A question that arises in the sale of a business operated by a corporation is whether the buyer will purchase the corporation’s shares or its business assets. When a buyer purchases shares, the seller receives the sale proceeds directly and pays taxes on the proceeds at a favourable capital gains rate. Alternatively, if the buyer purchases the business’s assets, it can bump up the cost amount of the assets for tax purposes and can ensure that it is not buying unwanted assets or unknown liabilities.
Due to these considerations, sellers and buyers have conflicting interests — sellers prefer to sell the business’s shares, and buyers prefer to purchase the business’s assets. To meet each other halfway, a common approach is to structure a “hybrid” asset and share sale transaction. However, this variety of transaction needs to be carefully planned in order to be effective, especially in light of a recent decision of the Federal Court of Appeal.
Under Canada’s Income Tax Act, there are a myriad of rules in place to prevent businesses from inappropriately skirting their tax obligations. These are generally referred to as “anti-avoidance rules.” These rules state that where a transaction (or a series of transactions) results in a reduction, avoidance, or deferral of taxes owing, and the transaction is only being contemplated for the tax benefits, the transaction may be disallowed.
There are many important considerations for Alberta business-owners attempting to wind up a company, including tax implications. Generally, when winding-up a corporation, the business sells its assets, pays its outstanding liabilities, and distributes the remaining cash to its shareholders in exchange for their shares. The shares are then cancelled, which can trigger tax effects for the shareholders.
Section 84(2) of the Income Tax Act sets out an important anti-avoidance rule that applies in the context of a business’s winding-up. The section deals with situations where the funds or property of a corporation have been distributed or otherwise appropriated for the benefit of shareholders on the winding-up, discontinuance, or reorganization of a corporation. In this situation, the legislation says that the amount or value distributed or appropriated is deemed to be a dividend, precluding any capital gain that would otherwise be realized.
In Foix v. Canada, the Federal Court of Appeal commented on the application of section 84(2) of the Income Tax Act in a hybrid asset and share sale transaction. The individual taxpayers in this case, Mr. Foix, Mr. Souty and a family trust, attempted a hybrid sale of their incorporated company (“W4N”) that involved the sale of some of its business assets to the purchaser (“EMC”) and the sale of its shares to EMC’s Canadian subsidiary (“EMC Canada”).
The hybrid sale involved a complex series of transactions that resulted in a distribution of funds to W4N shareholders, triggering section 84(2) of the Income Tax Act. Briefly, the transaction involved three steps:
- EMC Canada acquired the W4N shares held by Mr. Foix’s family trust and Mr. Souty’s family trust in exchange for a promissory note issued to each trust;
- EMC acquired W4N’s software, intellectual property assets and non-Canadian contracts in exchange for EMC providing a series of promissory notes and agreeing to assume a portion of W4N’s liabilities; and
- EMC Canada acquired the remaining shares of W4N, except for those held by Mr. Foix’s holding company, Virtuose. Instead, EMC purchased all the shares of Virtuose, the purchase of which was paid in cash to Virtuose and W4N shareholders.
After the transaction, W4N, Virtuose, and EMC Canada were amalgamated into a single entity.
Mr. Foix, Mr. Souty, and Mr. Souty’s family trust reported capital gains on the sale of their W4N and Virtuose shares and claimed their respective capital gains exemptions. However, the Canada Revenue Agency reassessed their claims and recharacterized the capital gains as deemed dispositions, captured by section 84(2) of the Income Tax Act.
In deciding that the section applied, the Tax Court of Canada interpreted the provision broadly. The Court traced the purchase price of the W4N and Virtuose shares to excess cash held by W4N at closing, which was indirectly distributed to the taxpayers, with EMC acting as an intermediary. Further, the Court concluded that the distribution happened on the winding-up, discontinuance, and reorganization of W4N and Virtuose.
The taxpayers appealed the Tax Court’s decision to the Federal Court of Appeal. On appeal, the Court highlighted three key questions it would need to address:
- Were funds or property of W4N and Virtuose distributed to or otherwise appropriated by or for the benefit of their shareholders?
- Does subsection 84(2) of the Income Tax Act have a sufficiently broad scope to cover this type of distribution?
- Did the distribution or appropriation take place on the reorganization or discontinuance of W4N’s and Virtuose’s respective businesses?
Turning to the first question, the Court cited case law, including Descarries v the Queen, in explaining that section 84(2) of the Income Tax Act should be interpreted broadly to capture “indirect” distributions of funds or property from a corporation. Further, for there to have been such a distribution, there must have been a corresponding impoverishment of the corporation.
The Court held that W4N had been impoverished since the promissory note payable by EMC to W4N remained unpaid and, presumably, the repayment funds had been used instead to purchase W4N and Virtuose shares from the taxpayers. Since Virtuose’s share value depended on the value of W4N, it was also impoverished.
The impoverishment of W4N and Virtuose amounted to an indirect distribution of their funds to the taxpayers.
Noting that “reorganization” is not defined in the Income Tax Act, the Court construed it not as a legal term but as a commercial term that contemplated the end of a business in one form and its continuance in a different form.
Framing the term in this way, the Court found that there had been a reorganization of W4N’s business. Even though the business would carry on similarly as it did before the transaction, it would be carried out by separate legal persons. Further, Virtuose would cease to perform its only function — namely, holding shares in W4N on behalf of Mr. Foix. Thus, Virtuose’s business had effectively been discontinued, invoking section 84(2) of the Income Tax Act.
The Court dismissed the appeal and upheld the decision of the Tax Court of Canada.
The talented legal team at Dunphy Best Blocksom LLP in Calgary have practical experience in diverse personal and corporate tax matters. We provide our clients with proactive, reliable advice through every stage of the tax planning process, from creation to implementation. Our tax law practitioners also have experience in other areas, allowing them to bring a multi-faceted approach to each client’s issue. To learn how our team can help you reach out to our firm online or by phone at 403-265-7777.