WHAT IS A BUTTERFLY TRANSACTION

A Butterfly Transaction, technically known as a Divisive Reorganization, is a tax-free method of dividing up assets in a corporation into separate corporate allocations, which is commonly implemented when the shareholders are seeking to go their separate ways and thus divide out the corporation’s assets.

A Butterfly Transaction can also be carried out when the corporation consists of two different businesses with a view to separating the divisions so that they are each in a separate corporation; or alternatively, to “purify” a corporation of its non-active business assets, such that the corporation with the active business assets might allow its shareholders to draw upon their Lifetime Capital Gains Exemption.

In each scenario, the objective is to facilitate the division of the corporation’s assets on a tax-free basis and in conformity with the Income Tax Act.

The complexity intrinsic in Butterfly Transactions emanates from the numerous anti-avoidance provisions from the Income Tax Act, and applied by the Canada Revenue Agency, that can adversely impact an incorrectly structured Butterfly Transaction, resulting in substantial tax liability.

The term Butterfly Transaction or Butterfly Reorganization emanates from the conceptual image when the transaction is actually drawn out and it takes the appearance of a butterfly.

Two winged butterflies and single winged butterflies refer to the detailed way in which the transaction is carried out.

• A Full Butterfly entails the disposition of all corporate assets to all shareholders.

• A Partial Butterfly involves transferring only certain corporate assets to the shareholders while the corporation retains its remaining assets.

• A Single-Wing Butterfly is a transaction wherein only one of the shareholders receives assets, and the remaining shareholders would remain in the corporation.

In essence, the Butterfly Transaction consists of a series of tax-free rollovers under section 85 of the Income Tax Act and cross redemptions of shares.

A Butterfly Reorganization cannot be undertaken in contemplation of an arm’s length sale.

So, in the case of a business with different divisions, if there is ever to be a sale of one of the divisions, the butterfly division has to be done before any sale is being considered, otherwise it will not qualify. Butterfly Transactions that are undertaken to “purify” a corporation, are designed to satisfy the 90% Rule required for business owners to qualify to use their Lifetime Capital Gains Exemption (LCGE).

In order to qualify for use of one’s Lifetime Capital Gains Exemption, the business owner’s shares, (i) must be held for 24 months prior to the sale, (ii) must be Qualified Small Business Corporation shares (iii) in a Canadian-controlled private corporation (“CCPC”) and (iv) all or most (at least 90%) of the corporation’s assets are used for “active business” (the 90% Rule).

Butterfly Transactions are commonly used to meet this threshold by splitting out non-active business assets to “purify” the corporation’s remaining assets.

Without a Butterfly, the business owner would effectively “taint” their corporation and subject it to a capital gains tax liability from the retention of non-active assets in the corporation.

The Canada Revenue Agency views the improper exploitation of Butterfly Transactions as a means to achieve improper tax treatment for certain transactions, such that it is critical to properly develop and implement Butterfly Transactions to be compliant with the Income Tax Act, as opposed to improperly abusing the concept.

From a Canadian corporate tax planning perspective, Butterfly Transactions (divisive reorganizations) are one of the most significant corporate tax planning strategies. If your corporation requires the implementation of a Butterfly Transaction, or is looking for other corporate tax planning strategies, contact our law firm for a confidential initial consultation at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.