23 May 2023
by Neil Gurmukh
Miller Thomson LLP
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In the context of a sale of a business operated by acorporation, the seller and buyer typically have competinginterests. Whereas sellers tend to prefer selling their shares ofthe corporation so that they can receive the sale proceeds directlyand pay tax on any gains at preferential capital gains rates,buyers tend to prefer buying the corporation's business assetsin order to step-up the cost amount of those assets and avoidacquiring unwanted assets and unknown liabilities.
While "hybrid" asset and share sale transactions haveproven to be a popular tool for bridging this gap between sellersand buyers, they need to carefully planned and considered,particularly in light of the increasingly broad interpretationbeing 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 ofAppeal (the "FCA") recently concludedthat subsection 84(2) of the Tax Act applied to a series of"indirect, structured and inter-related" transactionsinvolving distributions of a corporation's cash or cashequivalents to a taxpayer when a third-party facilitator isinvolved. As a result of the FCA's finding, certain amountsreceived by the taxpayers in that case as part of a hybrid salewere deemed to be dividends instead of proceeds of disposition,which precluded the taxpayers from claiming their lifetime capitalgains exemptions.
The facts at issue in Foix involved a complicatedhybrid sale of the shares and assets of Watch4NetSolutions Inc.("W4N"), which carried on the businessof software development. All of the outstanding shares of W4N weredirectly and indirectly owned by Mr. Foix, Mr. Souty, their familytrusts and their holding companies.
In November 2011, Mr. Foix and Mr. Souty entered into a letterof intent with EMC Corporation ("EMCUS") and EMC Corporation of Canada ("EMCCanada") to sell the shares of W4M for a purchaseprice of $50 million. The letter of intent provided that W4N coulddistribute to its shareholders any excess cash on hand beforeclosing, subject to maintaining an agreed upon working capitalbalance.
In April 2012, the parties agreed to convert the proposed W4Nshare sale to a hybrid sale of W4N's assets and shares for atotal purchase price of $70 million. This hybrid sale involved thefollowing steps:
- EMC Canada acquired the W4N shares held by Mr. Foix'sfamily trust and Mr. Souty's family trust in exchange for EMCCanada issuing a $2,489,591 promissory note to each family trust(the "Trust Notes"). The Trust Noteswere paid by the escrow agent at the conclusion of the hybridtransaction steps.
- EMC US acquired W4N's software, intellectual propertyassets and non-Canadian contracts in exchange for EMC US providingthe following consideration to W4N: (i) two promissory notes witheach note having a principal amount of $11 million (the"Capital Dividend Notes"), (ii) apromissory note in the principal amount of $19.75 million (the"Balance Note"), and (iii) EMC USassuming $2.3 million of W4N's liabilities. The CapitalDividend Notes were paid by the escrow agent at the conclusion ofthe hybrid transaction steps, but the Balance Note was not andremained outstanding and payable after completion of thetransaction.
- EMC Canada acquired all of the remaining shares of W4N, exceptthe W4N shares held by Mr. Foix's holding company, VirtuoseInformatique Inc. ("Virtuose"). Insteadof acquiring the W4N shares held by Virtuose, EMC Canada acquiredall of the shares of Virtuose. The purchase price for these shareswas 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 familytrust (of which Ms. Lebel (Mr. Souty's spouse) was abeneficiary), reported a capital gain on the sale of their W4N orVirtuose shares, as applicable, and claimed their respectivelifetime capital gains exemptions, the Canada Revenue Agency (the"CRA") reassessed and re-characterizedsuch 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, theTax Court of Canada (the "TCC") gave abroad interpretation to that subsection that allowed it to tracethe purchase price for the W4N and Virtuose shares to the excesscash that remained in W4N at closing, which was indirectlydistributed to the taxpayers through the EMC group as anintermediary according to the TCC. The TCC also concluded that suchdistribution occurred on the winding-up, discontinuance andreorganization of the businesses of W4N and Virtuose. The taxpayersappealed both of these findings to the FCA.
In dismissing the taxpayers' appeal and upholding thedecision of the TCC, the FCA concluded that subsection 84(2) canbroadly apply to "indirect, structured and inter-related"transactions involving distributions of a corporation's cash orcash equivalents to a taxpayer at a time when the taxpayer is nolonger a shareholder of the corporation when a third-partyfacilitator is involved.
Pursuant to subsection 84(2) of the Tax Act, where property of acorporation has been distributed or otherwise appropriated in anymanner whatever to or for the benefit of the shareholders on thewinding-up, discontinuance or reorganization of its business, theshareholders are generally deemed to have received a dividend.Therefore, in order for subsection 84(2) to apply, the followingtwo conditions must be satisfied, which were considered by theFCA:
- Funds or property of a corporation must be distributed orotherwise appropriated in any manner whatever to or for the benefitof the shareholders; and
- If so, the distribution or appropriation must have occurred onthe winding-up, discontinuance or reorganization of thecorporation's business.
With respect to the first question, the FCA was of the view thatthe Balance Note debt owing to W4N by EMC US amounted to a cashequivalent of W4N that was, in fact, excess and beyond what wasneeded to operate W4N's business as a result of selling itsoperating business assets. The FCA was also of the view that W4Nhas been impoverished to the benefit of its shareholders (i.e., thetaxpayers), which is a requirement of subsection 84(2), on thebasis that the amount owing under the Balance Note remained unpaidin favour of EMC Canada using the Balance Note repayment funds toinstead fund the purchase price for the W4N and Virtuose sharesacquired from the taxpayers. Moreover, since the value of theVirtuose shares was derived from the value of the W4N shares, theimpoverishment of W4N resulted in a corresponding impoverishment ofVirtuose.
In reaching this conclusion, the FCA held that the scope ofsubsection 84(2) is sufficiently broad to apply to an indirectdistribution in circumstances where the property being distributedis fungible and a third-party facilitator was involved in theextraction process, which was the case here. In support of this,the FCA emphasized that "distributed or otherwiseappropriated" in subsection 84(2) is broadly qualified by thephrase "in any manner whatever" and that an overlyliteral reading of that subsection would defeat its anti-avoidancemission. The FCA also stated that, based on its decision in TheQueen v. Vaillancourt-Tremblay,2 the indirectdistribution of fungible property (e.g., cash), in contrast withnon-fungible property, does not preclude the application ofsubsection 84(2) when the property can be traced back to the targetcorporation.
With respect to the second question, the FCA was of the viewthat the phrase "winding-up, discontinuance orreorganization" in subsection 84(2) should also be interpretedbroadly. According to the FCA, the hybrid transaction amounted to areorganization of W4N's business for purposes of subsection84(2) on the basis that W4N's business, as it existed prior tothe transaction, was split into two, with EMS US having acquiredW4N's software, intellectual property assets and non-Canadiancontracts, and EMC Canada having acquired the balance of W4N'sassets. With respect to Virtuose, the FCA characterized itspre-sale business as acting as a holding company on behalf of Mr.Foix with that business being discontinued as a result of thehybrid transaction.
Based on this decision, taxpayers who undertake hybridtransactions, or other transactions involving the extraction of acorporation's surplus with the assistance of third-partyfacilitators, must beware of subsection 84(2) and its wide scope.Any such transactions need to be carefully planned to ensure thatthey do not run afoul of subsection 84(2).
1. 2023 FCA 38.
2. 2010 FCA 119.
The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circumstances.
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