On February 20, 2023, the Federal Court of Appeal ("FCA") rendered its decision in Foix v The King.1 Under appeal were three decisions from the Tax Court of Canada ("TCC") confirming reassessments of the Minister of National Revenue pursuant to subsection 84(2) of the Income Tax Act.2 The FCA dismissed the appeals.
The issue at the heart of the appeals was the breadth of subsection 84(2). At a high level, subsection 84(2) is intended to tax, as a deemed dividend, distributions "in any manner whatever" made by a Canadian resident corporation on the "winding-up, discontinuance or reorganization" of its business, except to the extent the distribution represents a return of paid-up capital.
The FCA decision in Foix reaffirms that subsection 84(2) should be interpreted broadly, particularly where the purchaser acts as a facilitator of the seller's tax planning, in helping with the indirect distribution of the target's liquid assets. In the view of some, Geransky3 was precedent for subsection 84(2) not applying to hybrid asset-share transactions.4 Foix confirms that subsection 84(2) can apply to hybrid asset-share transactions and raises questions as to how the timing of distributions in surplus stripping transactions impacts its application.
In the transaction at issue, the purchaser parties were The EMC Corporation ("EMC US"), a large US public corporation, and EMC Corporation of Canada ("EMC Canada", together with EMC US, the "EMC Group"), a Canadian subsidiary of EMC US. The target corporation was Watch4Net Solutions Inc. ("W4N"), all of the shares of which were held directly or indirectly by Mr. Foix, Mr. Souty, their family trusts and their holding companies.
Through a series of steps the TCC described as "indirect, structured, simultaneous and inter-related", the EMC Group purchased W4N in a hybrid asset-share transaction. The total purchase price of W4N's assets and shares was approximately $70,000,000, which was paid in a combination of promissory notes and cash. However, due to the non-payment of a particular promissory note (the "Balance Note"), the amounts actually disbursed were in the vicinity of $50,000,000.
When the parties negotiated the transaction, they provided that the sellers could distribute out of W4N any of its excess cash prior to the closing. The series of transactions was designed to minimize the tax consequences resulting therefrom, by allowing such excess to be taxed as additional sale proceeds rather than as a dividend.
A key focus of the FCA's analysis was the Balance Note, which arose between EMC US and W4N as part of the asset sale component of the hybrid sale transactions. Since EMC Canada ultimately acquired all of W4N's shares, the EMC Group reacquired the Balance Note, which was left unpaid and became internal to the EMC Group as an outstanding debt between EMC US and EMC Canada. On the basis of the Balance Note, the appellants argued that subsection 84(2) did not apply because W4N had not been impoverished, which is one of the conditions for the application of subsection 84(2).
The FCA held that subsection 84(2) applied to the transactions. The FCA explained that:
- the TCC found that the amount that was to be used to pay the Balance Note was in fact used to pay for W4N's shares – put another way, the FCA stated that the "nonpayment of the debt in the course of the hybrid sale freed up the necessary funds to defray the cost of W4N's shares";5
- the appellants did not call witnesses from EMC US or EMC Canada to show what became of the Balance Note, which would have been a simple matter; and
- the view of W4N's accountant was that the Balance Note would never be paid, and that EMC US had no interest in paying it given its amount exceeded W4N's operational needs.
In such circumstances, the FCA held that it was open to the trial judge to find as a fact that the debt evidenced by the Balance Note was used to "fund" the cost of W4N's shares, thereby impoverishing W4N, to whom the debt was owed. Put differently, the Balance Note represented excess cash out of W4N that was distributed to the sellers. The FCA emphasized that subsection 84(2) should be read broadly, and the focus should not be exclusively on the legal characterization of the transactions, where fungible property is being distributed indirectly and accommodation is involved. The FCA distinguished Geransky on the basis that the third-party purchaser in Geransky case did not act as a facilitator because the "saving of tax" that the sellers were contemplating had no impact on negotiations, which was not the case in Foix.
Pipeline Transactions and Timing of Distributions
The broad reading of subsection 84(2) in Foix is interesting in the context of past judicial comments on the timing of distributions and its impact on the application of subsection 84(2). In a 2012 case, MacDonald,6 the TCC considered whether subsection 84(2) applied to a surplus stripping plan similar to what is referred to as a "post-mortem pipeline" transaction,7 which the CRA has issued favourable rulings in respect of.
In MacDonald, the TCC expressed dissatisfaction with the inconsistency between the CRA's rulings on post-mortem pipeline transactions and the CRA's challenge to other, similar surplus stripping transactions. In the court's view, the CRA's conditions were "arbitrary" and intended to make these transactions "look" less artificial.8 To resolve this inconsistency, the TCC held that subsection 84(2) should be applied literally in all cases and the general anti-avoidance rule applied in cases of abuse. On appeal, the FCA overturned the TCC, taking a broader view of subsection 84(2) and holding that it applied to the corporate funds received by the taxpayer as a distribution "in any manner whatever", notwithstanding that the legal character of the receipt was repayment of debt instead of a dividend.9
In another surplus stripping case, Descarries,10 the TCC held that, for subsection 84(2) to apply, there must not only be a distribution of funds of the company, but the distribution must coincide with a "winding-up, discontinuance or reorganization." After the release of Descarries, the CRA stated that it did not agree with the decision, suggesting that a distribution may occur "on" the winding-up, discontinuance or reorganization of the corporation's business, notwithstanding that the distribution occurs some time after the transactions were undertaken.11
In Foix, the FCA discussed both MacDonald and Descarries and seemed to minimize a distribution's timing as a factor relevant to determine the application of subsection 84(2). The FCA stated:
Unfortunately, the distinction that was drawn in MacDonald (FCA) was subsequently used by the Tax Court to validate a formalistic and restrictive application of subsection 84(2) because... the impoverishment of the target corporation did not perfectly coincide with the alleged distribution (Descarries, paras. 26–28), even though this impoverishment and the shareholders' related enrichment were caused by a series of transactions spread over two years and made possible through the involvement of a third-party facilitator (Descarries, paras. 1–2).12
Accordingly, Foix raises questions as to how the timing of distributions in surplus stripping transactions impacts the application of subsection 84(2), and how that impact differs in comparison to its impact in post-mortem pipeline transactions, where the CRA has issued multiple rulings to the effect that a one-year delay prevents the application of subsection 84(2).13 It will be important to monitor how this issue develops in future cases.
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1. 2023 FCA 38 ("Foix").
2. All references to legal provisions in the present text constitute a reference to the Income Tax Act.
3. Geransky v R (2001), 55 DTC 243 (TCC) ("Geransky").
4. In a sale of a business carried on by a corporation, the sale is sometimes structured as an asset sale, which is often favourable to buyers, and is sometimes structured as a share sale, which is often favourable to sellers. As an alternative, the sale may be structured as a hybrid asset-share sale, which can provide both buyer and seller with some benefits. In Geransky, the TCC found that 84(2) did not apply to a particular hybrid asset-share sale.
5. Foix (FCA), para 66.
6. MacDonald v R, 2012 TCC 123 ("MacDonald").
7. The CRA has issued rulings that certain post-mortem pipeline transactions will not be subject to subsection 84(2) if the liquidating distribution does not take place within one year and the deceased's company continues to carry on its pre-death activities during that period.
8. MacDonald (TCC), para 80.
9. MacDonald v R, 2013 FCA 110.
10. 2014 TCC 75 [Informal Procedure] ("Descarries").
11. CRA Doc No. 2014-0538091C6.
12. Foix (FCA), para 75.
13. See e.g., CRA Doc Nos. 2012-0464501R3; 2011 STEP Roundtable, Q. 5 2011-0401861C6; and 2018 STEP Roundtable Q. 10 2018-0748381C6.
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