By Pierre Alary of Gowling Lafleur Henderson LLP
Sometimes, two is better than one. A company in dire straits can potentially attain success by dividing itself into two separate entities. Whether the issues plaguing the company are financial or philosophical in nature, a separation of the business should be considered by corporations and practitioners alike. In addition to making good business sense, a divisive reorganization, or “corporate divorce”, can be structured to benefit both parties from a tax perspective. In other words, a corporate divorce does not need to be a painful experience. This article will conduct a brief overview of the well-known butterfly transactions, but will primarily focus on an alternative method, the “McMullen Method”, which was approved by the Tax Court of Canada in recent years.
II. Butterfly Transactions
Divisive reorganizations can take many forms, the most common of which are known as butterfly transactions. In the case of a butterfly transaction, the Income Tax Act (“ITA”) allows for the allocation of corporate assets to shareholders on a tax-deferred basis. The popular split-up and spin-off versions of butterfly transactions are used to achieve different results. Following a split-up transaction, the shareholders own different company assets than their fellow shareholders. For example, if two shareholders own a 50-50 share in the company, the assets will be divided 50-50. Conversely, a spin-off transaction results in each shareholder owning an interest in the company’s assets proportionate to their interest in the company prior to the transaction. Therefore, 50-50 shareholders would each own 50% of all company assets.
Due to legislative restrictions and depending on the assets and corporate make-up of the company, butterfly transactions are not always suitable options. Such restrictions include the requirement that each shareholder obtain a pro-rata share of the corporation’s assets, based on the percentage of shares owned by each shareholder. Therefore, butterfly transactions are not appropriate for the division of land nor situations where the shareholders’ interests are not proportionate to the value of the assets they wish to obtain.
An alternative method to the butterfly transactions was at the heart of the Tax Court of Canada decision in McMullen v. The Queen.1
III. The McMullen Method and its Tax Benefits
In McMullen, two shareholders each owned 50% of the outstanding common shares of a heating and air conditioning business (the “Company”). The Company was operated from two offices located in the cities of Belleville and Kingston. The business was at an economic loss, and the shareholders held opposing views as to how to manage the Company going forward. The shareholders considered bankruptcy, however, they feared the Company’s assets would not cover the payables, thereby allowing the bank to seek satisfaction from the shareholders’ personal guarantees upon dissolution.
The shareholders acknowledged that a separation of the two branches was a viable option. Under this scenario, each would operate one of the branches, and the shareholders would have no further involvement with each other. The two shareholders held an equal share in the company, but the two branches were not of equal value, meaning that a butterfly transaction could not be implemented due to its pro-rata restriction.
The shareholders completed several transactions in order to finalize the divorce.
- A holding company (“HoldCo”) was incorporated to acquire Shareholder A’s shares. The sole shareholder of HoldCo was Shareholder B’s wife. HoldCo was a 50-50 shareholder of the Company along with Shareholder B.
- The existing common shares of the Company were redesignated as Class A common shares, and an unlimited number of Class B common shares were created. Class A shares were convertible into Class B shares at any time at the option of the holder.
- Shareholder B converted his Class A common shares into Class B common shares.
- Shareholder A sold 100 Class A common shares of the Company to HoldCo for $150,000.
- The Company declared a dividend of $150,000 on the Class A shares, these being held solely by HoldCo. The Company obtained a midnight bank loan to pay this dividend. The intercorporate dividend was not taxable pursuant to section 112 of the ITA. The $150,000 was assigned by HoldCo to Shareholder A in satisfaction of the purchase price of the shares.
- Shareholder A received these funds tax-free by virtue of the capital gains exemption. He assumed the debts of the Kingston branch and acquired the branch at its fair market value through a new corporation incorporated by he and his wife (“NewCo”). The $150,000 made-up part of the purchase price. As the $150,000 was now back with the Company, the midnight bank loan was repaid.
The two corporations signed a non-compete agreement, and never had any dealings with each other afterwards.
b) Tax Benefits and Tax Court’s Interpretation
i) Arm’s length transaction
Three questions have been identified by the Courts to determine if parties are acting at arm’s length. First, is there a common mind directing the bargaining for both parties to the transaction? Second, did the parties to the transaction act in concert without separate interests? Third, did one party to the transaction exercise de facto control over the other?
In the case of a corporate divorce, the parties are negotiating with their own self-interest in mind. As stated by Justice Lamarre in McMullen, the fact that parties agree on the sale price of shares does not mean we must infer that the interests of the vendor and the purchaser are not divergent.2 In addition, buyers and sellers do not act in concert simply because the agreement which they seek to achieve can be expected to benefit both.3 Since this transaction is considered arm’s length, it does not fall under paragraph 84.1(1)(b) of the ITA. This section serves as an anti-avoidance clause by treating the sale of shares by a taxpayer to an arm’s length corporation as a dividend.
ii) Not a reorganization under subsection 84(2)
Subsection 84(2) of the ITA states that where funds or property are distributed by the corporation for the benefit of shareholders on the winding-up, discontinuance or reorganization of its business, a dividend will be deemed to have been paid by the corporation and received by the shareholders. This dividend is equal to the amount that it exceeds the paid-up capital in respect of the shares.
In McMullen, the Tax Court held that no reorganization had taken place. To this end, it was determined that subsection 84(2) requires a conclusion of the conduct of the business in one form and its continuance in a different form. Justice Lamarre characterized the acquisition of the Kingston branch by Shareholder A as essentially a sale to a third party. If the Company had sold the Kingston branch to a third party, it presumably would not have been considered a reorganization within the meaning of subsection 84(2).
iii) Not caught by GAAR
Section 245 of the ITA (the general anti-avoidance rule (“GAAR”)) applies if three requirements are established:
- A tax benefit resulting from a transaction or part of a series of transactions (s. 245(1) and (2));
- The transaction is an avoidance transaction in the sense that it cannot be said to have been reasonably undertaken or arranged primarily for a bona fide purpose other than to obtain a tax benefit; and
- There was abusive tax avoidance in the sense that it cannot be reasonably concluded that a tax benefit would be consistent with the object, spirit or purpose of the provisions relied upon by the taxpayer.4
In the McMullen case, the Crown argued that the transactions between the parties were without a primary business purpose. Section 112 was relied upon to declare a non-taxable intercorporate dividend, and sections 38 and 110.6 were used to claim a capital gain on the sale of the shares, and an offsetting capital gains exemption. Justice Lamarre disagreed with the Crown and ruled that the primary purpose of the transactions was to separate the single business of the Company into two independently owned businesses. The Court relied on the Tax Court’s decision in Evans v. The Queen5, where Chief Justice Bowman stated:
28 . . . I do not see how it can be said that to rely upon a provision that permits a tax free rollover of assets for shares, followed by a tax free intercorporate dividend, can possibly be said to frustrate or defeat the object or spirit of those provisions within the context of the Act as a whole.
35 … To treat the transactions as abusive so that their results can be recharacterized would not preserve but rather would destroy certainty, predictability and fairness and would frustrate Parliament’s intention that taxpayers take full advantage of the provisions of the Act that confer tax benefits.
The views of Chief Justice Bowman and Justice Lamarre confirm the Duke of Westminster principle that tax planning – arranging one’s affairs so as to attract the least amount of tax – is a legitimate and accepted part of Canadian tax law.
Justice Lamarre reaffirmed several established principles in the McMullen decision which should be considered when structuring a similar transaction.
- It cannot be concluded that parties have acted in concert simply because they have used the same financial advisors;
- Recharacterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect;
- If the existence of abusive tax avoidance is unclear, the benefit of the doubt goes to the taxpayer; and
- Subsection 245(3) does not permit a transaction to be considered an avoidance transaction simply because an alternative transaction that might have achieved an equivalent result would have resulted in higher taxes.
The McMullen decision illustrates that butterfly transactions are not the only means to a corporate divorce, however, businesses using alternative methods should proceed with caution during the planning stages. For instance, the case confirmed that GAAR could apply if even one of the transactions in a series of transactions is an avoidance transaction. Nevertheless, if the divorce is executed for a bona fide business purpose, it could breathe new life into a dying business, while providing tax benefits for all parties involved.
1 McMullen v. The Queen, 2007 TCC 16.
2 Supra note 1 at para. 28.
3 McNichol et al. v. The Queen, 97 DTC 111 at page 118.
4 Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54 at para. 66.
5 Evans v. The Queen, 2005 TCC 684