Acquisition of control on a single-wing butterfly helps address RDTOH circularity issue

Where the distributing corporation (DC) in a butterfly is a Canadian-controlled private corporation which earns investment income and has refundable dividend tax on hand, a circularity complication arises, relating to the fact that that the butterfly mechanics entail a cross-redemption of shares between DC and the transferee corporation (TC), resulting in each receiving a deemed dividend from the other: (1) the deemed dividend paid by DC generates a dividend refund to it which, in turn, generates Part IV tax to TC under s. 186(1)(b), thereby generating RDTOH to TC; (2) this RDTOH of TC means that it generates a dividend refund on the deemed dividend paid by it to DC; which (3) generates Part IV tax and an increase to the RDTOH account of DC, thereby increasing its dividend refund in step 1; and so on until following the reaching by at least one of them of the 1/3 dividend refund limit in s. 129(1)(a)(i) – which could produce asymmetrical results if the paid-up capital of the cross-shareholdings differs.

A single-wing butterfly conveniently (from the standpoint of this circularity issue) resulted in an acquisition of control of DC by its remaining shareholder when the common shares in DC of TC were redeemed.  This meant that DC had a deemed year end immediately before the cross redemptions started (as no s. 256(9) election was made).  This, in turn, meant that DC (which had sufficient safe income on hand vis-à-vis both shareholders) could flush out its existing RDTOH account in its pre-butterfly taxation year through s. 84(1) deemed dividends.

This was not a complete solution, as DC and TC could still earn investment income post-butterfly (and TC still had a full taxation year, so that its "flush out" RDTOH could bounce back to DC in DC's second taxation year).  However, rather than transferring the pro rata portion of its properties to TC directly, DC made this transfer to a sub of TC, so that it received a deemed dividend on a subsequent share redemption by the sub (which was immediately wound up into TC, and did not generate any RDTOH) rather than receiving a deemed dividend from TC.  This eliminated circularity issues for DC's 2nd taxation year as well.

Neal Armstrong.  Summary of 2013 Ruling 2012-0449611R3 under s. 55(1) – distribution.  See also Michael N. Kandev and Alan Shragie, "RDTOH on Butterfly", Canadian Tax Highlights, Volume 16, Number 11, November 2008, p. 2.