Two unrelated shareholders split one corporation into two before selling separately, and the pro-rata split of each type of property is what the reorganisation had to satisfy.

The situation

Two unrelated business partners had run a company together for years, each holding half of OpCo's shares. OpCo owned two kinds of property: the operating business and its goodwill, worth roughly $6,000,000, and the commercial building it operated out of, worth roughly $4,000,000, held as a separate investment rather than as part of the operating business itself. The partners wanted to go their separate ways ahead of a sale — one wanted to keep running, and eventually sell, the business; the other wanted the real estate and the rental income it could produce once the business tenant moved on.

The problem

Their first instinct was the obvious one: split OpCo into two new companies along the two asset types, one owning the business, the other owning the building, each wholly owned by one partner. Their tax adviser flagged that this is not a “distribution” the way the Income Tax Act uses that word, and without a qualifying distribution, the reorganisation would trigger the ordinary rule it was trying to avoid — a deemed dividend to each shareholder on the wind-up, taxed as a capital gain rather than deferred at all.

The numbers

OpCo total FMV $10,000,000 ($6,000,000 business, $4,000,000 real property), split 50/50 by shareholding. The first plan would have given Shareholder A's new company the whole $6,000,000 business and Shareholder B's the whole $4,000,000 building — unequal in value on top of being non-proportional by type, which made it doubly clear the plan did not track the statute. The compliant version gave each new company $3,000,000 of the business and $2,000,000 of the real property: $5,000,000 each, split by type, not by asset. NewcoA later paid $3,000,000 cash to buy NewcoB's residual interest in the operating business, as a separate and fully taxable step.

The rule that decided it

ITA s.55(1) defines distribution as “a direct or indirect transfer of property of a corporation (referred to in this section as the ‘distributing corporation’) to one or more corporations… where, in respect of each type of property owned by the distributing corporation immediately before the transfer, each transferee corporation receives property of that type the fair market value of which is equal to or approximates the amount determined by the formula A × B/C where A is the fair market value… of all property of that type owned… by the distributing corporation, B is the fair market value… of all the shares of the capital stock of the distributing corporation owned… by the transferee corporation, and C is the fair market value… of all the issued shares of the capital stock of the distributing corporation”. B/C here is 50% for each transferee. The formula therefore requires each of NewcoA and NewcoB to receive 50% of the $6,000,000 business type and 50% of the $4,000,000 real property type — not one type each.

That definition is what s.55(3)(b) then exempts. It excludes from s.55(2) a dividend “received (i) in the course of a reorganization in which (A) a distributing corporation made a distribution to one or more transferee corporations, and (B) the distributing corporation was wound up or all of the shares of its capital stock owned by each transferee corporation immediately before the distribution were redeemed or cancelled… and (ii) on a permitted redemption in relation to the distribution or on the winding-up of the distributing corporation”. This is the route available to shareholders who are not related to each other — the related-persons exemption sits in the separate paragraph s.55(3)(a), and does not need the pro-rata distribution mechanics at all. Two unrelated business partners have only the s.55(3)(b) route open to them, and it is conditioned entirely on the distribution being proportional by type.

The reorganisation still had to clear s.55(3.1), which disqualifies a s.55(3)(b) dividend where property became property of the distributing corporation, in contemplation of the distribution, from a source other than the listed related-party transactions — put simply, neither partner had recently contributed outside property into OpCo as part of a plan to load value into one side of the split. On these facts nothing had, and the exemption held.

Once OpCo's property was split proportionally into NewcoA and NewcoB and OpCo was wound up, each partner still had to end up as the sole owner of one company rather than a 50% owner of two — a separate step, using the permitted-exchange and permitted-redemption mechanics s.55(1) defines for that purpose, and outside the scope of what this file needs to trace in detail.

The outcome

The compliant, pro-rata distribution went ahead: NewcoA and NewcoB each ended up holding half of the business and half of the real property, and OpCo was wound up under the s.55(3)(b) route without triggering s.55(2). What the partners actually wanted — one company holding the whole business, the other the whole building — was reached afterward, through a separate, fully taxable purchase: NewcoA paid NewcoB $3,000,000 cash for its residual half of the operating business. NewcoB recognised a capital gain on that sale, priced into the plan from the outset rather than discovered afterward.

What it would have cost otherwise

Had the partners gone ahead with the original, asset-by-asset split, the distribution would not have met the s.55(1) definition at all, s.55(3)(b) would not have applied, and s.55(2) would have deemed the entire value transferred on OpCo's wind-up to be a dividend recharacterised as a capital gain — taxing both partners on the full $10,000,000 of value moved, rather than the $3,000,000 buy-out that was the only piece the compliant structure left exposed.

The tell

The partners' first-draft term sheet described the split as “I get the business, you get the building”, in exactly those words. That is a clean commercial outcome and an incompatible tax structure at the same time — the statute does not ask what the partners want to end up with, only whether the transfer that gets them part-way there is proportional.

Takeaways

• • A “distribution” under s.55(1) requires each transferee to receive its proportionate share of every type of property, not a clean asset-by-asset split — the most common way a butterfly plan fails before a lawyer ever sees it.
• • s.55(3)(b) is the route for shareholders who are not related to each other; the related-persons exemption at s.55(3)(a) is a different paragraph with different conditions.
• • s.55(3.1) can disqualify an otherwise-compliant distribution where property arrived at the distributing corporation in contemplation of the split from outside the permitted sources — check the history of the corporation's property, not just the split itself.
• • The tax-deferred reorganisation gets the parties to proportional co-ownership of everything. Getting from there to the commercial outcome they actually want is a separate, and separately taxable, transaction.
• • This is not the same computation as a purification dividend limited by safe income — there is no safe-income test in a s.55(3)(b) butterfly; the gate is proportionality, not accumulated earnings.

Sources

• • Income Tax Act s.55(1) (definition of “distribution”), s.55(3)(b) and s.55(3.1) — the pro-rata distribution test, the butterfly exemption for unrelated shareholders, and its disqualifying rules.
• • Treadstone Law — corporate reorganization services, Ontario — general background on structuring a corporate split ahead of a sale; it does not address the s.55(3)(b) pro-rata distribution mechanics, which is the specific rule this file turns on.