Corporate Tax Planning: Utilizing The Butterfly

Corporate Tax Planning: Utilizing The Butterfly



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In 1981, John Robertson, then director general of the CCRA’s Corporate Rulings Directorate, presented a paper at the annual conference of the Canadian Tax Foundation setting out the Canada Customs and Revenue Agency’s (CCRA’s – as the department was then called) concerns related to the ability of  taxpayers to use the butterfly transaction to separate business and investment properties, as well as sell any asset, on a tax-deferred basis at the corporate level.  [1]

The butterfly transaction introduced a complex and effective corporate tax planning Canada concept for two partners involved in a corporation.  He indicated that the CCRA would apply subsection 55(1) of the Income Tax Act4 (as it then read) to tax as a capital gain any tax-deferred intercorporate dividend where the parties were seeking to avoid tax on the unrealized gain on the shares of a taxable Canadian corporation.  In an attempt to remedy weaknesses in subsection 55(1), the Department of Finance (“the department”) codified the nucleus of Robertson’s comments with specific legislation that was enacted in 1981. The rules, under new subsection 55(2), allowed the intercorporate transfer of income on which tax had already been paid at the corporate level after 1971. This came to be known as “safe income.”

The department also enacted two exceptions to the anti-avoidance rule in subsection 55(2) that would serve as the divisive reorganization provisions in the Act. The first exception, set out in paragraph 55(3)(a), applied in situations where the parties did not deal at arm’s length with each other. The second exception, in paragraph 55(3)(b), applied in situations where the parties involved in the transaction dealt at arm’s length with each other (“the butterfly”

Over the next decade, the department became aware of additional abuses and losses of revenue at the corporate level. In particular, the department was concerned that resident and non-resident taxpayers were misusing the purchase butterfly to transform what would normally be a taxable sale of assets into an inter-corporate dividend.


The Basic Steps of the Butterfly

Step 1: The shareholders of a distributing corporation (DC) will transfer a percentage of their common shares into a newly incorporated transferee corporation (TC) and take back common shares of the TC.

Step 2: The DC will roll over the assets of the business it wishes to spin off into the TC and take back preferred shares of the TC.

Step 3: The DC will repurchase for cancellation its common shares held by the TC and issue a promissory note as consideration to the TC. The TC will receive a deemed dividend and a deduction from part I tax.

Step 4: The TC will redeem its preferred shares held by the DC and issue a promissory note as consideration. The DC will receive a deemed dividend and a deduction from part I tax.

Step 5: The notes will be set off against each other in both the DC and the TC. Since they will be of equal fair market value (FMV), there should be no tax consequences to either the DC or the TC.  The original shareholders of the DC now hold shares in both the DC and the TC.[2]


Such a comprehensive corporate tax planning Canada require the assistance of qualified accountant experts as they prioritize the main purpose. The purpose of a spinoff butterfly is to move some property of a distributing corporation to one or more newly incorporated transferee corporations having the same shareholders in the same proportions as the distributing corporation.

As a pre-distribution step in a typical spinoff butterfly, shareholders of the distributing corporation exchange their common shares in the distributing corporation for new common and preferred shares in the distributing corporation on a tax-deferred basis under subsection 51(1) or 86(1). Such an exchange is a "permitted exchange" under subsection 55(1), provided that it does not result in an acquisition of control of the distributing corporation. Thus, one presumes that the exchange is unobjectionable under the butterfly rules in section 55. However, the share exchange may technically infringe paragraph 55(3.1)(a). If that is the case, paragraph 55(3)(b) will not operate to prevent the application of subsection 55(2).



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Paragraph 55(3.1)(a) will cause paragraph 55(3)(b) not to apply where, in contemplation of and before a distribution made in the course of the reorganization in which the dividend was received, property became property of the distributing corporation otherwise than as a result of certain enumerated exceptions, none of which appears to apply to a share exchange. Thus, whether paragraph 55(3.1)(a) will apply to the share exchange turns on whether the old shares become property of the distributing corporation.

The CRA has taken the position that a clearance certificate is required when a non-resident shareholder exchanges common shares in a corporation for preferred shares under subsection 51(1)

The purpose of paragraph 55(3.1)(a) is to prevent property from being acquired by a distributing corporation before a butterfly in order to change the types of property owned by the distributing corporation that would permit the tax-free cashing out of a shareholder. The Department of Finance made a deliberate policy decision to exclude public corporations from the "types of property" requirement through the addition of subsection 55(3.02).  Amendments provide that paragraph 55(3.1)(a) does not apply to public corporations. Because the paragraph is concerned with the "types of property" requirement, the exclusion of public corporations from its application makes sense.

In the private company context, the share exchange does not offend the policy at which paragraph 55(3.1)(a) is aimed, since it will not change the types of property that the distributing corporation holds. The share exchange is simply a necessary pre-distribution step to facilitate the paragraph 55(3)(b) butterfly. Nevertheless, owing to the current wording of paragraph 55(3.1)(a), the share exchange may technically trigger its application.

Notwithstanding the analysis above, the CRA does not appear to consider a share exchange objectionable: it has issued favourable rulings in the when a share exchange took place as a pre-distribution step in a spinoff butterfly. Normally, when proposing to engage in butterfly transactions, comfort letters from the CAR are secured in order to have the benefit of the analysis from the CRA regarding such proposed transactions.  Although not binding, these comfort letters provide not only comfort to the client and the tax practitioner regarding the proposed series of events encapsulated as a part of the transaction, but also confidence to progress in the transaction.

We at Burgess Kilpatrick, offer end-to-end assistance and understanding for such complex corporate tax return Vancouver concepts.


If you have any questions or want to speak further about your corporation or estate planning matters, contact Nicholas Kilpatrick at


Nicholas Kilpatrick is a partner with the accounting firm of  Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients.  Please visit our website at or on Facebook at Kilpatrick for more information on our firm.



[1] Haughey, Marshall, Spinoff Butterflies in Trouble?, Bennett Jones LLP.

[2] Kakkar, Manu, A Critique of Canada’s Divisive Reorganization Rules: Should Breaking Up Be So Hard To Do?, Canadian Tax Foundation, Vol. 49 No. 4.

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