Canadian Tax Law: 5. What is a butterfly and how can you use it to help you?

How Butterfly Transactions Minimize Taxes When You Split Your Business

If you’re a business owner looking to part ways with your partner or co-owner, a butterfly transaction can save both of you from serious tax consequences.

A butterfly - also known as a corporate divorce - is a restructuring method that lets Canadian business owners divide a company on a tax-free basis.

If you split up your company without a butterfly, you and your partner will be liable to pay capital gains tax on the disposition or transfer of assets to shareholders.

Butterflies Can Purify Your Corporation

Business owners can use a butterfly transaction to “purify” their corporation.

Business owners can use a butterfly transaction to “purify” a corporation so it pass the 90% rule required for owners to qualify to use their Lifetime Capital Gains Exemption (LCGE). In order to qualify for the LCGE, the owner’s shares, for 24 months prior to the sale, must be Canadian-controlled private corporation (“CCPC”) and Qualified Small Business Corporation shares, which have to pass the 90% rule.

The 90 percent rule stipulates that all or most (at least 90%) of a company’s assets are used for “active business.” Butterflies are commonly used to meet this threshold by splitting out non-active business assets to “purify” the corporation’s remaining assets.

Without a butterfly, you can “taint” your corporation with a capital gains tax liability from your non-active assets.

How Do Butterfly Transactions Work?

Broadly speaking, there are two categories of butterfly transactions: divisive butterflies, and related party butterflies. The mechanisms and applicable rules of each transaction are slightly different, but the general approach is the same.

·   Divisive butterflies apply to business owners at arm’s-length from one another.

·   Related party butterflies apply to owners that are related by blood, adoption, marriage, or common law partnership and are deemed not to be at arm’s-length.

The Divisive Butterfly

When you split up a company’s assets, you need to abide by rigid rules that vary based on your relationship to the other owners.

For example, each new company that forms as a result of the butterfly must receive proportional shares of the business’ assets. If any of the company’s assets cannot be easily divided - like property, investment portfolios, or share classes with differing values - this can lead to planning issues.

The Related-Party Butterfly

The related-party butterfly is a much simpler transaction that applies to non-arm’s-length parties like common-law partners, married couples, and family members.

In a related-party transaction, separating family members can choose the most prudent manner of dividing the company’s assets, which is not always an even 50/50 split.

The owners’ goals are also important in choosing the right kind of butterfly. Different butterfly transactions are used for specific scenarios and objectives:

·    A full butterfly allows owners divest 100 percent of the business’ assets to shareholders.

·    A partial butterfly allow owners divest a portion of assets to shareholders.

·   A double-wing butterfly involves both business partners to receive a portion of the assets.

·   A single-wing butterfly gives one shareholder a portion of the business’ assets while the corporation and its shareholders retain the remaining assets.

Moving Forward:

A butterfly transaction is a complex yet common way to divide ownership of a company after a business or relationship breakdown.

If you want to know more about full, partial, single, or double butterfly transactions, Du Plooy Law is here to help.

Website: https://www.duplooylaw.com/

Email: [email protected]

Phone: 403-718-9877

As of the date of publication, the contents of this article are believed to be accurate and reliable; however, tax laws are complex and subject to change on an annual basis. Before implementing any tax or succession plan, you should always consult professional legal and accounting advice.

This article is purely educational in nature and is not to be construed as legal advice. Du Plooy Law does not accept any liability for the tax consequences that may result from actions made based on this article.

Written by Jenna Pich