In Foix v. The King, 2023 FCA 38, the Federal Court of Appeal (FCA) ruled that a distribution of funds following a hybrid sale was subject to the application of subsection 84(2) of the Income Tax Act (ITA), affirming the Tax Court of Canada (TCC) ruling, Foix v. The Queen, 2021 TCC 52.

The taxpayers were denied a capital gains deduction on the basis they had no capital gain from the sale of their shares; rather, the receipt of proceeds was deemed to be a dividend.

Subsection 84(2) of the ITA stipulates that where funds or property of a corporation resident in Canada have been distributed or otherwise appropriated in any manner whatever to or for the benefit of shareholders on the winding‑up, discontinuance or reorganization of its business, the amount or value distributed or appropriated is deemed to be a dividend, which precludes a capital gain.

While the fact pattern in Foix is not the same as in a conventional hybrid share sale, the outcome of the FCA ruling is broad such that transactions that are “indirect, structured, simultaneous and inter‑related” must be considered as a whole for the purpose of subsection 84(2). Due to this broad interpretation, a taxpayer can be assessed a deemed dividend at a time when the taxpayer is no longer a shareholder but instead a creditor, which is consistent with previous FCA rulings centered around subsection 84(2), including MacDonald v. R., 2013 FCA 110.

The facts of the case

To briefly summarize the facts in Foix, the individual taxpayers, Mr. Foix, Mr. Souty and a family trust of Mr. Souty undertook a hybrid sale of their incorporated business (“W4N”) that involved a sale of certain business assets of W4N to the purchaser (“EMC”) and a sale of W4N shares to a separate entity ⁠–⁠ a Canadian subsidiary of EMC (“EMC Canada”). The hybrid sale consisted of a complex series of transactions, resulting in the taxpayers indirectly receiving a distribution of funds of W4N, evoking subsection 84(2) of the ITA. Key aspects of the transactions included the following, (all occurring prior to the W4N share sale):

• The distribution of funds from W4N was facilitated by EMC and was all planned in a pre‑closing reorganization done with the concurrence of EMC;
• There was an impoverishment of W4N following the payment of the funds;
• There was a merger of W4N, Virtuose (a holding corporation that held W4N shares for Mr. Foix) and EMC Canada; and
• The merged entity did not operate its business in the same manner as W4N, nor did it operate all of the same business previously conducted by W4N which, the court concluded, amounted to a reorganization of W4N’s business.

The FCA decision in Foix was based on a review of three main issues centered around subsection 84(2):

1. Were funds or property of W4N and of Virtuose distributed to or otherwise appropriated by or for the benefit of their shareholders?
2. Does subsection 84(2) have a sufficiently broad scope to counter this type of distribution?
3. Did the distribution or appropriation take place on the reorganization or the discontinuance of W4N's and Virtuose's respective businesses?

Both the TCC and FCA relied on existing jurisprudence, including MacDonald v. R., 2013 FCA 110, which had set a precedent for a broad interpretation of subsection 84(2) to capture “indirect” distributions of funds or property from a corporation, as was found to be the case in Foix. Furthermore, a distribution of funds or property necessitates an impoverishment of a corporation.

In Foix, though the taxpayers argued there was no impoverishment of the corporations, the court concluded that W4N had been impoverished since a note payable by EMC to W4N on account of the asset sale remained unpaid and, presumably, EMC used its funds to repay the share purchase price owing to the taxpayers rather than this note. Since Virtuose’s share value was dependent 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.

What remained to be determined, then, was whether there was a reorganization of the business of W4N or Virtuose because, if there was no reorganization, 84(2) would not apply. The word “reorganization” is not defined within the ITA. In Foix, the courts construed the word “reorganization” not as a legal term, but as a commercial term that presupposed the conclusion of the conduct of a business in one form and its continuance in a different form. Post‑sale, the former business of W4N was continued by two different entities: EMC and EMC Canada.

The court concluded there was a reorganization of W4N’s business. The arguments raised by the taxpayers in support of their position that no reorganization existed included the fact that EMC and EMC Canada conducted W4N’s business with the same employees, the same offices, the same service and maintenance contracts, the same software, the same markets, the same resellers, the same technology partners and the same competitors. The court concluded that there was a reorganization as separate legal persons now carried on the business, even though it was carried on in an otherwise similar way as before.

In addition, Virtuose ceased to perform its only function after the amalgamation, namely, holding W4N shares for Mr. Foix as a holding company. It followed that Virtuose’s business was discontinued such that subsection 84(2) would apply to any distribution of funds from Virtuose.

Finally, the court acknowledged that subsection 84(2), being an anti-avoidance provision with such a broad interpretation, will create uncertainty for taxpayers who, with the assistance of third‑party facilitators, structure the sale of their business to extract surpluses without tax or at a reduced rate. The court noted that “an anti‑avoidance measure will necessarily raise question marks in the minds of those who choose to test its limits,” suggesting that such uncertainty is intended.

Even though the FCA ruling was in the context of a hybrid sale transaction, the principles can extend to other transactions, including pipeline transactions where there is an extraction of surplus at capital gains rate. Taxpayers who undertake, and practitioners who advise on, transactions that result in an extraction of surplus, either directly or indirectly, will want to take note of this decision.