Everything You Need to Know About The Butterfly Transaction

Why do we call it a Butterfly Transaction?

A butterfly transaction, also known as a corporate reorganization, 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.

 

Relevant Provisions of

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 of the ITA 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 to prevent potential abuses of the section 85 provisions. In effect, subsection 55(2) was designed to prevent a corporation from turning the 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 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 several 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.

Types of Butterfly Transactions

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 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.

Double-Wing Butterfly

In a double-wing butterfly, each shareholder receives a portion of the corporation’s assets, and the original corporation ceases to exist. This method is suitable for situations where business partners want to completely wind up the business and pursue their separate ventures.

Steps Involved:

1. Incorporation: Each shareholder incorporates a new company (NewCo A and NewCo B).
2. Share Transfer: Shareholders transfer their shares of the original corporation (OldCo) to their respective new companies.
3. Asset Transfer: OldCo transfers a proportionate share of its assets to NewCo A and NewCo B.
4. Redemption: NewCo A and NewCo B redeem their shares in OldCo, and OldCo redeems its shares in NewCo A and NewCo B, using promissory notes to balance the values.

Example: Shareholders Mr. A and Mr. B decide to dissolve their jointly-owned corporation. Each business owner incorporates its own company, and assets from the original corporation are divided and transferred to the new companies. The original corporation is then dissolved, and each shareholder continues with their own entity.

Full Butterfly

A full butterfly transaction involves the complete distribution of all the corporation’s assets to all its shareholders. This effectively splits the business entirely, with each shareholder receiving their proportionate share of the assets.

Steps Involved:

1. Asset Division: The corporation’s assets are valued and divided into equal shares.
2. Transfer: Each shareholder’s new corporation (NewCo) receives its share of the assets from the original corporation (OldCo).
3. Redemption: The shares held in OldCo by NewCo are redeemed, and OldCo redeems its shares in NewCo, typically through promissory notes.

Example: A business owned equally by four shareholders is completely divided. Each shareholder forms a new corporation, and the assets of the original corporation are distributed equally among the new corporations. The original corporation is then dissolved.

Partial Butterfly

In a partial butterfly transaction, only certain assets of the corporation are transferred, and the corporation retains the remaining assets or some of its assets. This type of transaction is useful when only part of the business needs to be separated.

Steps Involved:

1. Selective Asset Transfer: The corporation decides which assets will be transferred to the new corporation(s).
2. Share Transfer: The shareholder(s) of the original corporation (OldCo) transfer their shares to the new corporation (NewCo) in exchange for shares of NewCo.
3. Asset Transfer: OldCo transfers the selected assets to NewCo.
4. Redemption: OldCo and NewCo redeem their shares in each other.

Example: A corporation with both active business operations and passive investments decides to separate these operations. The passive investments are transferred to a new corporation, while the original corporation retains the active business operations.

Applications of Butterfly Transactions

Butterfly transactions are used in various corporate and tax planning contexts. They provide a mechanism for dividing assets without immediate tax consequences. Here are some key applications:

Corporate Divorce

Corporate divorce occurs when business partners or family members who jointly own a business decide to part ways. This situation often arises due to differing visions, conflicts, or the desire to pursue independent ventures. A butterfly transaction allows for the equitable division of corporate assets, ensuring that each related-party butterfly receives their fair share without triggering significant tax liabilities.

Example: Two siblings own a family business together but decide to split due to differing business goals. Through a butterfly transaction, they can divide the assets of the business into separate entities, allowing each sibling to continue independently without facing immediate capital gains tax liability.

Estate Planning

In estate planning, butterfly transactions can be used to distribute assets among heirs without immediate tax implications. This method ensures that the assets are transferred in a tax-efficient manner, preserving the estate’s value and providing flexibility in the distribution process.

Example: A parent owns a holding company with multiple properties. Through a butterfly transaction, the parent can transfer specific properties to different holding companies owned by their children. This division ensures that each child receives their inheritance in a structured, tax-efficient manner.

Business Restructuring

Butterfly transactions are also useful in business restructuring, where different divisions of a business need to be separated into distinct entities. This is often necessary for operational efficiency, strategic realignment, or preparing parts of the business for sale.

Example: A corporation operates both a manufacturing division and a retail division. The company decides to separate these divisions into two distinct entities to streamline operations and potentially sell one of the divisions in the future. A butterfly transaction enables this separation without immediate tax consequences, allowing each division to operate as an independent business.

Benefits of Butterfly Transactions

Butterfly transactions offer several benefits, making them a popular choice for corporate reorganizations and tax planning:

Avoids Immediate Capital Gains Tax

One of the primary benefits of butterfly transactions is that they avoid immediate capital gains tax. By utilizing provisions under Section 85 of the Income Tax Act, assets can be transferred on a tax-deferred basis. This deferral is crucial for preserving the value of the assets being distributed.

Allows for Equitable Distribution of Assets

Butterfly transactions facilitate the equitable distribution of assets among shareholders or heirs. This is particularly important in situations where fairness and equal treatment are essential, such as in family businesses or estate planning.

Facilitates Smooth Transitions

These transactions enable smooth transitions during business separations or successions. By providing a clear, tax-efficient method for dividing assets, butterfly transactions help prevent disputes and ensure that all parties can move forward with their respective plans.

Get Help from Expert Litigation Lawyers

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 on the transfer 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. It is essential to seek professional legal and tax advice to ensure these transactions are executed correctly and comply with relevant tax laws. For more detailed information, contact professional litigation experts at Cowan & Carter Civil Litigation Toronto Firm.

Published on December 3, 2021