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 85 of the Income Tax Act (Canada) (“ITA”) offers a valuable tax-planning tool for business owners, allowing them to transfer assets to a corporation without triggering immediate taxable gains. Commonly known as a “section 85 rollover,” this provision allows business owners to defer capital gains taxes and optimize their corporate structure by “rolling over” assets to a corporation at a chosen value within certain limits.
This guide provides an overview of how section 85 works, its benefits, and the requirements for successful implementation.
- What is a Section 85 Rollover?
A section 85 rollover allows taxpayers to transfer eligible assets to a Canadian corporation at an “elected amount” agreed upon between the transferor and the corporation. This elected amount can be set at a level that defers immediate tax consequences. The transferred assets are then received by the corporation in exchange for shares or other consideration.
The purpose of a section 85 rollover is to defer capital gains and recapture taxes that would otherwise be due if the assets were sold at their fair market value. It’s a strategic tool frequently used in:
Corporate Reorganizations: Business owners may roll over assets to a newly formed corporation to facilitate growth or streamline their corporate structure.
Estate Planning and Succession: Section 85 allows business owners to transition assets to family members or key employees through a corporation while deferring taxes.
Divisive Reorganizations: Taxpayers can split a corporation’s assets among different entities while deferring taxes.
- Eligible Assets for Section 85 Rollovers
Under section 85, not all assets qualify for rollover treatment. Eligible assets include:
• Capital Property: Real estate, equipment, and investments.
• Eligible Capital Property: Intangible assets such as goodwill.
• Inventory: Certain types of inventory may qualify.
• Resource Properties: Including Canadian and foreign resource properties.
Certain assets, like cash, receivables, and accounts, generally do not qualify for a section 85 rollover. The Canada Revenue Agency (CRA) specifies that each transfer must meet the eligibility requirements set out in the ITA to qualify for rollover treatment.
- How a Section 85 Rollover Works
The process for completing a section 85 rollover involves several steps to ensure compliance and maximize tax benefits. Here’s a high-level look at how it works:
Identify Assets for Transfer: Determine which assets qualify for a section 85 rollover and assess the current fair market value (FMV) of these assets.
Choose the Elected Amount: Select an “elected amount” between the original cost base and FMV of the asset. The elected amount is critical, as it determines the deferred tax impact:
• Tax-Deferred Amount: By setting the elected amount at the asset’s original cost base, taxpayers can defer all gains and taxes.
• Partial Tax Recognition: Taxpayers can choose a higher elected amount to trigger partial tax recognition.
Complete and File Form T2057: To formalize the transfer, both the transferor and the corporation must complete CRA Form T2057, “Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation.” This form documents the elected amount and provides the necessary details of the rollover.
Issue Consideration in Exchange for Assets: In return for the transferred assets, the corporation issues shares or other consideration to the transferor. If non-share consideration (such as promissory notes) is issued, it is referred to as “boot” and may trigger tax consequences if it exceeds certain limits.
- Benefits of a Section 85 Rollover
Section 85 rollovers are popular in corporate tax planning due to their flexibility and tax deferral benefits. Some key advantages include:
Deferral of Capital Gains Taxes: By selecting an appropriate elected amount, taxpayers can defer capital gains taxes until a later date, preserving cash flow and maximizing asset value.
Flexible Asset Valuation: Taxpayers have flexibility in choosing the elected amount, allowing them to optimize their tax position based on current and future tax considerations.
Estate and Succession Planning: Section 85 allows business owners to transfer assets to successors or heirs through a corporation without incurring immediate tax liabilities, making it ideal for intergenerational wealth transfer and family business succession.
Corporate Structuring: Rollovers can help business owners restructure or separate corporate assets efficiently, facilitating mergers, spin-offs, and other reorganizations without triggering immediate tax consequences.
- Key Considerations and Limitations
While section 85 rollovers offer valuable tax advantages, they come with strict rules and considerations to ensure compliance with the ITA. Key limitations include:
Share Valuation Rules: The FMV of the shares issued must align with the value of the assets transferred. Overvaluation or undervaluation of shares can lead to CRA scrutiny and potential tax issues.
Boot Rules: If the corporation issues non-share consideration (boot), any amount exceeding the original cost base of the transferred assets can trigger immediate tax on the gain.
Attribution Rules: When transferring assets to a related party (such as a spouse or family member), attribution rules may apply, resulting in income being attributed back to the transferor. These rules can complicate family-owned business succession if not properly planned.
Anti-Avoidance Provisions: The ITA contains general anti-avoidance rules (GAAR) to prevent taxpayers from using section 85 rollovers solely to avoid taxes without a legitimate business purpose. Transactions must demonstrate a sound commercial rationale to qualify.
Proper Filing of Form T2057: Failure to correctly complete and file Form T2057 by the prescribed deadline can invalidate the rollover, leading to immediate tax recognition. Form T2057 must be filed on or before the earlier of the transferor’s or transferee corporation’s tax return due date for the year in which the transfer occurred.
- Practical Examples of Section 85 Rollovers in Action
Example 1: Real Estate Incorporation
An Ontario business owner holds a rental property with a significant increase in value. By transferring the property to a newly formed corporation via a section 85 rollover, they can defer capital gains tax until a later sale, allowing them to retain cash flow and enhance liquidity.
Example 2: Family Business Succession
A family-owned manufacturing business seeks to transfer ownership to the next generation. Using a section 85 rollover, the current owners transfer shares and goodwill to a corporation owned by their children. This enables an efficient succession process, with deferred tax liability and continuity of business operations.
- Conclusion
Section 85 rollovers under the ITA are a powerful tax-planning tool that can help business owners optimize their corporate structure, plan for succession, and achieve tax deferral on asset transfers. However, rollovers require careful planning and attention to tax compliance rules, as errors in filing or valuation can lead to immediate tax consequences.
Working closely with corporate and tax professionals and understanding the specific requirements of section 85 can ensure a successful rollover and unlock significant tax advantages. Properly executed, a section 85 rollover can provide strategic benefits for both short-term financial planning and long-term business growth.
Sources:
Canada Revenue Agency
Form T2057: Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation, CRA.Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), Section 85.
Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), Section 85.