My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, December 5, 2011

Corporate Divorces and Butterflies

Over the last couple months I have received a few private emails enquiring about the services provided by my firm Cunningham LLP. I have never directly marketed my firm on this blog; however, today will be the exception.

Cunningham LLP is a mid-market CA firm that deals almost exclusively with owner/managed corporations. We prepare financial statements (Notice to Readers, Reviews and Audits) and provide advisory services on acquisitions, divestitures, financing and succession planning to name a few. In addition, we provide business valuations, bookkeeping, wealth management services and, the service area most dear to my heart, income tax services. The income tax services range from corporate reorganizations and remuneration strategies, to estate planning, estate freezes and the introduction of family trusts amongst a plethora of other services. Today, I have decided to show off some of our income tax expertise; at least that is what I told my tax partner Aaron Schechter (I really needed a break from writing) when I convinced him to write today's guest post.

Corporate Divorces and Butterflies


In the ordinary sense of the word, a butterfly (noun) is defined as a nectar-feeding insect, characterized by two pairs of large, typically colorful wings and clubbed or dilated antennae. However, the term “butterfly” when used in an income tax context is often the most tax efficient solution for shareholders who often can no longer stand each other and want to part ways, while each taking their pro rata share of the business with them. In other words, a “butterfly” transaction is used to divvy up the business on a tax-free basis.

The transaction is referred to as a “butterfly” by tax practitioners because when diagrammed, the series of steps resemble the wing(s) of a butterfly.

A butterfly transaction is one of the more complicated transactions to carry out for Canadian income tax purposes. Butterfly transactions are typically used where there are arm’s length parties. It should be noted that when the shareholders are related (siblings are deemed not to be related for purposes of the butterfly rules) there are usually simpler ways to achieve the intended divorce than a butterfly.

The complexities lie in the provisions and rules found in the Income Tax Act that make the transaction tax-free. These provisions contain several income tax minefields and should the parties misstep they can quickly find themselves outside the tax-free provisions. Since the dollar amounts involved in a butterfly transaction are generally fairly large (if the dollar amounts were small, the parties would more than likely opt to create a taxable divisive transaction rather than dealing with the administration e.g. obtaining a tax ruling and incurring the professional fees associated with a tax-free butterfly transaction), a misstep can result in significant taxes owing.

While the specifics of the tax-free butterfly provisions are beyond the scope of this blog, in general a tax-free divisive reorganization of private corporations can be accomplished if:

1. Each type of corporate property is distributed pro rata to all shareholders. Corporate property is divided into three types – cash and near cash, investment property and business property;

2. A shareholder’s proportionate share of each type of corporate property is determined immediately before the transfer and is equal to the proportion of the fair market value of the shares of the distributing corporation owned by the shareholder relative to the total fair market value of all the issued shares of the distributing corporation.

3. The recipient(s) of the corporate property is(are) a corporate shareholder(s).

4. The recipient(s)’s shares of the distributing corporation is cancelled or redeemed at the end of the transaction.


The tax-free butterfly transaction is best illustrated with an example. Say Mr. Sheen and Mr. Lorre each own 50% of a company that specializes in organizing children’s birthday parties called Children Birthday Surprises Ltd. or CBS for short. Mr. Lorre believes that Mr. Sheen has not been devoting himself to the business and his recent behaviour has been negative for CBS. On the other hand, Mr. Sheen believes that he has not been properly remunerated by CBS for his contributions to the business. In other words, Mr. Sheen and Mr. Lorre want to part ways and each take a part of the business with them. They wish to undertake a tax-free butterfly transaction.

Prior to separating, the company owns $1,000,000 of cash, $2,500,000 of marketable securities (cost $1,000,000) and $5,000,000 of inventory (cost $4,000,000) and the ownership structure looks like this:





The first step of the butterfly is to have Mr. Sheen incorporate a new company, SheenCo. He then transfers his 50% ownership of CBS to SheenCo. The transfer takes place on a tax-free basis under the rollover provisions in the Income Tax Act.





Next, CBS transfers 50% of the cash, 50% of the marketable securities (investment property) and 50% of the inventory (business property) to SheenCo. in exchange for shares of SheenCo. Again, the transfer takes place on a tax free basis under the rollover provisions in the Income Tax Act.





Immediately thereafter, SheenCo, has its 50% share ownership in CBS redeemed for $4,250,000 and CBS has its shares of SheenCo. redeemed for $4,250,000. The redemption proceeds for each redemption are satisfied by promissory notes worth $4,250,000.






The promissory notes are then offset by each other and cancelled. Each of SheenCo. and CBS now own 50% of the original assets and can carry on business separately.



The transaction discussed above is commonly referred to a “single wing” butterfly since only one additional corporation is incorporated. However, “multi-winged” butterfly transactions are also possible.

Butterfly divisive reorganizations are generally much more complicated and involved than the example provided, so it is often recommended that the parties obtain an advanced tax ruling from the Canada Revenue Agency to confirm that the transactions proposed will indeed be tax-free. When undertaken properly, the tax-free butterfly transaction can be as beautiful as the real thing, just remember to tread carefully, otherwise the process could metamorphosize into something a whole lot uglier.

Finally, I hope it goes without saying, but today's discussion has been general in nature and the specific nuances related to a divisive reorganization are vitally important. Thus, do not act without first seeking professional advice.

Aaron Schechter CA, is a partner with Cunningham LLP, who specializes in income tax planning and income tax reorganizations.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

9 comments:

  1. It's interesting that the promissory notes are necessary for the transaction to be deemed non-taxable. I presume that when the dust settles, the marketable securities for each half have a cost of $500,000 and the inventories have a cost of $2 million?

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  2. Michael, I will let Aaron take this one.

    Thanks for your comment, Michael. The promissory notes are necessary as you point out to make the transaction work on a tax-free basis. The promissory notes need to offset and cancel each other out. If the promissory notes were satisfied instead by way of some of the assets, the accrued gains on the assets (i.e. fair market value less cost) would be realized by the transferor. You are correct that the marketable securities and the inventories would have cost bases of $500,000 and $2,000,000, respectively for each party.

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  3. Hi I had a quick question regarding the transaction proposed above. I was looking through S55(2) anti-avoidance provision and wondering if it would apply to above as it does not meet the exception under S55(3)(b)(i).

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    1. Hi Leah,

      Aaron has this to say

      “Thanks, Leah, but I believe that the exemption in subparagraph 55(3)(b)(i) does apply in the situation above – the dividend is received in the course of a reorganization in which a distributing corporation (i.e. CBS) made a distribution to a transferee corporation (i.e. SheenCo.) and all of the shares of the transferee corporation (i.e. SheenCo.) were redeemed or cancelled. I think you might have gotten caught up with the phrase “the distributing corporation was wound up”. This is not necessary since it is an “or” test. In our example, the distributing corporation was not wound up, however, the other part of the “or” test is that the transferee’s shares are redeemed or cancelled so the butterfly would meet the exemption.”

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  4. Awesome stuff. Definitely a good read. thanks!

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  5. How would this apply to a matrimonial settlement? And, would this be the most tax efficient way to divide a private business that does not have the
    cash to pay out right?

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    Replies
    1. HI Anon

      Here is what Aaron says:

      The division of family assets on a marital breakup takes place on a tax deferred basis. In other words, the spouse receiving assets on the breakdown of a marriage inherits the cost base (and potentially the accrued gains or losses) of the transferor spouse. This is also true for shares of a company.

      Shares of a private corporation are generally considered to be a family asset that is included in the value of the assets that are to be divided on a marriage breakdown. If only one spouse owns the shares of the corporation, more often than not other assets are used to equalize the values. If there are not sufficient other assets to be used for the equalization or both spouses own shares of the corporation prior to the marriage breakdown, a butterfly transaction could be used; however it can get very complicated.

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  6. Can you do a single wing reorg. for a company with 2 shareholders if one of the shareholders died?

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    Replies
    1. Hi Anon

      I no longer work with Aaron who wrote the post, so you need to ask your accountant.

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