Introduction – The Mechanisms Available for the Sale of a Private Business
Broadly, the sale of a private business can be structured as either a sale of shares, or as a sale of assets. Structuring the sale of a private business as an asset purchase or a share purchase is often tax-motivated for both the purchaser and the vendor. Generally speaking, a purchaser will prefer an asset purchase and sale because the cost base of those assets acquired will be increased. For the purchaser, this will translate into increased capital cost allowance deductions available in subsequent years to reduce taxable income. A vendor will generally prefer to sell the shares of an incorporated business as opposed to its assets because, where those shares are qualified small business corporation ("QSBC") shares, the vendor can usually take advantage of Canada's Lifetime Capital Gains Exemption to shelter part of the proceeds of sale.
A "hybrid sale" of a private business occurs when a private business is sold by selling both the assets and shares of the business to the purchaser separately. In a hybrid sale, the purchase typically acquires specific assets of the target corporation (i.e. intellectual property, patents, or other intangible assets like goodwill) that are most useful for the purchaser's business. After extracting desired assets, the purchaser will then acquire the shares of the target corporation. A properly structured hybrid sale thus allows each party to access the best tax benefits of an asset purchase and a share purchase where each has a different tax motivation behind how to structure the agreement.
The viability of structuring a hybrid sale depends on a number of factors unique to a proposed transaction, including the nature of the assets the target corporation holds, and the ability of the target corporation's shareholders to increase the adjusted cost base of their shares prior to sale. And while hybrid sales are not inherently offensive from a tax perspective, they have often been viewed with skepticism by the Canada Revenue Agency ("CRA"), given that tax reduction is almost always a principal goal.
The Federal Court of Appeal's ruling in Foix v His Majesty the King, 2023 FCA 38, has threatened to radically undermine the tax benefits of a hybrid sale when selling a private business.
At first blush, the Federal Court of Appeal's ruling in Foix undermines decades of jurisprudence concerning the meaning of a "reorganization" for tax purposes, and the extent to which even a carefully planned hybrid sale can avoid triggering the anti-avoidance rules of the Income Tax Act.
This article will begin by briefly exploring the nature of subsection 84(2) of the Income Tax Act, and the anti-avoidance rule with respect to business reorganizations. We will continue by exploring the actions of the taxpayers that were in question in Foix, and the judgements of the Tax Court of Canada and the Federal Court of Appeal.
Next, we will explore some of the implications of the Federal Court of Appeal's ruling for Canadian entrepreneurs and advisors who might otherwise want to structure a private business sale as a hybrid sale. We will conclude with some pro tax tips and some frequently asked questions concerning hybrid sales of private businesses and the anti-avoidance rule under subsection 84(2) under the Income Tax Act.
Subsection 84(2) of the Income Tax Act: Inappropriate Distributions to Shareholders on a Business Reorganization
Subsection 84(2) of the Income Tax Act is an anti-avoidance provision intended to prevent taxpayers from inappropriately extracting the accrued value of a corporation in the process of closing or reorganizing the corporation's business. In order to trigger subsection 84(2), the following conditions must be met:
- the subject corporation must be a resident Canadian corporation;
- there must be, in any manner whatsoever, a distribution or appropriation of the subject corporation's funds or property, in the context of a wind-up, reorganization, or discontinuance of the subject corporation's business; and
- that distribution or appropriation must be to or for the benefit of the subject corporation's shareholders.
If the conditions of subsection 84(2) are met, then any shareholder who receives a distribution or appropriation of the subject corporation's funds or property is deemed to receive a fully taxable dividend (to the extent those distributions or appropriations exceeded the "paid-up capital" ("PUC") of the shares on which that distribution or appropriation was made).
The phrase "in any manner whatever" has been interpreted quite broadly by Canadian courts. Distribution or appropriation is typically found where the subject corporation has been "impoverished" to the benefit of its shareholders. That typically means that some property or funds must actually leave the subject corporation and be received by the shareholders. But an indirect distribution of the subject corporation's property with the help of a related party or facilitator might also qualify.
Further, it is usually obvious when a wind-up or discontinuance occurs, because these require positive steps be taken by the subject corporation to terminate its own business. A "reorganization", however, occurs where there is an actual change to the way the subject corporation's business operates. Whether a business has been reorganized is fact-specific and depends on the form of a particular transaction or transactions, as well as the substance of the subject corporation's business. An improperly structured hybrid sale can easily run afoul of subsection 84(2) if the subject corporation's business is impacted by the sale, which could severely limit the tax benefits of the hybrid sale structure for the vendors.
The Facts of Foix
The Tax Court of Canada and Federal Court of Appeal both provided a very broad view of the facts concerning the taxpayers in Foix, and it remains unclear from both decisions exactly how the hybrid sale of the taxpayers' corporation was structured. But we can still glean some crucial facts about the taxpayers' affairs from both judgements. In Foix, the target corporation owned by the taxpayers, Watch4Net Solutions Inc. ("W4N"), earned a substantial profit exploiting its proprietary software, Automated Performance Grapher ("APG"). In 2012, the shareholders of W4N began arranging for the sale of its business to EMC, a U.S. public company and one of W4N's major competitors. In what would prove to be a crucial move for the taxpayers, EMC produced a letter of interest to W4N very early in the negotiation process agreeing that the excess cash held by W4N could be extracted by its shareholders through any pre-closing transactions. W4N's shareholders and EMC then agreed to sell W4N as a hybrid sale of assets and shares. W4N's intellectual property, including the APG software, was first sold directly to EMC. W4N's outstanding shares were then sold to a subsidiary of EMC for roughly $3.3 million.
The taxpayers each reported a capital gain related to the sale of W4N's shares on their 2012 tax returns, and each claimed the Lifetime Capital Gains Exemption to offset part of those gains. The CRA subsequently audited the sale of W4N's shares and reassessed the taxpayers on the basis the $3.3 million were deemed dividends pursuant to subsection 84(2).
The Taxpayer's Case Before the Tax Court of Canada
At the Tax Court of Canada, the Canadian tax litigation lawyer for the taxpayers argued that subsection 84(2) of the Income Tax Act had not been triggered by these distributions. The Tax Court of Canada found conclusively that subsection 84(2) had been triggered, and that the transaction had resulted in a reorganization of W4N's business for two reasons. First, the Tax Court of Canada took the view that, when the initial transfer of shares in W4N to EMC's subsidiary occurred, that W4N had been deprived of its core business assets, which included the APG software. As a result of that sale, W4N's business no longer resembled the business it had operated prior to the transaction. Second, because cash is a fungible asset, it did not matter whether the cash or cash equivalents that were exchanged between parties could not be traced to the original cash held by W4N. Rather, EMC had facilitated the reorganization and allowed W4N to structure the hybrid sale to distribute the $3.3 million indirectly from W4N, as part of a series of interconnected transactions. Each transaction was in contemplation of the same end-goal, which was to enrich W4N's shareholders using the assets of W4N. On this basis, the cash used to pay the purchase price of W4N's shares could be indirectly traced to the cash it held on closing.
The taxpayers case in Foix laid at odds with that of the taxpayers in Geransky v R, 2001 DTC 243 and McMillen v R, [2007] 2 CTC 2463, wherein those hybrid transactions avoided triggering of subsection 84(2) because at least some specific division of the target corporation's original business and related assets were preserved after the sale had occurred. Further, the cash the taxpayer in Geransky received after selling the target corporation's shares could not be traced whatsoever to the assets of the target corporation. So, the court found the amounts paid were deemed dividends under subsection 84(2).
The Taxpayer's Case Before the Federal Court of Appeal
On appeal, the Canadian tax litigation lawyer for the taxpayer again argued that the funds of W4N were not distributed for the benefit of the taxpayers within the meaning of subsection 84(2). Specifically, the taxpayer's Canadian tax litigation lawyer again argued that for subsection 84(2) to apply to the distribution, W4N would need to be "impoverished" for the benefit. Rather, W4N continued to hold its assts after its shares had been sold, and while EMC had acted as a facilitator, the amounts the taxpayers had received were distributions from EMC and its subsidiary, and not W4N. The taxpayer's Canadian tax litigation lawyer also argued that a reorganization had not occurred, because the manner in which its commercial activities were conducted had not changed. Rather, W4N's business still existed, but was run by EMC following the transaction, using the same employees and assets that W4N had prior to the transaction.
The Canadian tax litigation lawyer for the CRA, naturally, held a different view. The CRA's Canadian tax counsel argued that the two conditions precedent for a reorganization, that (1) W4N was impoverished for the benefit of its shareholders, and (2) W4N's business was reorganized as a result of the series of transactions, were met. The CRA's Canadian tax counsel argued it would be overly formulaic to hold that the funds of W4N were not distributed to its shareholders, simply because those distributions were not made by W4N itself but by other participants in the transactions.
The Federal Court of Appeal accepted the CRA's position and reaffirmed the judgement of the Tax Court of Canada. The Federal Court of Appeal found that the funds and property of W4N were appropriated for the benefit of its shareholders, and that those appropriations occurred in the context of the reorganization of W4N's business. But in doing so, the Federal Court of Appeal spent considerable time criticizing the previous attempts by courts to interpret and apply subsection 84(2). More specifically, the Federal Court of Appeal found that prior rulings had validated a "formalistic and restrictive application" of subsection 84(2), wherein indirect distributions of property or funds were found not to have triggered subsection 84(2), because it was found those distributions were not traceable as property of a target corporation but were simply property "of the same quality and quantity" held by a target corporation, like in the case of Geransky. In the view of the Federal Court of Appeal in Foix, these were intolerable errors. The Federal Court of Appeal emphasized that the decisions of prior courts to focus strictly on the "legal character" of transactions in a series failed to give the proper effect to the statutory phrase "in any manner whatever", and that the judge of the Tax Court of Canada in Foix had fallen prey to the same trap by distinguishing the taxpayer's case on these grounds.
It does not appear at first blush that the Federal Court of Canada's reasoning is inherently wrong. Canadian courts have consistently interpreted the phrase "in any manner whatever" in extraordinarily broad terms. It would vitiate the purpose of subsection 84(2) as an anti-avoidance rule if the provision could be defeated simply by involving a third-party in a transaction to receive and distribute property of the target corporation to its shareholders.
But the Federal Court of Appeal's judgement goes one step further, to discredit the court's prior rulings in Geransky and McMullen which have served as guidelines for structuring hybrid sales for nearly two decades. The Federal Court of Canada's ruling undoubtedly casts a shadow over the ability of practitioners to rely on the ruling in Geransky and McMullen as a means to avoid triggering subsection 84(2).
But it is equally questionable whether the decision in Foix fully overrides these previous rulings.
It remains the case that to trigger subsection 84(2), there must be an impoverishment of the target corporation for the benefit of its shareholders. Ignoring the distinction between the target corporation's assets and the purchaser's assets because of the fungible nature of cash in every case appears to stretch the language of subsection 84(2) beyond its statutory framework.
The Tax Court of Canada's judgement acknowledges that the evidence presented by the taxpayers was spotty and evasive, and the details of how the cash ended up in the shareholder's hands before and after the share sale was unclear.
And so it also remains unclear whether the ruling against the taxpayers in Foix has actually undermined the ability for taxpayers to rely on Geransky and McMullen to avoid eventually triggering subsection 84(2), or if this ruling simply emphasizes the need to exercise caution to avoid there being any possibility of the cash distributed to shareholders being characterized as possibly ever being from the target corporation.
Pro Tax Tip – Get Professional Canadian Tax Lawyer Advice From the Outset of Any Sale of a Business
The result in Foix emphasizes just how crucial it is to engage a top tax lawyer at the outset of any sale of a private business. As the taxpayers in Foix discovered, an acknowledgement by the purchaser that the transaction could be structured to allow shareholders to extract surplus value from the target corporation demolished the tax benefits of the structure.
Failing to explain the source of funds received and to present coherent evidence explaining how the transaction occurred led the court to take adverse inferences toward the transaction. This should never have been the case to begin with.
Any private business sale should be properly researched, vetted, documented and structured well in advance of the closing date. This is especially the case where parties intend to structure the sale as a hybrid sale. The importance of proper due diligence in advance of any private business sale cannot be emphasized enough.
The risks will become even greater come January 1, 2024, when the revised version of the General Anti-Avoidance Rule ("GAAR") under subsection 245 of the Income Tax Act become law.
The GAAR represents one of the CRA's most potent tools for challenging creative transactions to achieve tax benefits.
Under the version of the GAAR in effect prior to January 1, 2024, a transaction or series of transactions must meet three elements:
- there is a tax benefit;
- the transaction giving rise to the tax benefit is an "avoidance transaction"; and
- the avoidance transaction giving rise to the tax benefit is "abusive".
Where these three elements are met, the CRA is empowered to ignore the avoidance transaction in question and redetermine the income tax consequences of the transaction.
An "avoidance transaction" is defined as any transaction or series of transactions that gives rise to a tax benefit, unless the transaction or transactions are such that they are undertaken for bona fide purposes other than that of obtaining a tax benefit.
Whether a transaction is an avoidance transaction is a fact-specific inquiry, but under the current rule, a transaction will only be characterizable as an avoidance transaction if the primary purpose of the transaction is to obtain a tax benefit.
The new version of the GAAR, in effect as of January 1, 2024, modifies this rule in radical ways.
First, the new statutory language reduces the threshold for finding that a transaction is an "avoidance transaction". The requirement that the primary purpose of the transaction be tax avoidance will be reduced such that only one of the main purposes of the transaction must be tax avoidance.
Second, there will be a rebuttable presumption that an avoidance transaction that lacks "economic substance" results in a misuse or abuse under the third prong of the test.
Third, there are substantially higher financial penalties for a taxpayer who fails to report a transaction under the new reportable transaction and notifiable transaction rules when required, if the GAAR is applied to reassess that transaction.
The uncertainty taxpayers face structuring hybrid sales following the ruling in Foix could pale in comparison to the risks that those taxpayers will face under the new GAAR regime.
The CRA will certainly be eager to experiment with its new tools to suppress what it views as abusive and aggressive tax planning schemes. In light of the new GAAR regime and the decision in Foix, it is more important than ever to engage expert Canadian tax counsel at the outset of arranging for any private business sale, to ensure that current laws and rules are being observed, and that changes in the law are anticipated and accounted for properly.
FAQs:
What is subsection 84(2) of the Canadian Income Tax Act?
Subsection 84(2) is an anti-avoidance provision under the Income Tax Act intended to prevent taxpayers from extracting accrued value in a corporation in an abusive fashion. In order to trigger subsection 84(2), the following must exist:
- the subject corporation must be a resident Canadian corporation;
- there must be, in any manner whatsoever, a distribution or appropriation of the subject corporation's funds or property, in the context of a wind-up, reorganization, or discontinuance of the subject corporation's business; and
- that distribution or appropriation must be to or for the benefit of the subject corporation's shareholders.
Where subsection 84(2) is triggered, those shareholders who received a distribution or appropriation of the subject corporation's funds or property are deemed to receive a fully taxable dividend (to the extent those distributions exceeded the "paid-up capital" ("PUC") of the shares on which that distribution or appropriation was made".
What is a "hybrid sale" of a business?
A sale of a private business can generally be structured as either a sale of shares, or as a sale of assets. A hybrid sale occurs where the purchaser and vendor agree to arrange for the sale of a private business by selling assets and shares of the business separately. A vendor and purchaser might prefer a hybrid sale where the vendor wants to be able to access the Lifetime Capital Gains Exemption, and where the purchaser wishes to increase the cost base of property acquired from the target.
What was the Federal Court of Appeal's judgement in Foix v His Majesty the King, 2023 FCA 83?
The Federal Court of Appeal ultimately ruled in favour of the CRA and reaffirmed the judgement of the Tax Court of Canada, finding the sale of the taxpayers' business triggered subsection 84(2) of the Income Tax Act.
More specifically, the Federal Court of Appeal found that the target corporation's funds and property were appropriated for the benefit of its shareholders with the assistance of a third-party facilitator, the purchaser, because the purchaser helped to arrange the transaction so that the target corporation's surplus would flow directly to the taxpayers.
It was immaterial that the target corporation did not distribute those funds directly to its shareholders; the statutory language of subsection 84(2), that a distribution be made "in any manner whatever" contemplates an indirect distribution of property.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
