Section 85 Rollovers

A section 85 rollover allows Canadian taxpayers to transfer appreciated property to a taxable corporation without triggering the associated capital gains tax.

In other words, a section 85 election allows a taxpayer to defer all or part of the tax consequences that would normally arise on the transfer.

This post describes section 85 rollovers and provides two examples of how they might be used.

Investors use section 85 rollovers for a variety of reasons, including:

• Sole proprietors who are incorporating
• Capital gains crystallization
• Estate & succession planning
• Transfer of assets between businesses

What is eligible?

The types of assets that are eligible for a section 85 rollover include:

• Real estate
• Stocks
• Business inventories
• Resource properties
• Most other depreciable and non-depreciable capital property

Who is eligible?

For a section 85 rollover to qualify, both sides of the transaction must meet certain requirements. The transferor must be any taxpayer including individuals, corporations, or trusts. The transferee must be a taxable Canadian corporation.

Consideration

The transferor must receive shares of the transferee as part of the consideration for the section 85 rollover to qualify. The transferor may also receive non-share consideration, commonly referred to as “boot”. The fair market value (“FMV”) of the boot received cannot exceed the tax cost of the property transferred, otherwise it will trigger a capital gain. Common non-share consideration includes cash, or a note receivable. The FMV of the transferred assets must equal the FMV of the total consideration received.

Filing Requirements

Section 85 rollovers must be completed by sending Form T2057 to CRA. This form is sent separately from the annual return of the tax filer. This form is due the earlier of the income tax return filing deadline of the transferor or transferee for the taxation year that the transfer occurred.

Double Taxation

Taxpayers should be aware of the risk of double taxation by way of capital gains following a section 85 rollover. Consider an asset that is transferred to a corporation using a section 85 election. Then, this same asset appreciates in value and is subsequently sold by the corporation. This triggers a capital gain for the corporation. Further, consider the shareholder of that corporation who receives shares in the corporation as consideration for the asset. These shares could also be worth more than when they were received. There are ways to mitigate this double taxation risk including strategies to dispose of the shares in the corporation including a pipeline transaction at the end of the shareholder’s life.

Example: Transfer Stocks

An individual Canadian tax payer has a portfolio of US stocks with a FMV greater than $60,000 USD. This potentially makes their estate vulnerable to filing a US estate tax return, so to avoid this requirement, they decide to hold their US stocks inside of a Canadian corporation instead.

Most of the stocks in this person’s US stock portfolio have appreciated, so selling the stocks, or transferring them into their holdco would normally trigger capital gains taxes. However, using a section 85 rollover avoids this.

The taxpayer’s stock portfolio has an adjusted cost base (“ACB”) of $4,500,000 and FMV of $10,200,000. However, 12 of the individual stocks have appreciated, while 3 of them have a FMV lower than their ACB. The taxpayer’s holdco has 100 common shares currently outstanding with a total FMV of $5,000,000. Therefore, the FMV of each common share is $50,000.

The taxpayer opens a brokerage account for their holdco then transfers the 12 appreciated stocks with a combined ACB of $4,000,000 and a FMV of $10,000,000 to their holdco using a transfer form provided by their brokerage. In exchange, the paypayer issues 200 common shares of their holdco to themselves ($10,000,000 ACB / $50,000 per share). The taxpayer now owns 300 common shares of their holdco.

The holding company now owns the $10,000,000 US stocks and the taxpayer has received 200 shares of consideration.

Note, the shareholder has not avoided paying tax on the accrued gain eventually, they have just shifted this liability to their holdco and deferred it. After the transfer, the holdco has a FMV of $15,000,000 ($5 mil real estate, $10 mil US stocks), and 300 common shares outstanding. The holdco owns a stock portfolio with an ACB of $4,000,000 and a FMV of $10,000,000.

With the remaining 3 stocks which have FMV below their ACB, the taxpayer decides to sell these securities and trigger their associated capital losses.

Example: Transfer Duplex

An individual Canadian taxpayer has been a landlord for many years. During their early adult life, they acquired a duplex and successfully managed it for the past 20 years. Now, the landlord’s adult children are ready to take responsibility for this property, so the family has decided to re-organize the way the property is held as part of a succession plan.

The property is currently held inside a corporate holding company (“Oldco”) with an ACB of $500,000 and a FMV of $2,500,000. The oldco also owns a mortgage on property sold previously to a 3^rd party with a FMV of $2,000,000. So, a new corporate holding company is created (“Newco”) with fixed rate shares issued to the landlord father for a nominal amount and common (“growth”) shares issued to the landlord’s two adult children.

Using a section 85 rollover, the property is transferred to the Newco in exchange for $500,000 fixed rate shares of Newco and a $2,000,000 note from Newco with market rate terms. The $2,000,000 note is the “boot”.

This sale does not trigger any capital gains by the landlord’s Oldco. Instead, the Newco now owns the property with an ACB of $500,000 and a FMV of $2,500,000 and has provided consideration of $500,000 shares of Newco and a $2,000,000 note to Oldco. The share capital of Newco now includes the common shares issued to the adult children (possibly worth a nominal amount) and the $500,000 worth of fixed rate shares issued to Oldco. Oldco now owns $500,000 fixed rate shares of Newco, a $2,000,000 note from Newco, and remains the owner of a $2,000,000 mortgage from a 3^rd party.

The plan in this example is for Newco to redeem the fixed rate shares owned by Oldco as time goes by. Anyone transferring real estate should also make sure to avoid land transfer tax. There are a number of exceptions for paying land transfer, click here for examples.

Documentation

As you might realize based on the examples used in this post, section 85 rollovers require the taxpayer to keep good records. This includes keeping good records of the ACBs of the stocks & real estate in your personal portfolio, but also good records of your holdco including a share registry, issuing share certificates, the ACB/price of each share issued, etc.

Our family office provides extensive administration & documentation services to ensure that your financial records are kept in good standing. If you are interested in learning more about the services we provide, we will offer a complementary review of your record keeping process including recommendations for improvement. Please get in touch with us for more information.

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