A butterfly transaction is a tax free method of dividing up assets in a corporation between shareholders who are going their separate ways. It can also be carried out by a single shareholder who has two different businesses in a corporation with a view to separating the divisions so that they are each in a separate corporation. It is called a butterfly reorganization because when drawn out the transaction has the look of a butterfly. Two winged butterflies and single winged butterflies refer to the detailed way in which the transaction is carried out. In essence the butterfly transactions consist 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.
FAQ’s Butterfly Transactions:
Is there any downside tax-wise when it comes to butterfly transactions?
Butterfly transactions are used when shareholders in a business are going their separate ways. It’s a tax-free way of dividing assets between parties or between two companies in the same corporation. These transactions are essentially rollovers completed under section 85 of the Income Tax Act. Parties involved in butterfly transactions must ensure that they don’t put a foot wrong in completing the transaction. Any misstep could negate the tax-free benefit of the process.
What is the meaning of an arm’s length transaction for tax purposes?
In an arm’s length transaction, both parties act in their own best interests as if they have no relationship with each other. They can work fairly and negotiate a deal that doesn’t favour one party over the other. If parties are too close, e.g., family members, one might favour the other by offering a lower rate. On the opposite end of the scale, one party may force the other party to pay a higher price for goods purchased.
What is a spinoff butterfly?
A spinoff butterfly is a butterfly transaction in which assets are distributed directly to the shareholders through a series of processes that involve other corporations being created. The asset distribution between shareholders is proportionate to each shareholder’s investment in the company.