What Is a Butterfly Transaction? Overview for Canadian Business Owners
A butterfly transaction is a tax-free method of dividing up the assets of a corporation between shareholders who are going their separate ways. It can also be carried out by a single shareholder who operates two different businesses inside one corporation and wants to separate the divisions so that each is held in its own corporation.
The transaction is called a “butterfly” reorganization because, when diagrammed, the flow of assets and shares resembles the wings of a butterfly. “Two-winged” and “single-winged” butterflies refer to the specific mechanics used to carry out the division. In essence, a butterfly transaction consists of a series of tax-free rollovers under section 85 of the Income Tax Act combined with cross-redemptions of shares, all structured to satisfy the strict technical requirements of section 55 of the Act.
Under the anti-avoidance rules in subsection 55(3.1) of the Income Tax Act, a butterfly reorganization generally cannot be undertaken in contemplation of an arm’s-length sale: if one of the divisions is ever going to be sold to an outside buyer, the butterfly division has to be completed well before any sale is contemplated, or the transaction will not qualify for tax-free treatment.
How a Butterfly Reorganization Works
In a typical butterfly, a “distributing corporation” divides its property among one or more “transferee corporations,” each ultimately held by the shareholders in the same proportions they held before the reorganization, or split cleanly between shareholder groups who are going their separate ways.
To qualify as a tax-free “distribution” under subsection 55(1) of the Income Tax Act, the property being moved must first be sorted into three categories: business property, investment property, and cash or near-cash property. Each shareholder group generally must end up receiving a proportionate share of every category, a rule designed to stop one shareholder from “streaming” all the liquid cash to themselves while the other is left holding illiquid real estate or an operating business.
The actual mechanics are carried out through a defined sequence of steps: a permitted exchange, one or more permitted redemptions of shares, and a permitted acquisition, each of which is precisely defined in subsection 55(1) and must be completed in the right order.
A Simple Example: Splitting a Business Between Siblings
Consider Opco, a family business worth two million dollars, owned equally by siblings Anna and Ben. Opco holds an operating business division worth 1.2 million dollars, a rental property worth 500,000 dollars classified as investment property, and 300,000 dollars in cash. Anna and Ben have decided to go their separate ways: Anna will keep the operating business, and Ben will take the rental property and the cash.
Because each of them must end up with a proportionate share of every category of property, not simply a proportionate share of total value, they cannot divide the assets by dollar value alone. In a typical two-winged butterfly, Opco first distributes a proportionate share of every category, business property, investment property, and cash, to two new corporations, one for each sibling, through a permitted exchange and a series of permitted redemptions.
Anna and Ben then exchange the mismatched pieces between their respective corporations so that Anna ends up holding only the operating business and Ben ends up holding only the rental property and the cash, all without triggering tax on the reorganization itself.
If Ben had simply taken all the cash and the rental property from the outset, without first passing through the proportionate distribution and exchange steps required by subsection 55(1), the CRA could treat the value shift as a taxable dividend under subsection 55(2). This is a simplified illustration. An actual butterfly involves considerably more technical steps than shown here, which is one more reason the transaction is rarely attempted without an experienced Canadian tax lawyer.
Section 55(2): Why the Butterfly Exception Exists
Subsection 55(2) of the Income Tax Act is Parliament’s principal weapon against “capital gains stripping”: arrangements that convert what should be a taxable capital gain on a share sale into a tax-free intercorporate dividend.
Where a dividend is received or paid as part of a transaction or series of transactions that has, among its purposes, reducing a capital gain, increasing the cost of property, reducing income, or (since amendments introduced in the 2015 federal budget) significantly reducing the fair market value of a share without a corresponding reduction in its cost base or paid-up capital, subsection 55(2) recharacterizes the dividend as proceeds of disposition or a capital gain.
Paragraph 55(3)(a) exempts dividends paid in the course of a related-party reorganization from this rule, and paragraph 55(3)(b) exempts dividends paid in the course of a genuine butterfly “distribution” between corporations that are not related, provided the proportionate-sharing and asset-classification rules described above are followed precisely.
Because the exceptions are unforgiving, a single misstep, whether an asset misclassified, a redemption completed out of sequence, or a disproportionate allocation, can cause the entire exemption to fail and trigger exactly the tax liability the butterfly was structured to avoid.
2021 Update: Siblings Can Now Access the Related-Party Butterfly
Before June 2021, paragraph 55(5)(e) of the Income Tax Act deemed siblings to be unrelated and dealing at arm’s length for the purposes of section 55, even though siblings are related for most other purposes under the Act. This meant that siblings who jointly owned a family business and wanted to split it, including on a succession to the next generation, could not rely on the simpler related-party butterfly in paragraph 55(3)(a) and instead had to satisfy the far more onerous unrelated-party rules in paragraph 55(3)(b).
Bill C-208, which received royal assent on June 29, 2021, amended subparagraph 55(5)(e)(i) to carve out an exception: siblings are now treated as related for section 55 purposes where the dividend in question is paid on a share of a qualified small business corporation or a share of a family farm or fishing corporation. This change accompanied Bill C-208’s better-known amendments to section 84.1 for genuine intergenerational share transfers, later refined by the 2023 federal budget’s rules on immediate and gradual intergenerational transfers, effective January 1, 2024.
The sibling carve-out makes it significantly easier for siblings to divide a qualifying family business between themselves on a tax-deferred basis, but it remains narrow: it does not extend to butterflies involving shares that are not QSBC or family-farm or fishing-corporation shares, and professional advice is essential to confirm whether a particular sibling reorganization actually qualifies.
“For years, siblings splitting a family business faced a much harder test than parents transferring to children, even though the underlying goal was the same. The 2021 amendment finally let the law catch up to how families actually run businesses together, but it’s still a narrow door, not an open one.”
— David J. Rotfleisch
Advance Income Tax Rulings: When They Make Sense
Because subsection 55(1) and its surrounding provisions are drafted with unusual technical precision, and because the CRA has published extensive administrative positions on issues such as the calculation of “safe income” and the classification of particular assets, an Advance Income Tax Ruling from the CRA’s Income Tax Rulings Directorate is available to corporations seeking certainty before completing a reorganization.
Obtaining a ruling is not a routine step in most butterfly transactions, and many are completed without one, but for a complex or high-value structure, some tax lawyers will recommend seeking a ruling, given that a single failed step can convert a tax-free division into a fully taxable event, with the CRA able to reassess within the normal reassessment period and beyond it in cases of misrepresentation.
“As a Certified Specialist in Taxation, I’ve seen well-intentioned reorganizations turn into fully taxable events over a single asset that was classified the wrong way. The legislation lets you divide a company tax-free, but it doesn’t forgive you for getting the mechanics wrong, and that’s exactly why we look closely at whether a ruling makes sense before anyone starts talking about selling.”
— David J. Rotfleisch
Third-Party Liability Risk: The Eyeball Networks Case and Section 160
Even a butterfly transaction that successfully qualifies under section 55 can still create third-party liability exposure under a different provision: section 160 of the Income Tax Act, which makes a transferee jointly and severally liable for a transferor’s tax debts where property is transferred between non-arm’s-length persons for less than fair market value.
This risk was tested in Eyeball Networks Inc. v. The Queen, 2019 TCC 150, where the Tax Court of Canada held that the recipient corporation in a butterfly reorganization was liable under section 160 for a predecessor corporation’s tax debts, focusing on a set-off of intercompany promissory notes late in the transaction sequence.
The decision alarmed tax planners because it suggested that even a technically compliant butterfly could expose the transferee to the transferor’s undisclosed tax liabilities. On appeal, the Federal Court of Appeal reversed the Tax Court in Eyeball Networks Inc. v. Canada, 2021 FCA 17, holding that section 160 did not apply because every step in the butterfly series involved consideration equal to fair market value. The set-off did not, on close analysis, amount to a transfer for inadequate consideration.
The relief in Eyeball Networks was not the end of the story. In its 2021 federal budget, the government responded to Eyeball Networks and similar decisions by proposing a new set of anti-avoidance rules, now found in subsection 160(5) of the Income Tax Act. These rules can deem parties to be non-arm’s length, reviving the potential for section 160 liability, where a transaction or series of transactions has among its purposes the avoidance of joint liability for a tax debt, and they can deem a tax debt to have arisen earlier than it otherwise would where the transferor anticipated the liability.
The practical upshot for anyone considering a butterfly reorganization today: obtaining fair-market-value consideration at every step remains essential, but it is no longer sufficient on its own to guarantee protection from derivative liability if a purpose of the structure was to get ahead of an anticipated tax debt. A thorough review of the transferor’s tax history, and of the purpose behind the timing of the reorganization, is now a standard part of properly executing any butterfly transaction.
It is also worth noting that the general anti-avoidance rule in section 245 was not invoked in Eyeball Networks itself. The Federal Court of Appeal was explicit that its decision does not foreclose the CRA from invoking GAAR in circumstances where it might otherwise apply. A butterfly reorganization that survives scrutiny under section 55 and section 160 is not automatically immune from a GAAR challenge if the CRA views the series of transactions as an abuse of the Act read as a whole.
“Eyeball Networks was genuine relief for planners, but it wasn’t a green light to stop worrying about section 160. If a reorganization has anything to do with getting ahead of a tax debt you can see coming, the rules in subsection 160(5) are built specifically to catch that.”
— David J. Rotfleisch
Butterfly vs. Other Corporate Reorganization Tools
A butterfly is not the only tax-deferred reorganization tool available under the Income Tax Act, and it is usually the most technically demanding one to execute properly. The table below places it alongside the other reorganization provisions referenced in this article.
| Method | Governing Provision | Typical Use | Tax-Free? |
| Butterfly reorganization | Section 55(3), using section 85 rollovers | Dividing one corporation’s assets between separate shareholder groups (corporate divorce, succession, business split) | Yes, if the strict distribution and proportionate-sharing rules are met |
| Rollover | Section 85 | Transferring specific property into a corporation in exchange for shares | Yes, on eligible property up to the elected amount |
| Share exchange (estate freeze) | Section 86 | Exchanging common shares for fixed-value preferred shares to freeze value for succession or estate planning | Yes, generally, where the exchange qualifies as a capital reorganization |
| Wind-up | Subsections 88(1) and 88(2) | Absorbing a subsidiary into its parent, or winding up a corporation entirely | Yes, generally, between a parent and a 90%-plus owned subsidiary |
| Amalgamation | Section 87 | Combining two or more corporations into one | Yes, generally, on a tax-deferred merger basis |
For a related but distinct post-mortem planning technique used after a shareholder’s death rather than during their lifetime, see our guide to pipeline planning.
Pro Tax Tip: Confirm the Classification Before You Sign Anything
The single most common way a butterfly reorganization goes wrong is proceeding on the assumption that the transaction is straightforward. It rarely is. Before any share is redeemed or any asset is transferred, your experienced Canadian tax lawyer should confirm the asset classification and model the proportionate-sharing calculation, and, for a complex or high-value structure, discuss whether seeking a written Advance Income Tax Ruling from the CRA is worthwhile.
Unwinding a botched butterfly after the CRA has reassessed on the basis that the section 55(3) exception was not met is far more expensive, and far less certain, than addressing the risk beforehand.
FAQs: Butterfly Transactions
Is there a downside, tax-wise, to butterfly transactions?
Butterfly transactions are technically demanding, and a misstep in the asset classification, the proportionate-sharing calculation, or the sequencing of the permitted steps can cause the exemption under paragraph 55(3)(a) or (b) to fail entirely, triggering the deemed-dividend and capital-gains-stripping rules in subsection 55(2).
Even a technically successful butterfly can still expose a transferee to derivative liability for a predecessor corporation’s tax debts under section 160, particularly under the anti-avoidance rules in subsection 160(5) added after the Eyeball Networks litigation. In rare cases, the CRA may also attempt to rely on the general anti-avoidance rule in section 245 if it views the series of transactions as abusive, even where the technical requirements of section 55(3) have been met. The transaction costs of a properly executed butterfly are also significant.
None of this makes a butterfly a bad idea. It usually remains the most tax-efficient way to divide a corporation, but it is not a do-it-yourself transaction.
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 though they have no relationship with each other, and negotiate a deal that does not favour one party over the other.
Where parties are closely connected, family members, for example, one may favour the other by accepting a lower price, or one party may be able to pressure the other into paying more than fair market value. The Income Tax Act deems certain related persons never to deal at arm’s length, which is why the related-party and unrelated-party rules in section 55 matter so much to how a butterfly must be structured.
What is a spinoff butterfly?
A spinoff butterfly is a butterfly transaction in which assets are distributed to shareholders through a series of steps that create one or more new corporations, with each shareholder (or shareholder group) ending up with a proportionate interest in the distributed property. It is most often used to separate a public or large private corporation’s divisions into independent, separately traded or separately held entities.
What is a corporate divorce?
A “corporate divorce” describes the separation of shareholders in a corporation or partners in a business partnership, commonly caused by disagreements over financial decisions, differing views on the direction of the business, or a breakdown in following corporate formalities.
A butterfly reorganization is frequently the mechanism used to carry out a corporate divorce on a tax-free basis, allowing each shareholder to walk away with their proportionate share of the business without triggering an immediate tax bill. Anyone facing a corporate divorce should retain their own experienced Canadian tax lawyer to protect their interests before any shares are redeemed or assets transferred.
Can siblings complete a butterfly reorganization?
Yes, in more situations than before 2021. Historically, paragraph 55(5)(e) deemed siblings to be unrelated for section 55 purposes, forcing sibling reorganizations into the stricter unrelated-party butterfly rules. Since Bill C-208 received royal assent in June 2021, siblings are treated as related, and can use the simpler related-party butterfly, where the dividend is paid on a qualified small business corporation share or a share of a family farm or fishing corporation. Sibling butterflies outside those specific share types still face the more demanding unrelated-party requirements.
Do I need an Advance Income Tax Ruling to complete a butterfly transaction?
There is no statutory requirement to obtain a ruling, and most butterfly reorganizations proceed without one. For a complex or high-value structure, however, some tax lawyers will recommend seeking a ruling, because the CRA’s administrative positions on issues like safe-income calculations and asset classification go well beyond the bare text of the Income Tax Act, and a failed butterfly is a fully taxable event. A ruling gives the parties binding certainty before any irreversible step is taken, at the cost of the time and fees involved in obtaining it.
Does the Eyeball Networks decision mean a butterfly transaction is safe from CRA collection action?
Not entirely. The Federal Court of Appeal’s 2021 decision in Eyeball Networks confirmed that section 160 does not apply to a butterfly reorganization where every step genuinely involves fair-market-value consideration. But the 2021 federal budget introduced new anti-avoidance rules in subsection 160(5) specifically to prevent taxpayers from using transaction sequencing to sidestep joint liability for a tax debt they anticipated. A butterfly designed, in whole or in part, to get ahead of a known or anticipated tax liability can still expose the transferee to derivative liability today.
What is the difference between a related-party butterfly and an unrelated-party butterfly?
A related-party butterfly, exempted under paragraph 55(3)(a), applies where the corporations involved are already related to one another and generally involves fewer restrictions on what happens to the property after the distribution. An unrelated-party butterfly, exempted under paragraph 55(3)(b), applies where the corporations are not related, most commonly where shareholders who are not related persons are dividing a jointly owned business, and imposes the stricter asset-classification and proportionate-sharing “distribution” requirements described earlier in this article. Most corporate divorces between unrelated business partners rely on the unrelated-party rules; most intra-family reorganizations rely on the related-party rules, subject to the sibling carve-out discussed above.
What is “safe income” and why does it matter for a butterfly reorganization?
Safe income is, broadly, the portion of a corporation’s retained earnings that has already been subject to corporate tax and can support a tax-free intercorporate dividend without triggering subsection 55(2). Correctly calculating each corporation’s safe income before a butterfly is critical, because the CRA’s administrative positions on safe-income determination, including when it is measured and how contingent liabilities are treated, go into a level of detail the Income Tax Act itself does not spell out. Getting the safe-income calculation wrong is one of the more common ways an otherwise well-structured butterfly can trigger an unexpected capital-gains-stripping reassessment.
How long does a butterfly reorganization take, and what does it cost?
Timelines vary with complexity, but obtaining an Advance Income Tax Ruling alone commonly takes several months, and the full process, including corporate law steps, valuations, and (where sought) the ruling itself, often runs six months to a year for anything beyond the simplest structure. Professional fees are correspondingly significant. That cost reflects the technical risk being managed, not routine paperwork, and is generally far lower than the cost of unwinding a failed butterfly after a CRA reassessment.
Can a butterfly reorganization be completed if one of the businesses will later be sold?
Generally not on a tax-free basis if the sale is contemplated as part of the same series of transactions. Subsection 55(3.1) of the Income Tax Act denies the butterfly exemption where, as part of the same series, the distributing corporation or a transferee corporation disposes of a significant portion of the distributed property to a person who deals at arm’s length with the group, or where shares are acquired by an arm’s length purchaser in contemplation of the distribution. In practice, this means a butterfly reorganization has to be completed well before any sale of a business division is contemplated, and practitioners typically look for a meaningful gap between the two to avoid the CRA treating them as part of the same series.
Considering a Butterfly Reorganization?
If you are considering dividing a corporation, whether because of a corporate divorce, a succession to the next generation, or a plan to separate business divisions, a butterfly reorganization is only as safe as its execution. Contact an experienced Canadian tax lawyer before any share is redeemed or any asset is transferred to confirm whether your reorganization qualifies and whether seeking an advance ruling makes sense for your situation.
For a deeper technical walkthrough of how these reorganizations are structured, see our companion guide, Tax-Free Butterfly Reorganizations.
DISCLAIMER: This article provides broad information. It is only accurate as of the posting date. It has not been updated and may be out-of-date. It does not give legal advice and should not be relied on as tax advice. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
