The Income Tax Act in certain circumstances allows transfer of property to shareholders on a tax-deferred basis.
Generally, unless specifically exempt under the Income Tax Act, any distributions of profits and retained earnings by a corporation to a shareholder, such as dividends or long-term shareholder loans, result in income tax to the recipient. For example, a payment of dividend by a Canadian corporation to another Canadian corporation can be effected tax free. This provision implemented to avoid double-taxation of previously taxed corporate profits as they move between various corporate entities can, in certain circumstances, be used to extract untaxed earnings from a corporation. Subsection 55(2) is an anti-avoidance provision that specifically aims to stop abusive use of the inter-corporate tax-free dividends when the ultimate goal of the transaction or a series of the transaction is to extract untaxed earnings as a result of a transaction or series of transactions known as “surplus stripping.”
However, in certain circumstances, the Income Tax Act allows a shareholder to extract property from a corporation or even split an existing business between the existing shareholders in a tax-free reorganization.
These transactions known as butterfly transactions are governed by subsection 55(3) of the Act. The technical requirements for a successful butterfly transaction are very complex; and its implementation often requires establishing special The rules in subsection 55(3) are part of anti-avoidance provisions in the Income Tax Act that aim to prevent surplus-stripping from a Canadian corporation by the virtue of tax-free inter-corporate dividends.
The following example illustrates a split up effected by the way of butterfly transaction, in which the businesses carried by a corporation are divided up and transferred to separate corporations owned separately by the shareholders of the original corporation.
Two unrelated individuals, Mr. A and Ms. B, each own 50% of the shares of the capital stock of a taxable Canadian corporation (Opco). Opco operates two businesses (Division A and Division B) of approximately equal value. It has only two types of property: cash and properties used in its businesses.
Mr. A and Ms. B wish to separate their interests so that Mr. A can own and operate Division A and Ms. B can own and operate Division B. If the assets of Opco were simply distributed to them on a winding-up, the distribution of Opco’s assets and the disposition of their shares of Opco would be considered for income tax purposes to have occurred at fair market value.
If they instead undertake a butterfly reorganization, Division A will be owned by Aco (wholly owned by Mr. A.) and Division B will be owned by Bco (wholly owned by Ms. B.)
Caution: the slightest departure from the relieving provisions in subsection 55(3) and administrative practice guidance published over the years by the Canadian tax authorities may result in income taxation to the shareholder. In particular, the corporate property spun off to a shareholder may be treated as proceeds of disposition and result in a capital gain to the receiving shareholder.
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