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 cash and investment type assets of W4N that were in excess of the needs of the business. The shareholder group consisted of (i) two unrelated individuals (Souty, and Foix – who held his shares through a passive portfolio company (“Virtuose”),) (ii) trusts for the two respective families (the Souty and Foix Trusts) and (iii) after giving effect to intricate preliminary transactions, two holding companies for Souty and Foix through which they held a portion of their shares of W4N (in the case of “Souty Holdco”) or of Virtuose (in the case of “Foix Holdco”). What was implemented were hybrid transactions in which there was both an asset sale by W4N to EMC, and a share sale by the Souty/Foix shareholder groups to a Canadian subsidiary (“EMC Canada”) of EMC.
In very general terms, the steps involved:
- Souty Trust and Foix Trust selling 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.
- W4N selling 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.
- Souty and Virtuose selling special voting shares of W4N to EMC Canada for nominal consideration so as to effect an acquisition of control of W4N and a resulting year end.
- The balance of the shares of W4N now being sold directly, or through a sale of the balance of the Virtuose shares, for cash consideration of around $14 million.
- EMC Canada, Virtuose and W4N then amalgamating, so that the Amalco received the cash and near-cash assets of W4N, consisting of the Balance Note and cash and near-cash assets.
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 Messrs. Souty, and Foix in step 4, Noël C.J. first accepted (at para. 57) 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” (para. 66).
He went on to indicate (at para. 67) 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 (at para. 69) 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.” He indicated that 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” (para. 72) were incorrect, and that, contrary to Robillard, the proper interpretation of s. 84(2) has not narrowed in its modern context. After having previously noted (at para. 41) that the taxpayers were not now challenging “the trial judge’s finding that the EMC group acted as a third-party facilitator,” he reiterated (at para. 81) that “the involvement of a third-party facilitator to extract funds or property from a corporation is of paramount importance in guiding the courts’ analysis of the transactions entered into in order to achieve this result.”
In also confirming the finding below that the distribution had occurred on a “reorganization” of the business of W4N, Noël C.J. stated (at para. 93) that the “separation of W4N’s business and its continuation by two distinct entities was sufficiently important to ground the conclusion that W4N’s business ceased to be conducted in one form and began to be conducted in another.” In the case of Virtuose, its business had been “discontinued” as “it could not longer act as a holding company” (para. 96).