid by the escrow agent at the conclusion of the hybrid transaction steps.
- EMC US acquired W4N's software, intellectual property assets and non-Canadian contracts in exchange for EMC US providing the following consideration to W4N: (i) two promissory notes with each note having a principal amount of $11 million (the "Capital Dividend Notes"), (ii) a promissory note in the principal amount of $19.75 million (the "Balance Note"), and (iii) EMC US assuming $2.3 million of W4N's liabilities. The Capital Dividend Notes were paid by the escrow agent at the conclusion of the hybrid transaction steps, but the Balance Note was not and remained outstanding and payable after completion of the transaction.
- EMC Canada acquired all of the remaining shares of W4N, except the W4N shares held by Mr. Foix's holding company, Virtuose Informatique Inc. ("Virtuose"). Instead of acquiring the W4N shares held by Virtuose, EMC Canada acquired all of the shares of Virtuose. The purchase price for these shares was paid in cash to the W4N and Virtuose shareholders.
Following the completion of the hybrid transaction, W4N, Virtuose and EMC Canada were amalgamated.
Although each of Mr. Fox, Mr. Souty and Mr. Souty's family trust (of which Ms. Lebel (Mr. Souty's spouse) was a beneficiary), reported a capital gain on the sale of their W4N or Virtuose shares, as applicable, and claimed their respective lifetime capital gains exemptions, the Canada Revenue Agency (the "CRA") reassessed and re-characterized such capital gains as deemed dividends pursuant to subsection 84(2) of the Tax Act.
In concluding that subsection 84(2) of the Tax Act applied, the Tax Court of Canada (the "TCC") gave a broad interpretation to that subsection that allowed it to trace the purchase price for the W4N and Virtuose shares to the excess cash that remained in W4N at closing, which was indirectly distributed to the taxpayers through the EMC group as an intermediary according to the TCC. The TCC also concluded that such distribution occurred on the winding-up, discontinuance and reorganization of the businesses of W4N and Virtuose. The taxpayers appealed both of these findings to the FCA.
In dismissing the taxpayers' appeal and upholding the decision of the TCC, the FCA concluded that subsection 84(2) can broadly apply to "indirect, structured and inter-related" transactions involving distributions of a corporation's cash or cash equivalents to a taxpayer at a time when the taxpayer is no longer a shareholder of the corporation when a third-party facilitator is involved.
Pursuant to subsection 84(2) of the Tax Act, where property of a corporation has been distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders on the winding-up, discontinuance or reorganization of its business, the shareholders are generally deemed to have received a dividend. Therefore, in order for subsection 84(2) to apply, the following two conditions must be satisfied, which were considered by the FCA:
- Funds or property of a corporation must be distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders; and
- If so, the distribution or appropriation must have occurred on the winding-up, discontinuance or reorganization of the corporation's business.
With respect to the first question, the FCA was of the view that the Balance Note debt owing to W4N by EMC US amounted to a cash equivalent of W4N that was, in fact, excess and beyond what was needed to operate W4N's business as a result of selling its operating business assets. The FCA was also of the view that W4N has been impoverished to the benefit of its shareholders (i.e., the taxpayers), which is a requirement of subsection 84(2), on the basis that the amount owing under the Balance Note remained unpaid in favour of EMC Canada using the Balance Note repayment funds to instead fund the purchase price for the W4N and Virtuose shares acquired from the taxpayers. Moreover, since the value of the Virtuose shares was derived from the value of the W4N shares, the impoverishment of W4N resulted in a corresponding impoverishment of Virtuose.
In reaching this conclusion, the FCA held that the scope of subsection 84(2) is sufficiently broad to apply to an indirect distribution in circumstances where the property being distributed is fungible and a third-party facilitator was involved in the extraction process, which was the case here. In support of this, the FCA emphasized that "distributed or otherwise appropriated" in subsection 84(2) is broadly qualified by the phrase "in any manner whatever" and that an overly literal reading of that subsection would defeat its anti-avoidance mission. The FCA also stated that, based on its decision in The Queen v. Vaillancourt-Tremblay,2 the indirect distribution of fungible property (e.g., cash), in contrast with non-fungible property, does not preclude the application of subsection 84(2) when the property can be traced back to the target corporation.
With respect to the second question, the FCA was of the view that the phrase "winding-up, discontinuance or reorganization" in subsection 84(2) should also be interpreted broadly. According to the FCA, the hybrid transaction amounted to a reorganization of W4N's business for purposes of subsection 84(2) on the basis that W4N's business, as it existed prior to the transaction, was split into two, with EMS US having acquired W4N's software, intellectual property assets and non-Canadian contracts, and EMC Canada having acquired the balance of W4N's assets. With respect to Virtuose, the FCA characterized its pre-sale business as acting as a holding company on behalf of Mr. Foix with that business being discontinued as a result of the hybrid transaction.
Based on this decision, taxpayers who undertake hybrid transactions, or other transactions involving the extraction of a corporation's surplus with the assistance of third-party facilitators, must beware of subsection 84(2) and its wide scope. Any such transactions need to be carefully planned to ensure that they do not run afoul of subsection 84(2).
1. 2023 FCA 38.
2. 2010 FCA 119.
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