Published: February 24, 2021
Introduction – Eyeball Networks Inc. v the Queen and Butterfly Reorganization
A butterfly reorganization is a method of separating a corporation – through its assets – into two or more separate corporations. This often occurs where two or more shareholders wish to go their separate ways and, therefore, they divvy up the assets of the corporation. A butterfly reorganization can also be carried out by a single shareholder who has two different businesses in a corporation with a view of separating each business is into a separate corporation. This is typically referred to as a single wing butterfly. In particular, a butterfly reorganization allows shareholders to separate their businesses into two or more corporations on a tax-deferred basis under section 85 of Canada’s tax act, while avoiding the deemed capital gain that might otherwise be triggered pursuant to subsection 55(2) of the Act. Under subsection 55(3) of the Income Tax Act. a butterfly reorganization is exempt from subsection 55(2) of the Act. Parties engaged in a butterfly reorganization should ensure that they retain expert Canadian tax lawyers throughout the entire reorganization process in order to avoid any mishaps that could negate the tax-deferral. For the purpose of simplicity, the terms corporate reorganization, reorganization, or corporate butterfly reorganization throughout this article are one and the same.
Canada’s federal Income Tax Act contains anti-avoidance provisions that are designed to protect the collection of taxes by the Minister of National Revenue (the “Minister”). One of these provisions is subsection 160(1) of Canada’s tax act. Where a tax debtor transfers property to a related person in order to escape his or her tax liability, subsection 160(1) renders the other person (the property transferee) liable for the tax debt of the transferor.
In Eyeball Networks Inc. v the Queen, the Federal Court of Appeal overturned the Tax Court of Canada’s decision to confirm a section 160 assessment issued by the Minister in the context of a butterfly reorganization. This decision by the Federal Court of Appeal limits the scope of transactions under which the Minister may issue a section 160 assessment. In this article, our top Ontario tax lawyers provide tax guidance related to subsection 160(1) of the Income Tax Act in context of butterfly reorganization.
Eyeball Networks Inc. v the Queen – The Facts
Eyeball Networks Inc. (Newco, also the Appellant), a non-arm’s length affiliate (Oldco) and their sole shareholder, Mr. Piche, undertook a corporate reorganization, involving a number of transactions, for business reasons. In particular, Mr. Piche created Newco and transferred property, from Oldco to Newco, to continue the development and exploitation of a new technology to prospective buyers. The following transactions all took place on March 19, 2002:
- Agreement between Mr. Piche and Oldco – Piche sold his 11 million class A common shares in the capital of Oldco back to and Oldco at their fair market value, which was estimated to be $30 million. In exchange, Oldco issued to Mr. Piche 11 million class A voting shares and 11 million class C non-voting redeemable shares, having an aggregate redemption value of $30 million.
- Agreement between Mr. Piche and Newco – Mr. Pitche sold to Newco his 11 million class C non-voting redeemable shares in Oldco, valued at $30 million. In exchange, Newco issued to Mr. Pitche 11 million class A non-voting shares and 11 million class B voting shares. The parties also filed a subsection 85(1) election under the Income Tax Act.
- Agreement whereby Oldco sells assets to Newco – Oldco sold to Newco assets of its new business, valued at $30,175 million. In exchange, Newco assumed Oldco liabilities equal to $175,000 and issued to Oldco 11 million class C non-voting redeemable shares, having an aggregate redemption of $30 million. The parties also filed a subsection 85(1) election under the Income Tax Act.
- Oldco’s Share Redemption and Promissory Note – Oldco redeemed its 11 million class C non-voting redeemable shares held by Newco for the stated redemption amount of $30 million and issued a promissory note of $30 million to Newco (Oldco Note).
- Newco’s Share Redemption and Promissory Note – Newco redeemed its 11 million class C non-voting redeemable shares held by Oldco for the stated redemption amount of $30 million and issued a promissory note of $30 million to Oldco (Newco Note).
- Mutual Debt Cancellation Agreement – Oldco and Newco entered into a mutual debt cancellation agreement whereby the liabilities created by the two promissory notes were set-off against each other (the set-off).
- Escrow Agreement – the transactions were in escrow until March 22, 2002, to sort out a difficulty that had arisen in the change of the corporate name of Newco.
In 2003, the Minister reassessed Oldco for its 2000 and 2001 taxation years for the amount of $13,368.48. In 2004, the Minister reassessed Oldco for its 2002 taxation year for the amount of $113,366.10. In March 2014, the Minister assessed Newco for the amount of $287,233.51 pursuant to subsection 160(1) of the Income Tax Act. In particular, Newco was held “jointly and severally” liable for Oldco’s tax liability for the 2000, 2001 and 2002 taxation years (plus interest) on the basis that Newco did not give adequate consideration for the property transferred to it by Oldco, pursuant to step 3 of the corporate reorganization.
The Tax Court Decision and Analysis
The Tax Court judge focused on step 3 of the reorganization, namely, the transaction whereby Oldco conveyed assets to Newco, and whether the Newco gave to Oldco adequate consideration for the assets transferred. The Tax Court judge confirmed that the terms of the agreement are clear to the effect that consideration given by Newco to Oldco was to have a value corresponding with that of the transferred assets. The Tax Court judge’s textual analysis led him to conclude that the words “at the time” in subsection 160(1) of the Income Tax Act suggest a “value snapshot of the transfer of property when it occurs”. Turning to contextual analysis of the provisions, the Tax Court judge held that “the phrase by any other means whatever” in the introductory part of subsection 160(1) does not permit for the “examination of the net result of series”. In his purposive analysis, the Tax Court judge held that in applying subsection 160(1) of the Income Tax Act “both value of the transferred property and tax debtor liability must be established at the moment of transfer”. The Tax Court judge explained that the “time” referred to in subsection 160(1) of the Income Tax Act should be “linked to an identifiable and distinct transaction” and rejected the Minister’s contention on this basis. In addition, the Tax Court judge questioned whether (or not) the set-off which took place at step 6 of the reorganization “gave rise to a transfer of property without adequate consideration” and, therefore, subsection 160(1) of the Income Tax Act was engaged. Although the Tax Court judge did not explain why the value of the two promissory notes did not support each other, he concluded that “at the time of the set-off, the fair market value of the Oldco Note held by Newco was effectively valueless when compared to the fair market value of the Newco Note held by Oldco” which, in contrast, was backed by assets worth $30 million. As such, the Tax Court judge dismissed the appeal on the basis that the consideration given by Newco to Oldco in context of the set-off was inadequate and, therefore, subsection 160(1) of the Income Tax Act was engaged.
Consideration of the Issues by the Federal Court of Appeal
The Federal Court of Appeal began by addressing a preliminary issue surrounding Mr. Piche’s intent with respect to the corporate reorganization. In particular, during the hearing, the Minister raised a concern surrounding the possibility of an “improper motive” against Mr. Piche. In this context, the Federal Court of Appeal rejected the Minister’s contention that the reorganization was driven by a desire to void pre-existing tax liabilities, a motive which, if present, can influence the way in which a Court may view transactions and assesses their impact. The Federal Court of Appeal upheld the Tax Court judge’s conclusion that Mr. Piche’s intent for the reorganization was driven by his desire to separate the new technology from the old one and exploit it under Newco “for the prospective buyers of the new technology”.
The issue before the Federal Court of Appeal was whether (or not) the existence and value of the consideration given by Newco to Oldco must be determined at the time when the assets were transferred to Newco or after the completion of the reorganization in light of the overall results. The Federal Court of Appeal referred to Livingston v R, wherein the same court set out four key criteria to determining if section 160 of the Income Tax Act applies:
- The transferor must be liable to pay tax under the Act at the time of the transfer;
- There must be a transfer of property;
- The transferee must be a person with whom the transferor was not dealing at arm’s length or to an otherwise designated transferee;
- The fair market value of the property transferred must exceed the fair market value of the consideration given by the transferee for the property.
Since the first three requirements under the Livingston v R test were not in dispute, the primary issue before the Federal Court of Appeal was “whether Newco gave adequate consideration for the property transferred to it by Oldco”. In this context, the Federal Court of Appeal held that the concept of “series of transactions” does not apply where, as in the present case, each of the transactions were entered into “in the pursuit of a bona fide non-tax purpose”. The Federal Court of Appeal explained that the introductory words in subsection 160(1) of the Income tax Act capture all forms of transfers including those resulting from “the combined effect of multiple transactions”. In the present case, however, step 3 of the reorganization is a “straightforward transaction” and as such the Federal Court of Appeal held that there was no need to resort to the broad introductory language in the provision “in order to identify the transfer that took place”. In addition, the Federal Court of Appeal held that a “transfer of property takes place instantaneously both at civil and common law” and explained that Parliament was clear in providing “that the value of the property is determined at the time it was transferred” and the value of the “consideration given is determined at that time”. The Federal Court of Appeal further explained that allowing the values of the property transferred and of the consideration to be “ascertained over a period of time, without pinpointing exactly when, would produce inherently uncertain results, something that Parliament cannot have intended”. Therefore, the Federal Court of Appeal upheld the Tax Court judge’s decision that the “adequacy of the consideration given must be measured against the value of the property transferred by way of a snapshot taken at the point in time which the transfer takes place”.
As previously mentioned, the Tax Court judge questioned whether (or not) the set-off which took place at step 6 of the reorganization “gave rise to a transfer of property without adequate consideration” and, therefore, subsection 160(1) of the Income Tax Act was engaged. In this context, the Tax Court judge concluded that “at the time of the set-off, the fair market value of the Oldco Notes held by Newco was effectively valueless when compared to the fair market value of the Newco Note held by Oldco” which, in contrast, was backed by assets worth $30 million. In this context, the Federal Court of Appeal held that it was not open to the Tax Court judge to hold that the Newco Note had “considerable value” while the Oldco Note had “nominal value” on the basis that both promissory notes “were backed by the same assets”. The Federal Court of Appeal explained that the set-off of the two promissory notes (per step 6 of the reorganization) had the “same effect as if both notes were discharged by cross-payments” and, therefore, the payment of a bona fide debt cannot engage the application of subsection 160(1) under Canada’s tax act.
Federal Court of Appeal Judgment
The Federal Court of Appeal allowed the appeal with costs and set aside the judgement of the Tax Court on the basis that subsection 160(1) of the Income Tax Ac was not engaged based on the facts in the present case.
Implications of the Federal Court of Appeal’s Decision
Eyeball Networks Inc. v the Queen is a significant case for shareholders engaged in a butterfly reorganization, holding that subsection 160(1) of Canada’s tax act will not apply to transactions occurring in context of a butterfly reorganization. This case demonstrates that even in the absence of improper attempt to thwart Canada Revenue Agency’s (CRA) tax collectors, the potential application of subsection 160(1) of the Income Tax Act can be engaged. In addition, Eyeball Networks Inc. v the Queen sheds light on some of the complexities associated with a section 160 assessment. For example, a butterfly reorganization can create a derivative tax liability within the meaning of subsection 160(1) of Canada’s tax act. Further, this case illustrates the importance of maintaining corporate records and that the terms of a Mutual Debt Cancellation Agreement must be clear to the effect of the consideration.
In addition, Eyeball Networks Inc. v the Queen sheds light on the tax collection provisions in Canada’s Income Tax Act and the CRA’s collection powers and limitations under these provisions. The case speaks to the complexities associated with the interpretation of subsections 160(1) of the Income Tax Act the scope of transactions under which the Minister may consider issuing a section 160 assessment. Under certain circumstances, the CRA has the power to collect the tax debt of one taxpayer from another person. In all circumstances, the tax collection provisions, such as subsections 160(1), prevent double taxation and protect the collection of taxes.
Further, Eyeball Networks Inc. v the Queen highlights the need for shareholders and their experienced Canadian tax lawyers engaged in a butterfly reorganization to exercise due diligence at all stages of the reorganization process. This case also cautions shareholders engaged in a butterfly reorganization that failure to exercise due diligence may trigger a subsection 160(1) income tax liability.
Pro Tax Tips – Non-Arm’s Length Transfers & Corporation Reorganizations
A butterfly reorganization can create immense financial consequences and tax implications for businesses and their owners. As previously mentioned, Eyeball Networks Inc. v the Queen limits the scope of transactions under which the Minister can issue a subsection 160 assessment. As such, shareholders who plan on separating their businesses into two or more separate corporations should consult our certified specialist in taxation Canadian tax lawyers to ensure a smooth and efficient corporate reorganization process. Understanding the collection provisions under the Income Tax Act and the CRA’s collection procedures, powers and limitations is crucial for taxpayers to meet their tax obligations proactively and to avoid tax traps. If you have questions regarding corporate reorganization, a tax-deferred section 85 rollover or if you intend to engage in butterfly reorganization or challenge a section 160(1) assessment please contact our tax law office for tax guidance from one of our top Ontario tax lawyers.
Disclaimer:
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
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