Dividing up family property after separation or divorce can be a complicated affair. It is even more complicated when a family business is involved. The butterfly transaction or, divisive reorganization, is a common way of dividing up business assets after the breakdown of a common-law relationship or marriage. A butterfly transaction is a very complex process which requires the assistance of professional accountants and tax lawyers, but for some businesses the significant tax saving makes these professional fees worthwhile.
Generally, when assets are pulled out of company taxes must be paid to the Canadian Revenue Agency (CRA). It is important to understand basic family property division as well as some general information from the Income Tax Act if you are separated and contemplating dividing up a business because if the timing of separation or divorce is not carefully considered it can create negative tax consequences.
Family property is all the assets and debts accumulated during a relationship. This includes businesses that are started during the relationship, or even the increase in value of businesses developed during the relationship. It also includes all tax debts accumulated during the relationship. Generally, all family property is divided 50-50 between the former spouses after separation or divorce, although there are some exceptions and differences between provinces. For example, the Family Law Act in British Columbia provides that gifts from third parties, inheritances, property acquired prior the relationship, and a settlement or damages in an injury claim are all exempt from 50-50 division. However, the increase in value of this otherwise exempt family property is divisible.
Generally, the same rules apply in Alberta under the Matrimonial Property Act, however, at present the Alberta legislation only governs property division between married spouses and not common-law couples. Common-law couples in Alberta family Law must rely on the arcane and confusing doctrine of unjust enrichment, which does not provide for an equal division of assets accumulated during the relationship. This is set to change in Alberta with the introduction of Bill 28 in 2020, which will give common-law spouses the same property rights as married couples, just like in British Columbia.
In fact, the general trend in family law in Canada at present is the introduction of legislation and legal protections to provide former common-law spouses with the same rights to family property and support. This is being done through provincial legislative efforts and now common-law couples have the same property rights as married couples in British Columbia, Saskatchewan, Manitoba, Nova Scotia (if registered), and soon Alberta. However, the federal government has lagged behind in these efforts and this is apparent in the inequality between the treatment of common-law spouses and married spouses in the Income Tax Act.
Butterfly transaction is a term used in reference to a divisive corporate reorganization that is possible in the Income Tax Act. Essentially one company becomes two companies. Each company is owned by one of the former business partners and assets are moved into the new company without incurring business taxes. The term “butterfly transaction” does not appear in the Family Law Act or the Income Tax Act. Butterfly transactions are not solely used in the division of family businesses after separation of a marriage or common-law partnership. They are also carried out when two business partners decide to part ways and divide the business assets.
Generally, there are two types of butterfly transactions. First, the divisive butterfly, or nonrelated party butterfly transaction applies to business owners who are arms-length, thus us not married or in a common law relationship. It is a process by which the business is divided between two business owners with very strict guidelines, including that each new company must receive pro rata shares of business assets. This can create many complications especially when dealing with businesses holding real property, various classes of shares with different values, and investment portfolios.
Less complicated and rigid in the formalities required under the Income Tax Act, is the related party butterfly. This is what is used for common-law or married couples as it only applies to non-arm’s-length parties. It is flexible in that the separating couple gets to decide how to split up the assets contained in the business. This is appealing because a corporate asset division that is least detrimental to the business can be obtained. Also, the option to transfer less than 50% of the assets in the business to the new business is possible, with the difference being made up by other family property outside of the company like RRSPs or the family home.
Unfortunately, the rules in the Income Tax Act for butterfly transactions treat common-law spouses and married spouses very differently, contrary to the trends in Canadian family law. These rules make it nearly impossible for common-law spouses to successfully complete a related-party butterfly transaction after separation.
For separating couples to be considered related for the purposes of a butterfly transaction, they must be a spouse or common-law partner as defined by the federal Income Tax Act, regardless of what it may say in provincial family law or matrimonial law. According to federal tax law, spouses are people who are married. That means as long as you have not received a divorce, you are a spouse no matter how long you have been separated for.
In contrast, a common-law partnership is a conjugal relationship lasting at least 12 continuous months, with no periods of separation due to the breakdown of the relationship exceeding 90 days, or a couple living together who have a child together and are parents of that child, or a conjugal relationship where the parties to the relationship share custody and control of a child. Therefore, if separation has occurred and it has been more than 90 days since separation, the CRA will no longer regard the spouses as being common-law.
The result of these differences in the Income Tax Act between married couples and common-law spouses is that it is much easier for a married couple to utilize a related-party butterfly transaction than it is for a common-law couple to do the same. A married couple may utilize a related-party butterfly transaction as long as they are not divorced. This means that they could be separated for years while they sort out the division of their family property and family business. A common law couple on the other hand can only be separated for three months before they are no longer able to use a related party butterfly transaction. It is a race against the clock for a common law couple to organize business affairs, hire experts and negotiate a settlement.
In practical terms, it is therefore nearly impossible for common-law spouses to utilize related party butterfly transactions to divide family business assets after separation. Therefore, spouses in common-law relationships may want to postpone their separation long enough to give time for the division of family business assets, otherwise they could be penalized by the CRA through paying more taxes or they may have to resort to the more complex non-related party butterfly transaction, dividing up business assets in a damaging or less than ideal manner.
Unfortunately, it does not seem that there is any movement to change the Income Tax Act to provide common-law partners with the same advantages as married spouses when it comes to the related party butterfly transaction. This is a significant unfairness that runs contrary to the family Law legislation in a number of provinces. Unfortunately, a court challenge to this difference is unlikely given the Supreme Court’s past reluctance to intervene where there is legislative discrimination between common law and married couples.
Accountants and tax lawyers should be consulted before commencing a divisive reorganization of a business and an advance ruling by the CRA is also recommended. The tax advantages of a butterfly transaction can be very significant and it should be canvased in most family law files involving a business.
Marcus Sixta is the owner of Crossroads Law, a boutique family law firm in Vancouver and Calgary.