Spinoff Butterflies in Trouble?

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. Although it is generally understood that such transactions are acceptable tax planning, paragraph 55(3.1)(a) raises questions.

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).

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.

Under corporate law, there is generally a prohibition on a corporation holding shares in itself (for example, CBCA section 30(1)(a)). An exception to this rule arises when a corporation is allowed to purchase or otherwise acquire shares issued by it (for example, CBCA section 34(1)). When a corporation acquires its own shares, the shares are required to be cancelled (for example, CBCA section 39(6)); however, corporate legislation does not say that they are cancelled before they are acquired by the corporation. This omission suggests that the corporation holds its own shares for the period, however brief, between the time that it acquires the shares and the time that it cancels the shares. Therefore, it appears that corporate law does not preclude the possibility of the old shares becoming property of the distributing corporation on the share exchange.

In the section 116 context, the CRA took the position that a clearance certificate was required when a non-resident shareholder exchanged common shares in a corporation for preferred shares under subsection 51(1) (CRA document no. 9631575, February 12, 1997). The CRA determined that there was an acquisition of the old shares by the corporation. If this view is correct, the distributing corporation acquires the old shares upon the share exchange, which results in the old shares becoming property of the distributing corporation.

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) in 2001. Proposed amendments in Bill C-4 (introduced on October 22, 2013) 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 past (9813073 (1998) and 9727303 (1998)) when a share exchange took place as a pre-distribution step in a spinoff butterfly. These rulings were given before the November 26, 2004 Department of Finance comfort letter was issued. That letter was the impetus for the exclusion of public corporations from the application of paragraph 55(3.1)(a).

Marshall Haughey
Bennett Jones LLP, Calgary

Canadian Tax Focus
Volume 3, Number 4, November 2013
©2013, Canadian Tax Foundation