Canada: Canadian Tax @ Gowlings: October 20, 2010

Last Updated: October 26 2010
Article by Pierre G. Alary


  • A Corporate Divorce Alternative When the Butterfly Won't Fly
  • Taxand - access Taxand Take for the latest tax issues affecting multinationals worldwide as well as Taxand's latest range of publications.

A Corporate Divorce Alternative When the Butterfly Won't Fly

By Pierre Alary

I.   Introduction

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

a) Background

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.

  1. 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.
  2. 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.
  3. Shareholder B converted his Class A common shares into Class B common shares.
  4. Shareholder A sold 100 Class A common shares of the Company to HoldCo for $150,000.
  5. 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.
  6. 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:

  1. A tax benefit resulting from a transaction or part of a series of transactions (s. 245(1) and (2));
  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
  3. 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.

IV.   Conclusion

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

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

Events from this Firm
8 Nov 2016, Seminar, Ottawa, Canada

The prospect of an internal investigation raises many thorny issues. This presentation will canvass some of the potential triggering events, and discuss how to structure an investigation, retain forensic assistance and manage the inevitable ethical issues that will arise.

22 Nov 2016, Seminar, Ottawa, Canada

From the boardroom to the shop floor, effective organizations recognize the value of having a diverse workplace. This presentation will explore effective strategies to promote diversity, defeat bias and encourage a broader community outlook.

7 Dec 2016, Seminar, Ottawa, Canada

Staying local but going global presents its challenges. Gowling WLG lawyers offer an international roundtable on doing business in the U.K., France, Germany, China and Russia. This three-hour session will videoconference in lawyers from around the world to discuss business and intellectual property hurdles.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.