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.
Spousal rollover: If assets are transferred between non-arm's length individuals, the transaction is deemed to occur at fair market value (FMV), regardless of the amount actually paid for the assets. For example, if you were to sell $100,000 worth of shares to your brother for $50,000, you would still be considered to have sold the shares for their FMV of $100,000. However, spouses can disregard this rule. Assets transferred between spouses and common-law partners are transferred at cost—often referred to as a spousal rollover. Following the breakdown of your relationship, you can only transfer on a rollover basis provided that the transfer results from a settlement. If transferred outside of a settlement, the rollover rule no longer applies which potentially results in a larger capital gains tax impact on the transfer of assets.
Spousal attribution rules: Under the spousal attribution rules, when one spouse or common-law partner transfers property to the other for less than FMV, the income or gains from that property continue to be taxable to the transferor. For example, if you were to give your spouse $100,000 in stock assets as a gift, the dividends on those stocks would be taxed on your tax return even though your spouse is the person who received and is legally entitled to keep the dividends. This spousal attribution ends immediately when a common-law couple separates, or a married couple finalizes a divorce. Attribution is also suspended when common-law partners or spouses are living apart as a result of the breakdown of the relationship. While this suspension happens automatically on the attribution of income, a joint election is required to stop the attribution of capital gains during the separation period.
Tax on split income (TOSI) rules: The expanded TOSI rules have increased the complexity of a division of family assets. Any income taxed under the TOSI rules, including dividends and capital gains, is subject to tax at the highest personal marginal tax rates. However, there are relieving provisions from TOSI in the case of a marital breakdown. One such exemption will generally require that the spouses or common-law partners live separate and apart from each other, at the end of the year, because of a breakdown of their marriage or common-law partnership. While this exclusion should be available in many situations where a couple has separated but not yet divorced, a thorough analysis of your facts and circumstances are required to determine whether this exemption is available to you. There may be cases where this exemption may not apply, especially in more complex factual situations. This would require further analysis to determine whether another TOSI exemption on income from property that is transferred to a spouse or common-law partner pursuant to a decree, order or judgement of a competent tribunal or pursuant to a written separation agreement may be available, provided that certain conditions are met. Careful planning is needed to ensure TOSI will not negatively impact your division of asset calculations.
Capital gains exemption: Normally, in situations where a corporation is buying your shares and those shares qualify for the capital gains exemption, you will have a capital gain and can claim your lifetime capital gains exemption. However, when the purchasing corporation is non-arm's length and the proceeds exceed the paid-up capital of the shares, the excess could be deemed a dividend and not a capital gain. Spouses are non-arm's length, as are the corporations that they control. Even after a divorce or the end of a common-law relationship, some former partners may still be considered at non-arm's length—depending on the facts. This can have significant tax implications in situations where a corporation controlled by one former partner buys shares in another corporation controlled by the other, which can be a part of a division-of-assets strategy.
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.
You need to improve your tax planning strategies, we’re here
For more information on dividing your business assets, contact your trusted BDO advisor.
Peter Routly, Partner, Private Client Services Practice Leader
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.