Separation or divorce is the outcome of many relationships and it can be a very difficult experience. If there is a breakdown in your marriage, you and your partner will need to determine how to divide your assets in accordance with the laws that apply in your province.
As a business owner, your most valuable asset may very well be your company, which will add complexities to the process—from an operational perspective, and from a valuation and tax perspective. You should carefully consider your options before moving forward with a plan for the business. It is important to consider the approach and timing for dividing the company and/or its assets, as they can have significant long-term tax implications for you, your former partner, and your business.
What is the definition of a spouse and a common-law partner for tax purposes?
For tax purposes, the definitions of a spouse and a common-law partner, as well as the length of time required to dissolve a formal partnership, need to be kept in mind throughout the process of separating business assets.
Under Canadian tax law, a spouse is a person to whom you are legally married. A marriage is ended only through legal divorce, regardless of the length or distance of your separation. This means that even if you have been separated from your spouse for years and live on opposite sides of the country you cannot be considered to be at ‘arm's length’ for tax purposes—until a divorce is finalized. (That said, there may be circumstances under which you do not deal at arm's length, even after divorce.) ‘arm's length’ and ‘non-arm's length’ are important concepts for income tax purposes—particularly when there is a transfer of property that is not considered to be at arm's length.
In contrast, a common-law partner is someone you are not legally married to, but with whom you live in a conjugal relationship, and at least one of three scenarios applies:
- you have been living together for the last twelve continuous months, with no separation periods of more than 90 days due to breakdown of the relationship during that time;
- they are the parent of your child, either by birth or adoption; and/or
- they have custody and control of your child, and your child is wholly dependent on them for support.
Ending a common-law partnership is less complicated than ending a marriage. A common-law partnership is deemed to be terminated once partners have been separated for 90 days or more.
However, if you are getting out of a common-law relationship, the 90-day rule may mean that you are racing against the clock when it comes to splitting your business assets. This time restriction may also limit your available planning alternatives.
It is often best to reach out to a tax professional before a formal separation or divorce, if possible, as the most tax-effective way of dividing your assets may require you to be separated, divorced, or still legally married to your partner.
Key tax rules to consider during separation or divorce
There are several tax areas business owners need to be especially cognizant of when tax planning for the division of business assets during or following a marital breakdown.
In situations that involve a spousal rollover, the spousal attribution rules, TOSI, or the capital gains exemption, timing is critical, as is the legal status of the relationship when the business separation plan is enacted.
Understanding butterfly transactions
One common way of managing a business through a divorce or separation is dividing corporate assets with the use of a butterfly transaction. This is basically splitting the assets of one corporation into two corporations (which may or may not include the original business entity), one owned by each partner, without incurring income taxes. There are generally two ways to achieve a butterfly transaction:
- The related-party butterfly applies only to non-arm's length parties—thus must be completed while a couple is still considered ‘together’ for tax purposes. The appeal of this approach is its flexibility. The couple gets to decide what assets are allocated to which of the two resulting companies. For example, partners can choose to split corporate assets so that passive assets, such as an investment portfolio, go to one company (thus one partner), while the active business assets stay or go to another corporation.
- The divisive butterfly applies when owners are arm's-length parties. This approach can be much more complicated, and it is considerably less flexible, as there are specific rules dictating that each company must receive pro-rata shares of business and non-business assets. Understandably, deciding this division can become contentious, especially following a difficult divorce.
It is important to remember that there are complexities in effecting a butterfly transaction even when utilizing the comparatively simpler related-party butterfly to divide corporate assets. Detailed planning and adherence to certain conditions are imperative to ensure that the steps involved in this type of planning can be achieved on a tax-deferred basis.
Finding the right plan for division
There are many approaches to dividing a business depending on your needs and desires, and those of your former partner. The plan to achieve an optimal outcome will look very different depending on whether one or both parties own shares, are active in the business activities, and/or want to continue with the current business, among other considerations.
Proper tax support during your separation or divorce can deliver an optimal tax outcome and limit damage and disruption to your business during a difficult time.
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For more information on dividing your business assets, contact your trusted BDO advisor.
The information in this publication is current as of July 16, 2021.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.