This resource has been prepared by Nicholas dePencier Wright of Wright Business Law for educational purposes. This information is current as of the date of writing and does not constitute legal advice, which should be obtained prior to relying on anything herein.
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Section 86 of Canada’s Income Tax Act (ITA) provides an effective tax-planning tool for business owners seeking to exchange shares within a corporation without triggering immediate tax consequences. Known as a “section 86 share exchange,” this provision allows taxpayers to swap old shares for new shares in the same corporation, often as part of a corporate reorganization, restructuring, or estate planning. By facilitating a tax-deferred exchange, section 86 helps shareholders manage corporate transitions while minimizing tax impacts.
For legal and tax professionals advising Canadian corporations, understanding the mechanics and benefits of section 86 share exchanges is essential. This guide covers the basics, applications, and important considerations of implementing a section 86 share exchange.
- What is a Section 86 Share Exchange?
A section 86 share exchange allows a shareholder to exchange their existing shares in a corporation for new shares of the same corporation under certain conditions without realizing an immediate gain or loss. The primary purpose of this exchange is to facilitate corporate reorganizations or succession planning without triggering tax liability that would normally arise from a change in share ownership.
In a section 86 exchange, the “old shares” (originally owned) are replaced with “new shares” under terms that align with section 86’s requirements. This provision is frequently used in situations where a corporation wants to restructure its share class, provide different types of shares to existing shareholders, or transfer ownership to the next generation as part of an estate plan.
- When Is Section 86 Useful?
Section 86 share exchanges are commonly employed in a range of business situations:
Corporate Reorganization: Restructuring the share classes in a corporation to allow for different rights, such as voting rights, dividend preferences, or liquidation preferences, can make the company more flexible for strategic goals, like raising capital or implementing a new corporate structure.
Estate and Succession Planning: Business owners may use section 86 to “freeze” the current value of their shares, exchanging common shares for fixed-value preferred shares. This locks in the present value for the owner and allows future growth to accrue to new common shares held by successors, such as family members.
Business Valuation and Tax Planning: Section 86 allows business owners to defer tax on the share exchange, which can help with managing tax liability in a way that is tax-efficient and better suited to long-term planning.
- How Does a Section 86 Share Exchange Work?
The section 86 share exchange process generally involves the following steps:
Identifying the Need for a Share Exchange: A business owner or corporation assesses whether a share exchange aligns with corporate goals, such as restructuring or succession planning. The corporation determines which existing shares (“old shares”) will be exchanged and designs a new share class with desired attributes.
Exchanging Old Shares for New Shares: The old shares are exchanged for new shares of the same corporation, which may have different rights or restrictions than the original shares. The old shares are cancelled, and the new shares are issued under the conditions of the exchange.
Tax-Deferred Treatment of the Exchange: For the share exchange to qualify under section 86, certain requirements must be met, ensuring the exchange does not trigger an immediate gain or loss. If eligible, the tax basis of the old shares is transferred to the new shares, and any gain or loss is deferred until the new shares are sold or disposed of in the future.
- Key Requirements of a Section 86 Exchange
For an exchange to qualify under section 86, several conditions must be met:
Same Corporation: The exchange must occur within the same corporation. A section 86 exchange does not apply to share exchanges involving different corporations.
Exchange of Shares Only: The exchange must involve an exchange of shares for other shares, not for cash or other consideration. However, “boot” (non-share consideration) may be included, but it can trigger partial tax consequences.
New Shares in Place of Old Shares: The exchange must result in the old shares being effectively replaced by new shares that continue to represent an ownership interest in the corporation, albeit potentially with different rights and restrictions.
Fair Market Value and Tax Basis: The tax basis of the old shares is transferred to the new shares, which defers any gain or loss until the disposition of the new shares. It is essential that the fair market value of the shares aligns with the elected values to avoid CRA scrutiny.
These conditions ensure that section 86 is used for genuine corporate restructuring and not for tax avoidance. Consulting with a tax professional is advised to ensure compliance with all requirements and to maximize the benefits of the rollover.
- Benefits of a Section 86 Share Exchange
Section 86 exchanges provide several strategic advantages:
Tax Deferral: By deferring gains, taxpayers can avoid immediate tax consequences and continue to control cash flow, which can be crucial for corporate planning.
Flexible Corporate Structuring: Section 86 allows for the creation of different share classes with tailored attributes, such as voting rights, dividends, or liquidation preferences, providing flexibility for strategic growth or family planning.
Value Freezing for Estate Planning: Section 86 is often used to freeze the value of the current ownership stake, which allows the transfer of future growth to other shareholders (e.g., children or heirs). This can reduce future tax liability on the estate and facilitate business continuity.
Control over Future Tax Events: By deferring tax to the point of eventual sale of the new shares, section 86 provides business owners with greater control over when they realize gains and losses, optimizing their tax planning.
- Key Considerations and Potential Pitfalls
Section 86 exchanges can be complex, and it’s important to be aware of certain challenges:
Accurate Valuation: An accurate fair market valuation of both old and new shares is essential. If the CRA determines that the elected amount is incorrect or unrealistic, it may assess the transfer at fair market value, leading to immediate tax consequences.
Potential for “Boot” Tax Consequences: If any part of the exchange includes non-share consideration (boot), this portion may trigger tax consequences. It’s essential to structure the transaction carefully if boot is involved.
Compliance with Anti-Avoidance Rules: The CRA applies General Anti-Avoidance Rules (GAAR) to prevent abusive tax avoidance. A section 86 exchange must demonstrate a legitimate business purpose beyond simple tax deferral.
Filing Requirements: There is no specific election form like Form T2057 for section 86 exchanges, but the details of the transaction must be clearly reported in the corporation’s and shareholder’s tax returns. Failure to properly document the exchange can lead to CRA scrutiny.
- Practical Example of a Section 86 Share Exchange
Example: An Ontario business owner, Jane, owns 100 common shares in her corporation, ABC Inc. These shares have appreciated significantly in value since Jane acquired them. Jane wants to transition the future growth of the corporation to her son, who is active in the business, while retaining control and securing her current value.
Using section 86, Jane exchanges her common shares for fixed-value preferred shares, effectively “freezing” the value of her interest in the corporation. ABC Inc. then issues new common shares to her son, allowing future growth in the company’s value to accrue to him. This structure achieves Jane’s succession goals, defers her tax obligations, and provides a clear path for her son to benefit from future appreciation.
- Conclusion
Section 86 share exchanges are a valuable mechanism within Canada’s Income Tax Act for business owners to restructure their corporate holdings, plan for succession, and defer taxes. By allowing tax deferral on share exchanges within a corporation, section 86 supports flexible, tax-efficient strategies for corporate reorganization and estate planning.
As with any tax-deferral mechanism, section 86 requires careful planning, accurate valuation, and attention to CRA requirements to avoid unintended tax consequences. Consulting with legal and tax advisors can help business owners structure these exchanges effectively, achieving their strategic goals while complying with the ITA.
Sources:
Canada Revenue Agency
Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), Section 86.
Canadian Tax Foundation