In situations where shareholders of a Corporation wish to go their separate ways, yet each wishes to retain an interest in the business of the Corporation, there would normally be a tax liability arising on the disposition by the Corporation of its assets to the shareholders.

A butterfly is a tax-free method of allocating some or all of the corporate assets to the shareholders of such corporation on a tax-free basis. 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.

The most basic use of the butterfly, and probably the reason for its insertion into the Tax Act, is the case of closely held private Corporations owned by 2 business partners who have a falling out, or for other reasons wish to go their separate ways. The classic butterfly is used in this situation to enable a tax deferred split of corporate assets to the shareholders. In a situation where the Corporation has 2 separate divisions of roughly equal value, each shareholder could end up with a separate division without incurring any immediate tax consequences at the corporate or personal level.

The butterfly rules are very flexible and have also been used to successfully spin out separate businesses in public Corporations.

Butterflies can also be used fully in cross-border reorganizations, but of course U.S. issues must be considered in any such proposed reorganization.

One of the more common uses of the butterfly in recent years has been as part of the purification process to enable a Corporation which does not meet the 90% active asset test rule to qualify under that rule. The purification process involves a disposition by the Corporation of its investment assets which are not part of its active business. Although there are several methods whereby such a divestiture can take place, a butterfly reorganization is useful in various scenarios.

In simple terms, a butterfly would be carried out as follows. Assume that Opco is 50% owned by each of Holdco A and Holdco B. Holdco A is owned by Mr. A. and Holdco B is owned by Mr. B. The shareholders of Opco want to divide the assets of the corporation between them and go their separate ways. In a single-wing butterfly, Opco would transfer 50% of its assets to Holdco B, electing under Subsection 85(1) of the Tax Act where applicable so that no immediate tax would be incurred as a result of the transfer. As consideration, Holdco B would assume 50% of Opco’s liabilities and issue preferred shares having a redemption amount equal to the difference between the fair market value of the assets transferred and the liabilities assumed. Holdco B would then redeem its preferred shares held by Opco, and Opco would purchase its shares held by Holdco B for cancellation. On completion of the butterfly, Holdco B would hold half of the assets and liabilities formerly held by Opco, and Holdco A would own all of the shares of Opco, which would hold half of the assets and liabilities that it formerly held. In a full double-wing butterfly, Holdco A and Holdco B would each receive half of Opco’s assets. Opco would acquire all of its shares for cancellation and thus would cease to exist. In a partial double-wing butterfly, Opco would acquire only some of its shares for cancellation and would continue to exist.

A butterfly transaction is a very complex reorganization and is typically only carried out after obtaining an advance ruling from Revenue Canada. The rules governing the butterfly which are actually set out in the Tax Act are very sketchy. Therefore, the butterfly has become a transaction which relies on Revenue Canada administrative positions. Failure to obtain an advance ruling could mean that Revenue Canada might attack the transaction at some point in the future.

Revenue Canada’s guidelines governing butterfly reorganization are set out in a number of papers which have been published by Revenue Canada officials over the years. For example, Revenue Canada requires that each shareholder receive a pro-rata share of each category of assets of the Corporation. These assets are categorized as cash or near cash, investment assets and business assets. This requirement that each shareholder obtain a pro-rata share of each type of property is at the heart of the butterfly. Hence it is important to ensure that accurate valuations are carried out of all assets in the Corporation.