Potentially serious difficulties can emerge in implementing a butterfly in the context of a spin-off by a foreign parent

When Foreign Pubco is planning to spin off some of its assets in the form of Foreign Spinco, there will be various points to consider respecting a potential preceding butterfly transfer of the Canadian spin-off assets by a Canadian subsidiary (DC) to a transferee corporation subsidiary of Foreign Spinco (TC), including:

1. Other "spin" assets would need to be contributed to Foreign Spinco before the butterfly of the Canadian "spin" business assets, in order to ensure that the Foreign Spinco shares never derived 10% or more of their FMV from the TC shares.
2. Given the relatively narrow meaning accorded to "reorganization" by CRA, in the context of a cross-border butterfly, one need only ensure that the series of transactions or events does not include prohibited transactions or events described in 55(3.1)(a) or 55(3.1)(b), “and the continuity of interests rules in paragraphs 55(3.1)(c) and (d) should be largely irrelevant.”
3. A "reverse" foreign spin-off, where the "keep" assets are butterflied to TC as part of the usual three-party share exchange and the Foreign Spinco that is distributed to the Foreign Pubco shareholders is the existing shareholder of DC, likely will not work – unless, for example, Foreign Spinco held the DC shares through a single purpose foreign holding company.
4. The standard three-party exchange mechanics do not accommodate the foreign shareholder transferring the DC shares on a s. 85 rollover basis, so that it is problematic if the DC shares are taxable Canadian property with an accrued gain.
5. Although CRA does not believe that a transaction can qualify as a "permitted exchange" if preferred shareholders of DC do not participate in the butterfly, it nonetheless may be that the FMV of the Foreign Spinco shares should be conisdered to "approximate" the amount determined under the "permitted exchange" formula where this difficulty arises.
6. A one-way cash adjustment mechanism was accepted in 2014-0530961R3 and 2013-0491651R3.
7. Although, under GAAP, a pro rata portion of DC’s retained earnings likely will be transferred onto the balance sheet of TC, this cannot occur as of the very beginning of TC’s taxation year, so that TC for its first year cannot “use” its retained earnings for thin cap purposes. Accordingly, TC might determine to have a year-end immediately after the butterfly.

Neal Armstrong. Summaries of Christian Desjardins and Nik Diksic, "Cross-Border Butterflies in the Context of Public Spin-Off Transactions", Draft 2015 CTF Annual Conference paper under s. 55(3.1)(b) and s. 55(1) – distribution.