Are hybrid sales of private businesses still a viable tax planning tool for business owners?

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm.

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 FCA'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 judgments of the Tax Court and the FCA.

Next, we will explore some of the implications of the FCA's ruling for Canadian entrepreneurs and advisors who might otherwise want to structure a private business sale as a hybrid sale.

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:

1. the subject corporation must be a resident Canadian corporation;
2. 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
3. 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 and FCA 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 judgments. 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, the taxpayers' lawyer argued that subsection 84(2) of the Income Tax Act had not been triggered by these distributions. The Tax Court 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 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 McMullen 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 taxpayers' lawyer 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 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 CRA, naturally, held a different view. The CRA's 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 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 FCA accepted the CRA's position and reaffirmed the judgment of the Tax Court. The FCA 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 FCA spent considerable time criticizing the previous attempts by courts to interpret and apply subsection 84(2).

More specifically, the FCA 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 FCA in Foix, these were intolerable errors. The FCA 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 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 FCA'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 FCA's judgment 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 FCA'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's judgment 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.

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm and is a Certified Specialist in Taxation Law who has completed the CICA in-depth tax planning course. He appears regularly in print, radio and TV and blogs extensively.  

With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, cryptocurrency traders, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax audit representation and tax litigation. Visit www.Taxpage.com and email David at david@taxpage.com.

Read the original article in full on TaxPage. Author photo courtesy Rotfleisch & Samulovitch P.C. Title image: Unsplash.