Foix – Federal Court of Appeal confirms that s. 84(2) extends to the indirect distribution of liquid assets of the target through its sale to an arm’s length purchaser cum “facilitator”

The shareholders of a private Canadian company (“W4N”) exploiting a valuable item of software had agreed in principle to sell W4N to a U.S. public company (“EMC”) for U.S.$50 million. However, EMC was amenable to a reorganization being implemented to permit the shareholders to extract the excess cash and investment type assets of W4N. What was implemented was a hybrid transaction in which there was both a sale of the software, goodwill and other business assets of W4N to EMC and a sale of shares of W4N (which continued to hold some Canadian business assets) by its shareholders to a Canadian subsidiary (“EMC Canada”) of EMC.

Although the steps to accomplish this and related safe-income, capital dividend and capital gains deduction planning were quite intricate, Noël C.J. focused for his purposes on the following five steps:

  1. Trusts for the families of the two principals (Souty and Foix) sold shares of W4N to EMC Canada for notes of EMC Canada, later paid in cash, with the resulting capital gains of $5 million (approximately equaling the proceeds) ultimately being distributed to various family beneficiaries.
  2. W4N sold its intellectual property, goodwill and some of its other business assets to EMC for consideration including two “capital dividend” notes totaling $22 million (which were later distributed) and a “Balance Note” for $19.75 million.
  3. Souty and the holding company for Foix (Virtuose) sold special voting shares of W4N to EMC Canada for nominal consideration so as to effect an acquisition of control of W4N.
  4. The balance of the shares of W4N now were sold directly, or through a sale of shares of Virtuose, to EMC Canada for cash consideration of around $14 million.
  5. EMC Canada, Virtuose and W4N amalgamated.

Noël C.J. essentially indicated that the final aggregate purchase price for the hybrid transaction had been increased by around the amount of the Balance Note but that the Balance Note was not repaid at any relevant time and that the payment of the cash sales proceeds in Step 4 essentially was funded by a diversion of cash resources of EMC that otherwise could have been used to repay the Balance Note.

In confirming the application of s. 84(2) to proceeds received under Step 2 that were distributed to a beneficiary of the Souty Trust and to some cash proceeds received by the two principals in Step 4, Noël C.J. first accepted the submission of the taxpayers “that the target corporation must be impoverished to the benefit of its shareholders for there to be a distribution or an appropriation,” but indicated that, here, there had been such impoverishment since the Balance Debt was not paid, and “the nonpayment of the debt in the course of the hybrid sale freed up the necessary funds to defray the cost of W4N’s and Virtuose’s shares.”

He went on to indicate that “the scope of subsection 84(2) is sufficiently broad to counter this type of distribution when the property being distributed is fungible and a third-party facilitator is involved in the extraction process” and that “it would be contrary to Parliament’s intention to turn a blind eye to the existence of a distribution or appropriation for the sole reason that, for example, the shareholder received the target corporation’s property as a creditor rather than as a shareholder … or, as in the present case, that the funds received by the shareholder originate directly from a third party but indirectly from the target corporation.” The presuppositions in McNichol and Descarries “that subsection 84(2) cannot apply to indirect distributions of property or funds because in such cases, the property distributed to the shareholders is not that of the target corporation, but property of the same quality and quantity” were incorrect. Furthermore, contrary to Robillard, the proper interpretation of s. 84(2) has not narrowed in its modern context.

He also confirmed that these indirect distributions had occurred on a “reorganization” of the business of W4N (its splitting into two pieces) and on a discontinuance of Virtuose’s business (it ceased to be a holding company).

Neal Armstrong. Summary of Foix v. Canada, 2023 FCA 38 under s. 84(2).