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There are several provisions under Canada’s Income Tax Act (ITA) that allow taxpayers to transfer property to a Canadian corporation without triggering immediate tax consequences. These transfers are known as rollovers. Under normal circumstances, dispositions of property will generally occur at fair market value (FMV), resulting in a potential capital gain to the taxpayer. However, with the use of rollovers, property dispositions can occur at cost, thus avoiding the immediate recognition of accrued capital gains.
This article reviews four of the most commonly used rollovers under the ITA and discusses their practical applications.
Section 85 of the ITA allows for a tax-deferred rollover of “eligible property” between a “transferor” and a “transferee corporation.” Under Section 85, eligible property available for a rollover includes depreciable property, non-depreciable capital property, and inventory, with specific exclusions for cash, prepaid expenses, and real property held as inventory or owned by non-residents. Under Section 85, a transferor can include an individual, trust, corporation, or partnership; the transferee, however, must be a taxable Canadian corporation.
This provision is versatile, and it’s often used by:
- Individuals who want to incorporate their sole proprietorship and contribute their business assets to the new corporation;
- Business owners who want to sell their business for shares of an acquirer or pass the future growth of their company to a key family member or stakeholder (an estate freeze);
- Parent companies that want to transfer assets to a new Canadian subsidiary; and
- Business owners who want to transfer shares of an operating company to a holding company, whether to assist in the sale of a business or for limited liability protection.
For the rollover to occur, the transferor and the transferee must jointly assign a “transfer price” for each asset being transferred. Generally, the transfer price must be a value between the asset’s tax basis—its undepreciated capital cost (UCC) or adjusted cost base (ACB)—and its FMV. As consideration, the transferor must receive at least one share of the transferee’s capital stock. Although the transferor may also receive non-share consideration (known as boot), the transfer price cannot be lower than the FMV of any boot received, and any boot received that exceeds an asset’s tax basis can result in adverse tax consequences.
Transferors will generally want to avoid transferring items expected to generate a capital loss (no tax to defer) and will want to ensure that the FMV of the consideration received is equal to the FMV of assets being transferred. The transfer price will determine the transferor’s proceeds of disposition, the transferor’s ACB of consideration received, and the transferee’s ACB of properties acquired (with some exceptions). Tax can be deferred if a taxpayer elects for the asset transfer to occur at the asset’s tax basis (UCC or ACB).
The parties may agree on a transfer price that is greater than an asset’s tax basis to allow the transferor to use up expiring tax loss carryforwards or to trigger a gain that can be eliminated by an individual’s lifetime capital gains exemption.
To undertake a Section 85 rollover, the transferor and the transferee must file a prescribed election (Form T2057/8) on the tax return due date of the transferor or transferee—whichever is earliest. Late elections are permitted up to three years after this due date, with payment of a penalty.
Section 86 of the ITA allows for a tax-deferred, share-for-share exchange when reorganizing a company’s capital. For example, using Section 86, a transferor could potentially exchange their common shares for preferred shares in the same company.
Section 86 is generally used by:
- Business owners who want to pass the future growth of their company to a key family member or stakeholder (an estate freeze); and
- Shareholders who want to bring in additional shareholders or restructure the voting rights of shareholders in a company.
For Section 86 to apply, the shares being given up must include all shares of a particular class held by the transferor (there is no requirement for other shareholders of a specific class to participate). The consideration received by the transferor must be shares of another class of the same corporation, and the articles of incorporation must be amended or altered as part of this process.
The transfer generally occurs at the ACB, which means that the ACB of the shares given up will usually equal that of the shares received. Boot may be received by the transferor; however, this will cause the ACB of the shares received to be drawn down by the FMV of the boot. Receiving boot could also trigger a capital gain.
Section 86 may also give rise to a potential deemed dividend and capital gain.
No election form is required to undertake a Section 86 rollover.
Section 85.1 of the ITA allows taxpayers (sellers) to exchange their shares for shares of a purchaser. This provision is often used by public companies that are looking to acquire shares of another corporation by issuing their own shares rather than paying for the acquired shares with cash.
For Section 85.1 to apply, the shares given up by the seller must be taxable Canadian property, the purchaser must be a taxable Canadian corporation, and the parties must be dealing at arm’s length. Following the transfer, the seller must not control the purchaser or own more than 50% of the FMV of the purchaser’s outstanding shares. As consideration, the seller must receive shares of a single class of the purchaser (no boot is permitted).
Taxpayers may not engage in a Section 85.1 rollover at any amount other than the ACB. As such, the ACB of the shares given up by the seller becomes the proceeds of disposition for the seller and the ACB of the shares acquired by the purchaser. The result is a tax-deferred exchange.
No election form is required to undertake a Section 85.1 rollover.
Section 51 of the ITA allows transferors to defer tax when converting their debt to shares or exchanging their shares for new shares of a different class of the same company, provided that the transferor receives no consideration other than the new shares. Section 51 does not apply if Section 85 or Section 86 applies to the conversion.
For Section 51 to apply, the transferor must give up capital property by way of shares or debt. The ACB of these shares or debt then becomes the ACB of the new shares received. As the ITA does not consider a Section 51 rollover to be a disposition of property, no gain is triggered. If a gain is desired, Section 85 is a better choice. Like the other rollover provisions, adverse tax consequences can result if the FMV of property given up is not equal to the FMV of the new shares received.
No election form is required for a Section 51 rollover.
The rollover provisions of the ITA allow for a tax-deferred transfer of property to a Canadian corporation in various circumstances. It is important to remember that rollovers are a way to defer (rather than eliminate) tax—meaning that while tax is not due at the outset of the rollover, it may be due when the property is ultimately sold. Taxpayers who are interested in pursuing a rollover should seek the advice of a lawyer and tax advisor as the rules are complex. Taxpayers should not undertake rollovers without first considering the implications of land transfer taxes, sales taxes, the tax on split income rules, attribution, paid-up capital reductions, non-resident transferors, non-arm’s-length tax rules, and price adjustment clauses in cases where the FMV of assets is uncertain.
Richard Wong is a tax manager in the technology and private company services practice at PwC’s Vancouver office. He is also an instructor at BCIT, Douglas College, and Kwantlen Polytechnic University. Richard would like to thank Iain Morris, CPA, CA, (a partner at PwC Vancouver) for his advice, support, and guidance on this article.