Why do we call it a Butterfly?
A butterfly transaction is a way to divide up assets in a corporation, or a set of corporations, in a tax-efficient manner under the Income Tax Act. These kinds of transactions typically involve rollovers under section 85 of the Income Tax Act which allows a taxpayer to transfer property on a tax-deferred basis to another corporation. When drawn out on a sheet of paper, the overall corporate reorganization tends to look like a butterfly.
Under section 85 of the Income Tax Act, a Canadian transferor and a transferee can jointly elect to respectively deem the transferors’ proceeds of disposition and the transferee’s cost in an eligible transaction between the two parties. Similarly, under section 85.1 of the Act, a Canadian taxpayer can dispose of its shares through a share for share exchange on a tax-deferred basis with another Canadian corporation.
In addition to sections 85 and 85.1, there are a number of provisions in the Act that often tend to come up when discussing butterfly transactions and other tax planning transactions. These include (but aren’t limited to):
- Subsection 55(2)
- Section 112
- Subsection 84(3);
- Section 86; and
Subsection 55(2) is a general anti-avoidance rule that was legislated into the Act in order to prevent potential abuses of the section 85 provisions. In effect, subsection 55(2) was designed to prevent a corporation from turning proceeds of a taxable capital gain into a tax-free intercorporate dividend. It usually applies where a corporation receives a dividend from another Canadian corporation under subsection 112(1) of the Income Tax Act.
Speaking of which, subsection 112(1) states that where a dividend is paid from one taxable Canadian corporation to another taxable Canadian corporation, the recipient corporation is allowed to deduct an amount equal to that dividend from its income for that reporting period. Note that this amount would otherwise have been taxable pursuant to paragraph 82(1)(a) of the Act. As a result of section 112, dividends can generally flow free of tax from corporation to corporation under the Income Tax Act.
Subsection 84(3) is another anti-avoidance rule that applies in the case of a share redemption. A share redemption is where a corporation buys back its own shares from a shareholder and cancels those shares. It makes it so that when a corporation has redeemed, acquired, or canceled, any of the shares of its capital stock for an amount exceeding the paid-up capital of those shares, there will be a deemed dividend paid by the corporation to the shareholder.
Section 86 allows a corporation to exchange a number of shares for newly authorized shares of a different class of shares on a tax-deferred basis. It’s commonly used in estate freezes where a shareholder gives up common shares in the corporation in return for fixed-value preference shares.
A Single Wing Butterfly
An example of a relatively simple butterfly transaction can be illustrated by the following example. Suppose Mr. A and Mrs. B each own 50% of a corporation called ABC. After years of operating ABC together, Mr. A and Mrs. B decide that they want to go their separate ways with their business and thus would like to organize a tax-free butterfly transaction. First, Mr. A needs to incorporate a new corporation called XYZ. He then transfers his shares of ABC to his new corporation XYZ using a tax-free rollover via subsection 85 of the Income Tax Act.
Next, Mr. A would once again use section 85 of the Act in order to transfer the relevant property from ABC to XYZ. Effectively, ABC would exchange the relevant property into XYZ in exchange for shares of XYZ. After that, ABC would redeem its shares of XYZ, and XYZ would do the same for its shares in ABC. The redemption of these shares could be satisfied with promissory notes, and, assuming that they are of equal value, can offset the other and thus be cancelled. The result would be Mr. A and Mrs. B going their separate ways with their respective corporations, XYZ and ABC.
In summation, a butterfly transaction is a useful method to help Canadian taxpayers reorganize their business affairs for a number of different reasons, without incurring unnecessary tax liabilities. Done poorly, however, these transactions can potentially lead to unintended realizations of capital gains and income inclusions that could have disruptive effects on the day-to-day operations of a business. Luckily, Canadian tax lawyers can help businesses navigate otherwise complex transactions with minimal tax liabilities.
DISCLAIMER: Please note this article is not legal advice. Always consult a lawyer for legal advice regarding your particular situation. The article is not necessarily a complete and accurate picture of the law – it is an article of a general nature.
Published on December 3, 2021