I often see structures where a person operates an active business, and also holds the real estate in which the active business is operated, in the same company. There are numerous reasons why this is not a good structure (including that it will likely “taint” the company for capital gains exemption purposes, creditor proofing issues, etc.). It is generally advisable to hold “passive” investments (including real estate, stocks, etc.) in a separate company. If this structure has not been set up from the outset (as if often the case), a corporate reorganization can be implemented in order to transfer the passive assets from the existing company to a new company. In general, transferring the real estate to a related company will give rise to a capital gain based on the increase in value of the real estate since the time of its purchase (even if the real estate is transferred for no consideration (see section 69 of the Income Tax Act (Canada) (the “ITA”)). However, if warranted by the circumstances, a related-party butterfly transaction can be implemented to transfer the real estate to a new holding company, without triggering any tax.
If you don’t care for the technicalities, then skip this paragraph. The steps for the butterfly transaction can be summarized (very generally) as follows:
-
The shareholder of the existing company (“Company A”) transfers shares of Company A with fair market value (“FMV”) equal to the FMV of the property desired to be transferred (the “Subject Property”), to the new company (“Company B”), in exchange for shares of Company B.
-
The shareholder elects under section 85 of the ITA for there to be no gain on the transfer of shares (i.e., on a “rollover” basis).
-
Company A then transfers the Subject Property to Company B in exchange for shares of Company B with a FMV equal to the FMV of the Subject Property.
-
Company A similarly elects under section 85 of the ITA for there to be no gain on the transfer of the Subject Property.
-
At this stage (if you’ve followed the above steps), Company A owns shares of Company B, and Company B owns shares of Company A (equal in FMV to each other) – at least for a moment in time.
-
The shares held by each company are redeemed, and the resulting payable/promissory notes are set-off.
In the above-described scenario, the result is that Company A (still owned by the shareholder) has retained the active assets used in the business, and Company B holds the passive assets, with the shareholder also owning shares of Company B.
This type of butterfly can also be used in the estate planning context. I have a client with the following scenario:
-
Parent owns a holding company (“Holdco”) with two properties: (i) a commercial strip plaza investment property (the “Investment Property”), and (ii) a commercial unit (the “Business Property”) used to operate a business from which the Parent recently retired (the “Business”).
-
The Business is operated through a separate company by one of the Parent’s sons (the “Business Son”) (and not by the other two sons).
-
As part of the Parent’s estate plan, the Parent would like to pass the Investment Property to the three children equally, and the Business Property to the Business Son.
As mentioned earlier, both properties are owned by the same Holdco. Therefore, in order to pass the Business Property to the Business Son exclusively, the Business Property would have to be sold or transferred by the Holdco to the Business Son (or the Business Son’s holding company) (which, either way, would trigger a capital gain), so that the existing Holdco (which holds the Investment Property) could be transferred to the three children equally.
However, the father may be able to use a butterfly to transfer the Business Property to an entirely new holding company (“New Holdco”) on a tax-deferred basis. The father would then be able to take further steps to transfer the New Holdco (which owns the Business Property) to the Business Son exclusively, leaving only the Investment Property in the existing Holdco, which can be transferred to the three children equally. (This can be accomplished through the father’s will, or further planning can be implemented during the father’s lifetime in order to further reduce the ultimate tax bill (by, for example, implementing an estate freeze and setting up a discretionary family trust).
When considering how to restructure your assets or establish an estate plan, always assume that there is a way to accomplish what you want to accomplish in a tax-efficient manner.
