By Tracey Harrod, Senior Partner & Adrienne Barclay, Partner |Taylor Leibow LLP
Hybrid transactions were born out of an apparent need for compromise where a purchaser prefers to acquire assets and the vendor prefers to sell shares. Subsequent to the decision in Geransky v. R. 2001 D.T.C. 243 the use of hybrid transactions evolved in many forms and seemed to be widely accepted by CRA assuming the transactions met the general criteria contained in Technical Interpretation 2003-0029955.
Despite Geransky and the CRA technical interpretation, the decisions in MacDonald v. R. 2013 D.T.C. 5091, RMM Canadian Enterprises Inc. v. R. 97 D.T.C. 302 and more recently Foix v. R. (2021), 2021 D.T.C. 1044 (under appeal), coupled with recent Canada Revenue Agency (CRA) audit activity of hybrid transactions may cause taxpayers and their advisors to pause and reconsider whether to undertake a hybrid transaction.
To date, CRA has not generally relied on nor been successful in challenging hybrid transactions using the General Anti-Avoidance Rule. Instead, the CRA has looked to apply subsection 84(2) of the Act, in some cases based on a very broad interpretation. Subsection 84(2) provides the following:
Where funds or property of a corporation resident in Canada have at any time … been distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders of any class of shares in its capital stock, on winding-up, discontinuance or reorganization of its business, the corporation shall be deemed to have paid at that time a dividend on the shares of that class equal to the amount …
There is some debate over what constitutes a “winding-up, discontinuance or reorganization” of the Corporation’s (“the Target’s”) business. In Geransky the Tax Court of Canada concluded there was not a discontinuance of the business, and thus 84(2) did not apply, where one of the two operating divisions of the business was retained by the Corporation. Despite the convenient circumstances in Geransky, many hybrid transactions result in the Corporation disposing of all the business assets resulting in a discontinuance of its business. In cases where a continuance of a part of the business is not feasible it will need to be determined whether funds or property of the Corporation have been distributed in any manner whatever to the shareholders.
RMM and MacDonald can arguably be classified as surplus stripping transactions involving a “facilitator or accommodator”. In these cases, 84(2) was deemed to apply based on a broad interpretation of the law. It should also be noted, that in both cases the Corporation’s assets consisted substantially of cash or near cash assets.
Geransky and, more recently, Foix can be classified as hybrid transactions. Geransky provided a strict application of the law where 84(2) was found not to apply. It should be noted that Geransky can be distinguished on its facts considering operating assets (and not excess cash that is surplus to the company’s operating needs) were sold in an arm’s length hybrid transaction without the existence of a facilitator. The more recent facts in Foix involve both the components of excess cash and the sale of operating assets. In Foix, 84(2) was applied based on a broad interpretation of the law with a strong focus on the distribution of excess cash. MacDonald, RMM and Foix are examined further below.
MacDonald was not a hybrid case but rather addressed surplus stripping and the application of 84(2). In short, Mr. MacDonald had approximately $500,000 of cash (or near cash) in his Corporation. He sold the Corporation to his brother-in-law who ultimately paid the purchase price with cash from Mr. MacDonald’s former Corporation. Despite the fact that Mr. MacDonald received the funds of the Corporation in his capacity as a creditor (subsequent to a sale of his shares and ceasing to be a shareholder of the Corporation) the court found 84(2) still applied. The court’s conclusion was based on a broad approach to the phrase distributed in any manner whatever which looked to: (i) who initiated the winding-up, discontinuance or reorganization of the business; (ii) who received the funds or property of the Corporation at the end of that winding-up, discontinuance or reorganization; and (iii) the circumstances in which the purported distributions took place. In the author’s view some of the hallmarks of the MacDonald case were as follows:
RMM was also a surplus stripping case involving a company holding only cash and near cash assets. The court concluded in a similar manner with respect to the broad based approach to 84(2) that was applied in MacDonald. In short, Justice Bowman concluded the transaction lacked commercial substance and was simply a conduit to avoid the application of 84(2) despite the fact that the purchaser used their own source of funds (short-term bank financing) to pay the purchase price.
These cases make it clear that CRA perceives an abuse in circumstances where cash corporations are wound down in a manner that avoids the application of 84(2).
Foix is a recent (2021) Tax Court of Canada case involving a hybrid transaction. This case also focused on the concept of excess cash being distributed in any manner whatever to the shareholders. A Letter of Interest was admitted into evidence that discussed the company “distributing excess cash to the shareholders prior to closing”. Ultimately this cash was distributed via a hybrid transaction allowing for the utilization of the life-time capital gains exemption by the shareholders. Justice Boyle concluded at paragraph 62 that the shareholders of the Corporation and their advisors were responsible for implementing the series of transactions that allowed for the withdrawal of the excess cash in a manner inconsistent with what was originally outlined in the Letter of Interest. In addition, the judge referenced doubts with respect to the reliability and credibility of the appellant’s two main witnesses.
At paragraph 58 of the decision Justice Boyle states “In general, courts take a fungible approach to cash and cash equivalents held by a corporation where there are structured, simultaneous and interdependent indirect transactions which allows them to view these amounts as indirect distributions of cash made on the winding up, discontinuance or reorganization of the business for the purposes of 84(2).”
Applying the broad approach to 84(2) as done in MacDonald one can see that (i) Justice Boyle concluded that the Corporation and its shareholders orchestrated the series of transactions that resulted in the winding up of the Corporation and (ii) the Corporation had excess cash that was ultimately distributed to the shareholders. It is a bit curious that the circumstances in which the distribution took place appear to be via a genuine third party negotiation where much more than just cash or near cash assets were transferred. This may lead to the conclusion that a hybrid transaction structured to extract excess cash even in the context of a genuine sale of the business or part of a business can attract the application of 84(2).
With respect to the matter of the winding-up, discontinuance or reorganization of the business the Court noted that after the hybrid transaction, the former business of the Corporation was carried on by an amalgamated corporation in a very different manner than the Corporation had carried on the business before the hybrid transaction. Further, even if the amalgamated corporation did operate the business in the same way and in the same form as it had been operated prior to the transaction, the amalgamation of the two corporations would likely be considered a reorganization of the Corporation’s business.
Foix seems to highlight the concept that the intention of the parties may be a consideration in determining whether 84(2) applies where a share sale is implemented as a mechanism to distribute excess cash. The decision also seems to suggest that separating the business into two entities within a corporate group or amalgamating the Target and the purchaser corporation are likely both transactions that would constitute a reorganization of the Corporation’s business.
The recent decision in Foix along with recent audit activity of hybrid transactions provides taxpayers and their advisors with substantial uncertainty. The CRA appears to be concerned with the distribution of excess cash in the context of a genuine hybrid sale arrangement where an operating business is also acquired. It is less clear whether CRA has an underlying concern with what they perceive to be surplus stripping via the utilization or multiplication of the capital gains exemption often in the context of using newly incorporated special purpose entities incorporated by the Target and/or the purchaser.
In the absence of a hybrid transaction involving the distribution of excess cash it may be difficult to ascertain a perceived abuse inherent in hybrid transactions considering often more tax revenue is collected on a current basis in a hybrid sale than would be collected under a share sale. Further, the courts (in Evans 2005 TCC 684; Gwartz 2013 TCC 86; Collins & Aikman 2009 TCC 299 affirmed FCA 251) have not found any scheme in the Income Tax Act requiring distributions to be taxed as dividends in circumstances where 84(2) is not applicable. Additionally, and perhaps of most relevance, the CRA does not appear to have updated their position stated in Technical Interpretation 2003-0029955.
Possible rules of thumb that may assist in undertaking successful hybrid transactions:
If anything is certain, it is that taxpayers and their advisors should approach hybrid transactions with caution and consider the potential risks and costs associated with a possible CRA reassessment.