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:
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.
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.
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.
A ‘corporate divorce’, otherwise referred to as a ‘butterfly transaction’ is a winding-up of a corporation that results in a tax-free division of the corporation’s assets to its shareholders.
Depending on the nature of the diversion, the income may be taxable in the hands of either the taxpayer or the recipient or of both in the case of potential tax evasion. The Canadian Income Tax Act has a number of provisions that prevent assignment of income or attribution of payments to related parties in a way that would defeat the taxpayer’s legitimate tax obligations. Failure to report income that arose as a result of these provisions may result in penalties and interest on amounts owing and potentially to criminal tax evasion charges.
In a typical private share transfer, an agreement of purchase and sale will need to be drafted outlining the price of the transfer, the parties involved and any relevant warranties, among other factors. As well, a closing date will need to be specified and a closing agenda drafted and issued to parties when the transfer is executed. New share certificates will be issued to the purchaser. Finally, the corporation’s minute books will need to be updated to reflect the change in share ownership and to record the corporate documents relevant to the share transfer.
The taxability of capital gains is not affected by your total income level. Only 50% of a capital gain will be taxable, but that 50% capital gain will be treated as income regardless of your income bracket.
CRA Tax Audits
There are over 350,000 tax audit and review actions conducted by the Canada Revenue Agency on a yearly basis. Around 15,000 of these tax audits deal with “cash only” businesses (i.e. the underground economy). Additionally, an estimated 35,000 are tax shelter audits.