17 September 1992 Income Tax Severed Letter 2M02730 - The Butterfly Reorganization

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

AN UPDATE OF REVENUE CANADA'S APPROACH
TO THE BUTTERFLY REORGANIZATION

T. Harris

A Paper Presented to the 1991 Annual Conference
of the Canadian Tax Foundation

Introduction

This paper addresses several issues regarding Revenue Canada's interpretations and administrative positions relating to the butterfly provisions found in paragraph 55(3)(b) of the Income Tax Act.1 Specifically, the following topics are covered:

• i) types of property: consolidated lookthrough approach; ii)valuation issues; iii)acquisitions of property in contemplation of the butterfly transfers; and iv)other issues.

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Types of Property: Consolidated Lookthrough Approach

The consolidated lookthrough approach has been described in some detail in our papers published in the 1988 and 1989 conference reports.2 As discussed in those papers, this approach was adopted because the department recognizes that practical difficulties may prevent a taxpayer from carrying out a pre-butterfly amalgamation, winding up, or preliminary butterfly as provided for in subparagraphs 55(3)(b)(iii), (iv), and (v). Under the consolidated lookthrough approach, the determination whether the pro rata types of property test in paragraph 55(3)(b) is satisfied in respect of a particular reorganization must be made on a consolidated basis.

The consolidated lookthrough approach is used in each case where the particular corporation referred to in paragraph 55(3)(b) owns shares of subsidiaries or other corporations, both Canadian and foreign, with respect to which the particular corporation has the ability to exercise significant influence, within the guidelines provided by section 3050 of the CICA Handbook.3 Those guidelines state that the existence of significant influence is a question of fact, but that it will be presumed to exist where a shareholder has a 20 percent or greater interest.

If a particular corporation has the ability to exercise significant influence over a second corporation, the use of the consolidated lookthrough approach is mandatory. If no significant influence exists, this approach will not generally be used.

Generally, the objective of the consolidated lookthrough approach is to determine the types of property that would exist in the particular corporation if a subparagraph 55(3)(b)(v) transaction (that is, a preliminary butterfly distribution to the particular corporation) were undertaken; in the case of a wholly owned subsidiary, the objective is to determine the types of property that would exist in the particular corporation if its wholly owned subsidiary were wound up.

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In using the consolidated lookthrough approach, the department does not consider some shares to be one type of property and other shares to be another type of property, but rather examines the consolidated result and considers each share of a lookthrough corporation to represent the types of property owned by the corporation. For example, each share of a lookthrough corporation that owns 75 percent business property, 10 percent investment property, and 15 percent cash or near-cash property will, for purposes of paragraph 55(3)(b), be classified as 75% business property, 10% investment property and 15% cash or near cash property.

In circumstances where the consolidated lookthrough approach applies to ascertain the value and types of property of the particular corporation on a consolidated basis, it must be remembered that the property owned by the particular corporation is generally the shares of the corporations over which it exercises significant influence. Therefore, for the purposes of determining the gross or net fair market value, as the case may be, of each type of property of the particular corporation, it is the fair market value of these shares that must be taken into account. The value of the underlying property of the subsidiary is relevant only for purposes of allocating the fair market value of the shares of the subsidiary to the various types of property.

Where the fair market value of the shares of the subsidiary is less than the net fair market value of its assets, such difference should generally be allocated proportionally to all of the assets owned by the subsidiary for purposes of determining the types of property represented by the shares of the subsidiary held by the particular corporation. Where, however, it can be established that the discount is attributable to one particular type of property, the department has accepted that the full discount may be allocated to that particular type of property only. The following example should help to illustrate the consolidated lookthrough approach. In this example, the only assets of the particular corporation are its shares of a wholly owned subsidiary, Subco 1, and the assets used to carry on the business of Division X.

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The shares of Subco 1 owned by the particular corporation have a fair market value (FMV) of $1250. Subco 1 owns business assets with an FMV of $300, which it uses in its own active business and net cash of $200 (that is, $300 less current liabilities of $100). In addition, Subco 1 owns 50 percent of the shares of Opco 1, having an FMV of $1,000. The property of Opco 1 consists of business property with an FMV of $2,250 and cash of $250. Division X owns business property with an FMV of $1,000 and net cash of $250 (that is, $400 less current liabilities of $150). The shares of the particular corporation are owned 50 percent by Holdco A and 50 percent by Holdco B.

In applying the consolidated lookthrough approach, we should look first at the type of property that the shares of Opco 1 represent to Subco 1. Since Subco 1 owns 50 percent of the shares of Opco 1, which have an FMV of $1,000, the shares of Opco 1 held by Subco 1 will be classified as business property of $900 (50% x $2,250/50% x $2,500 x $1,000) and cash of $100 (50% x $250 / 50% x $2500 X $1000). Therefore, the types of property held by Subco 1 for purposes of paragraph 55(3)(b) will consist of business property of $1,200 ($300 + $900) and cash of $300 ($200 + $100).

With respect to the shares of Subco 1 held by the particular corporation, since the particular corporation owns 100 percent of the shares of Subco 1 having an FMV of $1,250, these shares will be classified as business property of $1,000 ($1,200/$1,500 x $1,250) and cash of $250 ($300/$1,500 x $1,250). As mentioned previously, the property of Division X that is operated directly by the particular corporation will be classified as business property of $1,000 and net cash of $250.

The breakdown of the types of property held by the particular corporation using the consolidated lookthrough approach is as follows:

BusinessNet
propertycash

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Shares of Subco 1 ................$1,000$250
Division X .......................$1,000$250
Total ............................$2,000$500

Once the butterfly has been completed, Holdco A will acquire the shares of Subco 1 and Holdco B will acquire the assets and will assume the liabilities of Division X. The proportionate test set out in paragraph 55(3)(b) will have been met since the shares of Subco 1 will be considered to represent business property of $1,000 and cash of $250, which, on a net equity basis, is the same mix of properties as that held by Division X.

Where the particular corporation has an amount receivable from or an amount owing to a wholly owned subsidiary, the debt will in effect be eliminated when using the consolidated lookthrough approach to determine the balance of types of property of the particular corporation. Accordingly, in order for the pro rata test in paragraph 55(3)(b) to be satisfied in a situation involving intercorporate liabilities, it is usually necessary that both the liability and the receivable either be transferred to a shareholder-transferee or be retained by the particular corporation on the intended butterfly. Since such intercompany receivables are ordinarily classified as cash or near cash property, if the receivable is transferred to a shareholder-transferee while the liability is retained by the particular corporation, the shareholder- transferee will receive more than its pro rata share of cash or near- cash property. If, on the other hand, the particular corporation retains the receivable while the liability becomes a liability of the shareholder- transferee, the particular corporation will retain too much cash or near- cash property.

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In effect, property has been created on the butterfly. As mentioned previously, this problem can be eliminated by ensuring that both the intercompany receivable and the liability will either be retained by the particular corporation or be transferred to the same shareholder- transferee, so that such amounts will continue to be eliminated on consolidation.

A question has also arisen concerning the manner in which the consolidated lookthrough approach is to be accomplished in the situation where a corporation over which the particular corporation exercises significant influence has "negative" net cash or near-cash property (that is, its current liabilities exceed its current assets). In such circumstances, it is the department's position that the consolidated lookthrough is to be performed in such a manner that the excess current liabilities of such subsidiary reduce the cash or near-cash property of the particular corporation on a consolidated basis. In other words, such excess current liabilities of the subsidiary will not be allocated to the net business property or investment property of that subsidiary before consolidating its properties with those of the other corporations in the group. We refer to this as the full consolidation method. The following example illustrates how the consolidated look-through approach is to be applied in such circumstances.

The particular corporation (PC) in this example has the following assets and liabilities:

Cash ......................................................... $ 1,350
Business property: FMV ....................................... 10,150
100% of the shares of Subco1: FMV ............................ 1,000
50% of the shares of Subco2: FMV ............................. 2,750
Current liabilities .......................................... (250)

Net FMV of assets ............................................ $15,000

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The assets and liabilities of Subco1 consist of:

Cash ......................................................... $ 250 Business property: FMV ....................................... 1,850 Current liabilities .......................................... ($600) Long-term debt ............................................... ($500)

Net FMV of assets ............................................ $1,000

Subco2 has the following assets and liabilities:

Cash ......................................................... $2,000
Business property: FMV ....................................... 6,000
Current liabilities .......................................... (500)
Long-term debt ............................................... (2000)

Net FMV of assets ............................................ $5,500

For purposes of this example, we have assumed that the FMV of the shares of each corporation and the net FMV of the underlying assets owned by that corporation are equal and that all long-term debt is related to the business property of the relevant corporation.

Under the full consolidation method, the types of property of PC determined on a net equity basis are as follows:

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Property of PC - Full Consolidation Method

PC Subco1 Subco2Consolidated
(100%) (50%) Basis

Cash .................... $1,350 $ 250$1,000 $2,600
Current liabilities ..... (250) (600) (250) (1100)

Net Cash ................ $1,100 $(350) $750 $1,500

Business Property ...... $10,150 $1,850$3,000 $15,000
Long-term debt ......... nil (500)(1,000) (1,500)

Net business property .. $10,150 $1,350$2,000 $13,500

In the determination, on a consolidated basis, of the types of properties held by PC, the excess current liabilities of Subco 1 do not reduce the business property represented by the shares of Subco 1 held by PC, but rather are allocated to reduce the consolidated cash holdings of PC. Consequently, although the shares of Subco 1 represent only 1/15 of the value of the assets of PC, it will be necessary for a shareholder to own 10 percent of the shares of PC in order to receive the shares of Subco1 on a butterfly of PC that complies with the pro rata requirement of paragraph 55(3)(b).

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This proportion is determined by dividing the net FMV of the business property represented by the shares of Subco 1 by the net FMV of all of the business property of PC. In addition, the shareholder will have to receive $500 of PC's net cash property.

Let us assume that a butterfly of Subco 1 to a shareholder that owns 10 percent
of the shares of PC is implemented. Following the butterfly, the property of PC
and the property of the shareholder-transferee, both determined on a consolidated
basis, will be as follows:

Property of PC

PC Subco2 Consolidated
(50%) Basis

Cash ................... $ 850 $1,000 $1,850
Current liabilities .... (250) (250) (500)

Net cash ............... $ 600 $750 $1,350

Business property ...... $10,150 $3,000 $13,150
Long-term debt ......... nil (1,000) (1,000)

Net business property .. $10,150 $2,000 $12,150

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Property of Shareholder-Transferee (S-T)

S-T Subco1 Consolidated
(100%) Basis

Cash ................... $ 500 $ 250 $ 750
Current liabilities .... nil ( 600) ( 600)

Net cash ............... $ 500 $( 350) $ 150

Business property ...... nil $1,850 $1,850
Long-term debt ......... nil ( 500) (500)

Net business property .. nil $1,350 $1,350

As can be seen, the shareholder-transferee has received its proportionate share of each type of property of PC on a consolidated net equity basis.

As stated in our 1989 paper, although the department accepts arrangements in which the pro rata test can be met by relying on the consolidated lookthrough approach both before and after the distribution of shares of subsidiaries to shareholders of the particular corporation, there will still be cases where the pro rata test cannot be satisfied using this approach.4 In such cases, one of the methods set out in subparagraphs 55(3)(b)(iii) to (vii), such as an amalgamation, winding up, or preliminary butterfly, will have to be undertaken in order to meet that test.

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Valuation Issues

In response to question 53 at the 1981 Revenue Canada round table, the department stated, "The value of property relates to the attributes of the property and is unaffected by the tax position of the owner."5 In other words, deferred taxes in respect of a property to be transferred pursuant to a subsection 85(1) election in the course of a butterfly reorganization are not relevant for purposes of valuing the property to be transferred. Our views on this matter have not changed. Where, however, the particular corporation will incur a tax liability as a result of the butterfly transfers (for example, where the elected amount exceeds the cost amount of the property), such tax liability may be considered to be a current liability of the particular corporation that may be allocated in accordance with the procedures set out in our 1989 paper.6

The department also recognizes that in many instances the aggregate fair market value of the issued shares of the particular corporation will differ from the aggregate net fair market value of its assets. As a result of the requirement that each type of property of the particular corporation be distributed proportionally to its shareholders, this inequality will lead to a discrepancy between the aggregate fair market value of the shares of the particular corporation held by a transferee and the fair market value of the shares received by the particular corporation as consideration for the transfer. This inequality gives rise to the following issues:

• • Since, on the severing of the cross-shareholdings, each party must pay fair market value consideration for its shares and will issue promissory notes having a fair market value equal to that of its shares, the promissory notes will have unequal values and principal amounts; consequently, subsection 80(1) could apply on their setoff and cancellation.
• • Alternatively, if on the severing of the cross-shareholdings the parties give equivalent value consideration so as to avoid the application of subsection 80(1), a benefit under subsection 15(1) may be conferred on one of the parties.

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In this situation, the department would not normally apply the provisions of either subsection 15(1) or 80(1), since it is our view that, in a butterfly reorganization, compliance with the pro rata test in paragraph 55(3)(b) is the paramount requirement. We therefore will not generally interpret other provisions of the Act so as to render the meeting of that test impractical.

In circumstances where the fair market value of the shares of a corporation and the net fair market value of its assets are not equal, the fair market value of the shares of the particular corporation to be owned by the shareholder- transferee in order to implement a butterfly reorganization that satisfies the pro rata test is determined by the following formula:

FMV of main type of
property to be transferred FMV of all issued and
FMV of all property of that type X outstanding shares of
owned by the particular corporation the particular
immediately before the transfers corporation

The following example helps to illustrate these issues.

Assume that Parentco owns 100 percent of the issued and outstanding shares of the particular corporation (PC) which have an FMV of $900. The only property owned by PC consists of 100 percent of the shares of Subco 1 and Subco 2, both of which constitute business property to PC on a consolidated lookthrough basis. The FMV of the shares of Subco 1 is $400; the shares of Subco 2 have an FMV of $800. Parentco wishes to transfer the shares of Subco 1 to a newly incorporated corporation (Newco) by means of a butterfly reorganization and then sell the shares of Newco to an arm's-length purchaser.

Although the shares of Subco 1 have an FMV of $400, Parentco will need to transfer shares of PC having an FMV of only $300 (that is, $400/$1200 x $900) to Newco in order to implement the butterfly reorganization. Following Parentco's transfer of these shares of PC to Newco, PC will transfer its shares of Subco 1 to Newco for retractable preferred shares of Newco having an FMV of $400, an amount equal to the FMV of the transferred property.

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Newco will then redeem its preferred shares held by PC for a promissory note having a principal amount and FMV of $400, being an amount equal to the FMV of the preferred shares so redeemed. PC will then purchase its common shares held by Newco for cancellation in consideration for a promissory note having a principal amount and FMV of $300, being the FMV of such common shares. The obligations under the promissory notes will then be cancelled by offset. Finally, the shares of Newco will be sold to an arm's-length purchaser.

Although the facts in this example comply with the pro rata test in paragraph 55(3)(b) in that Newco, which owned one-third of the shares of PC, has received one-third of PC's business property, it is evident that section 80 will technically apply on the cancellation of the note owing by Newco to PC since this note, which has a principal amount of $400, will be settled in consideration for the note owing by PC to Newco, which has a principal amount of only $300. Also, depending on the circumstances, a benefit may have been conferred by PC on Newco which has received property worth $400 in return for its shares of PC which are worth only $300. However, since the department considers that the pro rata test is the paramount requirement in a butterfly, we will not generally apply section 80 or any of the benefit provisions in such circumstances.

Pursuant to paragraph 55(3)(b), the fair market value of each type of property received by a transferee must be equal to or approximately equal to that transferee's proportionate share of the fair market value of all property of that type owned by the particular corporation immediately before the transfers. The phrase "was equal to or approximated" as used in paragraph 55(3)(b) means very close to equal and permits limited scope for offsetting minor discrepancies between types of assets. For purposes of advance rulings, the department is prepared to accept a discrepancy of up to 1 percent, determined as a percentage of the amount of each type of property that a transferee has received as compared with what that transferee would have received if it had received its appropriate pro rata share of that type of property. Consider the following two scenarios where A Co. and B Co. each own 50 percent of the shares of the particular corporation (PC). The FMV of the property owned by PC is as follows:

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Cash or near-cash ..................................... $14,250
Investment ............................................ 750
Business .............................................. 85,000
$100,000

In the first scenario, B Co. wants to receive its pro rata share of PC's property pursuant to a butterfly reorganization. The property of each type that B Co. receives and the amount that it should have received are set out below.

Amount Pro Rata Percentage
Received Share difference

Cash or near-cash .... $ 7,125 $ 7,125 0.0
Investment ........... 625 375 66.67
Business ............. 42,250 42,500 0.59
Total ................ $50,000 $50,000

Although B Co. has received its approximate share of PC's cash or near-cash property and business property, the butterfly will not meet the requirements of paragraph 55(3)(b) since BCo. has received 66.67 percent ($625 - 375 = 250/375) more investment property than its proportionate share of that type of property.

In the second scenario also, it is intended that B Co. receive its pro rata share of PC's property pursuant to a butterfly. The property of each type that B Co. is to receive and the amount that it should receive are set out below.

Amount Pro Rata Percentage
Received Share difference

Cash or near cash ...... $ 7,175 $ 7,125 0.70
Business ............... 42,825 42,500 0.76
Total .................. $50,000

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Although B Co. will not receive its approximate share of PC's investment property, the butterfly will meet the requirements of paragraph 55(3)(b) since B Co. will receive its approximate share of each type of property (that is, cash or near-cash property and business property) which will be distributed on the butterfly. Pursuant to paragraph 55(3)(b), it is necessary only to consider whether a shareholder-transferee has received its approximate pro rata share of those types of property that are distributed in the course of the butterfly reorganization. This type of scenario, however, will work only where the type of property that is not being transferred has only a nominal value.

Acquisitions of Property in Contemplation of Butterfly Transfers

A butterfly reorganization will not qualify for the exemption provided by paragraph 55(3)(b) when there has been an acquisition of property in contemplation of and before the butterfly reorganization by the particular corporation, by a corporation controlled by the particular corporation or by a predecessor of any such corporation, except where the property acquisition is one described in one of subparagraphs 55(3)(b)(iii) to (vii). In this regard, it makes no difference whether the property is retained by the particular corporation (that is, in a partial or single-winged butterfly) or transferred to one of its shareholders.

Although this prohibition is broad, it applies only to property that is acquired in contemplation of a subsequent butterfly reorganization. Consequently, it is not necessary for a corporation that is contemplating a butterfly reorganization to virtually freeze its operations until after the implementation of the proposed butterfly. As stated in our 1989 paper,

It is not our view that property will necessarily be considered to have
become property in contemplation of a subsequent butterfly
reorganization merely because it is intended, at the time the property
becomes property of the particular corporation, to carry out the
butterfly reorganization; instead, there must be some connection between
the acquisition and the later reorganization.

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In other words, if it can be established that property would have become property of the particular corporation at a particular time, whether or not a butterfly reorganization would subsequently be undertaken, the transaction in which property became property of the particular corporation will not normally be considered to have occurred in contemplation of the butterfly reorganization."7

Where, however, the structure or timing of a transaction that occurs before a butterfly reorganization is affected by considerations relating to the butterfly reorganization, we would normally consider the transaction as being in contemplation of the butterfly reorganization.

In the situation where the particular corporation is a member of a general partnership, the department has accepted that, where, pursuant to the terms of the partnership agreement, it is reasonable to consider that each partner's share in a general partnership constitutes a proportionate interest in the specific items of property that together constitute the partnership property, no property will become property of the corporate general partner for purposes of paragraph 55(3)(b) when, upon a dissolution of the partnership or upon any distribution of partnership property, it receives an undivided interest, proportional to its interest in the partnership, in each asset distributed by the partnership. In the department's view, it will generally be reasonable to consider that each partner's share in a partnership constitutes a proportionate interest in the specific items of property that together constitute the partnership property where the partnership is a general partnership and where the partnership agreement provides that all profits, losses, capital gains, capital losses, and capital distributions will be allocated proportionally to the partners on the basis of their interest in the partnership.

Similarly, where the particular corporation forms a general partnership with its shareholders and transfers property to the partnership in consideration for a partnership interest which it then transfers to its shareholders, the acquisition of such a partnership interest will not be property acquired by the particular corporation in contemplation of the butterfly if, pursuant to the terms of the partnership agreement, it can reasonably be considered that each partner's share in the partnership constitutes a proportionate interest in the specific items of property that together constitute the partnership property.

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Instead, the transfer of the property to the partnership will be a step in the indirect transfer of property of the particular corporation (that is, the underlying assets that the particular corporation contributed to the partnership) to its shareholders.

It will, of course, be necessary that any such indirect transfer comply with the pro rata test in paragraph 55(3)(b) for any dividends arising on the transfers to qualify for the exemption in paragraph 55(3)(b). Also, a subsequent transfer of property by the partnership to another person or a subsequent transfer of the partnership interest to another person, which occurs in the course of the same reorganization will taint the original butterfly transfers since it will constitute an indirect transfer of property of the particular corporation to that person.

Also, as noted in Information Circular 88-2,8 where the property transferred to the partnership includes land inventory and the primary purpose for the formation of the partnership and the transfer of the land to the partnership is to circumvent the prohibition in section 85 against transferring land inventory to a corporation on a tax-deferred basis, the provisions of subsection 245(2) will apply since the transfer of the land inventory to the partnership will, in our view, constitute a misuse of subsection 97(2) or an abuse having regard to the provisions of the Act read as a whole. This will generally be the case where the partnership is to be dissolved within a short time following the transfer of the land inventory to it.

Where undivided interests in the property of a particular corporation have been distributed to its shareholders in accordance with the provisions of paragraph 55(3)(b) and the shareholder-transferees each contribute a proportional share of the transferred property to a general partnership of which the shareholder- transferees are the only partners, and their interests in the partnership correspond to their respective shareholdings in the particular corporation, it is the department's view that the transfer of the property to the partnership will not normally cause the paragraph 55(3)(b) exemption not to apply.

Document Disclosed Pursuant to The Access To Information Act Document Divulgué en vertu de la loi sur l'accès à l'information As mentioned in our 1988 paper, incurring a debt in contemplation of a butterfly will involve an acquisition of property (that is, the proceeds of the debt financing) in contemplation of the butterfly.9 It often happens that the implementation of a butterfly reorganization involves transactions that will constitute a breach of the terms of a particular corporation's indebtedness (for example, covenants regarding no substantial dispositions of assets, or no granting or creation of security interests in such assets). In such circumstances, it will usually be necessary for the particular corporation to refinance such indebtedness that has become or will, on the implementation of the butterfly transfers, be in default. Such refinancings will not normally be considered to result in an acquisition of property in contemplation of the butterfly reorganization provided that the principal amount of the new financing is equal to the principal amount of the indebtedness that is being refinanced and provided also that such refinancing does not result in a change in the mix of the properties owned by the particular corporation.

In our 1988 paper, it was stated,

If a butterfly is carried out on a net equity basis, the payment of
long-term debt will result in an increase in the net value of the asset
to which that debt is attributable. This increase in net value could,
in the context of a net equity butterfly, be viewed as the equivalent of
an acquisition of property in contemplation of a butterfly. This would
be the case if the repayment was clearly made to facilitate the property
distribution as part of the butterfly, such as in a case in which a
particular corporation uses existing cash to make a large, unscheduled
repayment of a debt associated with a business asset. In such a case,
the increase in the net value of the business asset would be considered
a prohibited acquisition of property in contemplation of the intended
butterfly.10

The department has, however, accepted that the use of existing cash to repay current liabilities will not result in a prohibited acquisition of property provided that the particular corporation does not avail itself of the department's administrative practice to treat the net fair market value of certain accounts receivable, inventory and rights arising out of prepaid expenses as business property.11 Since current liabilities are allocated against cash or near cash property in a net equity method butterfly, the payment of current liabilities with cash in such circumstances will not result in a net increase in the value of any type of property.

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Although subparagraph 55(3)(b)(vi) permits an acquisition of property by the particular corporation as a result of a disposition of property by the particular corporation or a corporation controlled by it to another corporation controlled by the particular corporation, it does not permit an acquisition of property by the particular corporation from a corporation controlled by it on a rollover basis except on the winding up of such controlled corporation. Similarly, although subparagraph 55(3)(b)(vii) permits an acquisition of property by the particular corporation as a result of a disposition of property by the particular corporation for consideration that consists only of cash or debt, a sale for cash or debt by a corporation controlled by the particular corporation is not permitted.

In certain circumstances, however, the department has accepted that such results may be achieved through a combination of permitted transactions. For example, the particular corporation could incorporate a new wholly owned subsidiary corporation (a transaction that is permitted by subparagraph 55(3)(b)(vi)), followed by a transfer of property by a corporation controlled by the particular corporation to the newly incorporated subsidiary corporation (a transaction that also is permitted by subparagraph 55(3)(b)(vi)), which is then followed by a winding up of the newly incorporated corporation into the particular corporation (a transaction that is permitted by subparagraph 55(3)(b)(iv)). In this manner, property could be transferred from a controlled corporation to the particular corporation so that the particular corporation might then sell the property for cash or debt or otherwise facilitate a proportionate distribution of property. It is our view that such a series of transactions would not generally result in a misuse or abuse of the provisions of the Act, so that subsection 245(2) would not normally apply to them.

It should, however, be mentioned that should a dividend arise as a result of any transfer of property described in subparagraph 55(3)(b)(vi) (for example, in the situation described above, the transfer of the property from the controlled corporation to the newly incorporated subsidiary), such dividend would not be exempted from the application of subsection 55(2) by virtue of paragraph 55(3)(b). It is the department's view that although such a dividend would arise as part of the series of transactions that includes the butterfly transfers to shareholders, it would not arise in the course of the butterfly reorganization.

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It is our interpretation, based on the wording of paragraph 55(3)(b), that any of the transactions described in subparagraphs (iii) to (vii) of paragraph 55(3)(b) are transactions carried out in contemplation of the butterfly reorganization, not in the course of that reorganization. Also, since the dividend would arise as part of the series of transactions or events that includes the butterfly transfers, it would not generally qualify for the exception found in paragraph 55(3)(a).

Although subparagraph 55(3)(b)(vii) permits an acquisition of property by the particular corporation in contemplation of an intended butterfly reorganization as a result of a disposition of property by it for cash or debt, it is our view that a taxable sale of property by the particular corporation to a shareholder will not qualify for the exemption found in subparagraph 55(3)(b)(vii) since such sale will generally constitute a transfer of property to a shareholder in the course of the reorganization and will therefore need to be taken into account in determining whether each shareholder-transferee has received its proportionate share of each type of property distributed by the particular corporation.

Finally, it should be mentioned that the term "property" as defined in subsection 248(1) has a very broad meaning and includes, inter alia, a right of any kind whatever. Accordingly, the prohibition in paragraph 55(3)(b) is sufficiently broad to prohibit the particular corporation from acquiring any rights under agreements if such rights were acquired in contemplation of and before the butterfly reorganization. Generally, however, we would not assert that property has become property of the particular corporation in contemplation of the butterfly reorganization in respect of those rights that accrue under agreements that must necessarily be entered into to implement the butterfly (for example, the agreement of purchase and sale of assets to be transferred and any ancillary agreements or consents such as those relating to the release of security on those assets). Where, however, the agreement is not necessary to implement the butterfly transfer, any rights acquired under the agreement will normally constitute a prohibited acquisition of property if there is a connection between the butterfly reorganization and the entering into of the agreement by the particular corporation.

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OTHER ISSUES

Impact of the Guaranty Properties Decision

In our 1988 paper, we stated,

It is our view that a transfer of property by a particular corporation
to a wholly owned subsidiary of a shareholder corporation, followed by
a winding up of the subsidiary into that shareholder corporation, would
constitute an indirect transfer of property by the particular
corporation to the shareholder corporation for the purposes of paragraph
55(3)(b). In contrast, a transfer by a particular corporation to a
wholly owned subsidiary of a shareholder corporation, followed by an
amalgamation described in subsection 87(1) of the subsidiary and that
shareholder corporation, would not be an indirect transfer of property
by the particular corporation to a transferee corporation that was a
shareholder of the particular corporation immediately before the
transfer, because the corporation resulting from the amalgamation is
deemed by paragraph 87(2)(a) to be a new corporation."12

This remains our view notwithstanding the decision in the Guaranty Properties case.13

Paragraph 55(3)(a) Versus Paragraph 55(3)(b)

For several years, it has been the department's interpretation that where a reorganization was structured to comply with the pro rata requirements of paragraph 55(3)(b) but the series of transactions or events did not result in either

• 1) a disposition of property to an arm's-length person or
• 2) a significant increase in the interest in any corporation of an arm's-length person,

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the exemption from the application of subsection 55(2) found in paragraph 55(3)(b) did not apply because the exemption in paragraph 55(3)(a) applied and, in our view, the paragraph 55(3)(a) exemption took precedence. Consequently, we were not willing to provide rulings under paragraph 55(3)(b) unless the series of transactions or events included one of the events described in point 1 or 2 above. We have recently reconsidered our position on this issue and are now prepared to provide favourable paragraph 55(3)(b) rulings in those situations where the exemption in paragraph 55(3)(a) also may apply, provided, of course, that the requirements of paragraph 55(3)(b) are met.

Price Adjustments

In view of the difficulties in accurately determining fair market values, many butterfly reorganizations of closely held companies include one or more price adjustment clauses relating to the transfers of property in the course of the reorganization. Should such price adjustment mechanisms come into effect owing to the fact that the values assigned by the parties to the transferred properties are materially different from the amounts subsequently determined to be their fair market values, it is likely that the pro rata requirement in paragraph 55(3)(b) will not have been met notwithstanding the existence of such price adjustment mechanisms. In fact, in respect of any butterfly ruling in which the existence of a price adjustment mechanism is disclosed, it is our practice to add a disclaimer to the effect that should the price adjustment mechanism become operative, the rulings given, and in particular the one given on the non- application of subsection 55(2) by virtue of paragraph 55(3)(b), may not be valid.

We have also encountered situations where the price to be paid by a purchaser to acquire shares of a particular corporation before the implementation of a purchase butterfly is subject to a post-closing adjustment or is to be determined pursuant to an earnout. We have refused to rule favourably in these circumstances since the existence of such price adjustment mechanisms is an indication that the parties are unable to agree on the fair market value of the shares of the particular corporation and/or the fair market value of its property. Paragraph 55(3)(b) requires that the fair market value of the property received on a butterfly reflect the fair market value of the shares of the particular corporation held by a transferee immediately before the transfer. Where such price adjustment mechanisms are present, we are unable to satisfy ourselves that this fundamental requirement is met.

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1RSC 1952, c. 148, as amended by SC 1970-71-72, c. 63, and as subsequently
amended (herein referred to as the "Act"). Unless otherwise stated,
statutory references in this paper are to the Act.

2Robert J.L. Read, "Section 55: A Review of Current Issues," in Report of
Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto:
Canadian Tax Foundation, 1989), 18:1-28; and Michael A. Hiltz, "The
Butterfly Reorganization: Revenue Canada's Approach," in Report of
Proceedings of the Forty-First Tax Conference, 1989 Conference Report
(Toronto: Canadian Tax Foundation, 1990), 20:32-48.

3Canadian Institute of Chartered Accountants, CICA Handbook (Toronto: CICA)
(looseleaf).

4Hiltz, supra footnote 2, at 20:39.

5Revenue Canada Round Table," in Report of Proceedings of the Thirty-Third
Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation,
1982), 726-66, question 53, at 763-64.

6Hiltz, supra footnote 2, question 13, at 20:40-11.

7Ibid., question 16(1), at 20:42-43.

8Information Circular 88-2, ~General Anti-Avoidance Rule: Section 245 of the
Income Tax Act," October 21, 1988.
9Read, supra footnote 2, at 18:22.

10Ibid., at 18:22.

11This administrative practice is described in Read, supra footnote 2, at
18:17-18, and Hiltz, supra footnote 2, at 20:41.

12Read, supra footnote 2, at 18:11).

13See The Queen v. Guaranty Properties Limited et al., 90 DTC 6363 (FCA).

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