A Caution To Canadian Tax Planners: A Butterfly Reorganization Might Trigger Derivative Tax Liability Under Section 160 Of The Income Tax Act: Eyeball Networks Inc. v The Queen (2019 TCC 150) – A Canadian Tax Lawyer's Analysis

Introduction: Butterfly Reorganizations & Derivative Tax Liability under Section 160 of the Income Tax Act

A butterfly reorganization is a method of splitting a corporation—and thereby its assets—into two or more separate corporations. This is often the case when the shareholders wish to go their separate ways and divvy up the assets of the corporation accordingly.

A butterfly reorganization allows the shareholders to divide the corporation into two or more components on a tax-deferred basis under section 85 of the Income Tax Act while avoiding the deemed capital gain that might otherwise arise under the subsection 55(2), an anti-avoidance rule aimed at preventing capital-gains stripping. (A capital-gains strip is a transaction that's structured to convert what would otherwise be a taxable capital gain into a tax-free intercorporate dividend. Subsection 55(2) pre-empts such a transaction by triggering a capital gain. A butterfly reorganization, however, is exempt from subsection 55(2) under subsection 55(3).)

While numerous variations of the butterfly exist, they all revolve around the same underlying technique: the target corporation divests its assets to one or more new corporations on a tax-deferred basis under section 85. In return, the target corporation receives redeemable shares that have a low paid-up capital and high redemption value. The redemption of the shares results in a non-taxable intercorporate dividend. As a result, the target corporation avoids the capital gain that it would have realized had it divested its assets directly to the individual shareholders.

Section 160 of the Income Tax Act is a tax collection tool. It thwarts a taxpayer who attempts to hide assets from a Canada Revenue Agency tax collector by transferring them to a non-arm's-length party. Basically, if you receive assets or cash from a related party—e.g., a spouse, a child, a business partner, or a trust or corporation in which you have an interest—that has outstanding tax debts, section 160 allows the CRA's tax collectors to pursue you for that person's tax debt. (Your liability, however, is capped at the fair market value of the transferred asset, and it is reduced by the value of what you paid in consideration for that asset. We detail the mechanics of section 160 in the following section.)

In Eyeball Networks Inc. v The Queen (2019 TCC 150), the Tax Court of Canada rendered a controversial decision, holding that section 160 applied to a setoff transaction occurring in the context of a butterfly reorganization. As a result, a corporate taxpayer inherited the income-tax debts of the soon inoperative corporation from which it purchased assets. Even more striking: the parties were unaware of these tax debts because the Canada Revenue Agency hadn't reassessed the defunct corporation until after the reorganization.

After discussing section 160 of the Income Tax Act, this article examines the Tax Court's Eyeball Networks decision. Finally, it concludes by offering some tax tips.

Section 160 of Canada's Income Tax Act

Section 160 of Canada's Income Tax Act is a tax collection tool. It aims to thwart taxpayers who try to keep assets away from Canada Revenue Agency tax collectors by transferring those assets to friends or relatives.

Section 160 is a harsh rule: It offers no due-diligence defence, it applies even if the transfer wasn't motivated by tax avoidance, and it catches transferees who don't even realize that they're receiving property from a tax debtor (e.g., see: Canada v Heavyside, 1996 CanLII 3932 (FCA), at para 3). In addition, section 160 doesn't contain a limitation period. So, the Canada Revenue Agency can assess you under the rule years after the purported transfer.

Section 160 applies if:

1) A property was transferred;

2) At the time of the transfer, the transferor owed a tax debt to the Canada Revenue Agency;

3) The recipient was, at the time of the transfer, either:

the transferor's spouse or common-law partner (or a person who has since become the transferor's spouse or common-law partner); a person who was under 18 years of age; or a person with whom the transferor was not dealing at arm's lengthe.g., a trust or corporation in which the transferor has an interest; and 4) The recipient...