Introduction – Tax-Deferred Transfers of Property to a Corporation
Section 85 of the Federal Income Tax Act (“Tax Act”), also known as a rollover provision, outlines the conditions required for a tax-deferred transfer of eligible property by a taxpayer (“transferor”) to a taxable Canadian corporation (“transferee”). Rollover provisions are a valuable tax planning tool because they allow taxpayers to defer all or part of the tax liability that may otherwise immediately arise from the disposition of property through the election of a transfer price below fair market value (“FMV”).
Subsection 85(1) is utilized by sole proprietors who have built successful businesses and would like to incorporate to take advantage of lower small business tax rates and limited liability protection. This provision then allows them to transfer eligible property to the corporation on a tax-deferred basis. In addition, this provision is useful for corporations looking to reorganize their assets into a more tax-efficient structure by transferring assets or shares into incorporated holding companies. This article will provide an overview of the requirements of a tax-deferred transfer of property to a corporation under section 85 of the Tax Act.
Why is Section 85 Necessary for a Tax-Deferred Transfer of Property to a Corporation?
By default, under subsection 69(1) of the Tax Act, a taxpayer who acquires property from a non-arm’s length party at an amount greater than its FMV is deemed to have acquired it at its FMV. Conversely, where a taxpayer disposes of property to a non-arm’s length party for less than its FMV, or to anyone as a gift, the proceeds of disposition are deemed to equal the FMV of the property. Lastly, where a taxpayer acquires property by way of gift, bequest or inheritance or because of a disposition that does not result in a change of the beneficial ownership, the taxpayer is deemed to acquire the property at its FMV.
When a taxpayer transfers property to a taxable Canadian corporation, and both parties jointly elect to proceed under a subsection 85(1) rollover, she is exempt from the deeming rules of subsection 69(1). The tax deferral for the taxpayer continues until she disposes of the capital stock that she received as consideration for the property. Deferring taxation on the disposition of property is always advantageous where the FMV of the property at the time of disposition is greater than the cost of the property to the taxpayer.
What are the Requirements of a Subsection 85(1) Tax-Deferred Transfer of Property to a Corporation?
There are five key considerations for determining whether the subsection 85(1) rollover provision may be available to a taxpayer.
- Eligible Transferor. An eligible transferor is an individual, trust, or corporate taxpayer, or a partnership if all of the partners are Canadian residents. There are no general residence requirements for a transferor to be considered eligible, however there are restrictions on eligible property for non-residents. In the context of a section 85 rollover, non-residents may transfer capital property (excluding certain types of real property), certain types of inventory, Canadian and foreign resource property, and certain security or debt obligations. In the case of real property, a non-resident who is not an insurer may only transfer capital real property used during the year in a business carried on in Canada by that person.
- Eligible Transferee. An eligible transferee is a taxable Canadian corporation. This requirement ensures that any eventual disposition of the property by the transferee is taxable in Canada.
- Eligible Property. Eligible property is defined in the Tax Act, and includes capital property, inventory, and resource property. It is important to note that real property inventory is not included, as this would convert income to capital gains.
- Share Consideration. In consideration for the transfer of eligible property by the transferor to the transferee, the transferor must receive at least one share of the taxable Canadian corporation’s capital stock. The transferor may also receive non-share consideration (sometimes called boot) in addition to the capital stock, but it is not mandatory. There is flexibility in the value of the non-share consideration as long as it does not exceed the original cost of the eligible property, at which point capital gains would be realized.
- Joint Election. Both the transferor and transferee must file a joint election using Canada Revenue Agency (“CRA”) Form T2057 or T2058 in the case of partnerships. The joint election must be filed on or before the earlier of the tax return filing deadlines for transferor or transferee, with limited exceptions. For more information on the joint election filing requirements, please contact our top Toronto tax law firm.
Section 85 Elected Amounts
When filing a joint election, the transferor and transferee must choose an elected amount, which represents the proceeds of disposition for the transferor and the cost to the transferee corporation. The Tax Act prescribes the following upper and lower limits on the elected amount:
- The elected amount cannot exceed the FMV of the property at the time of the transfer.
- The elected amount cannot be less than the FMV of the non-share consideration received by the transferor.
- The elected amount cannot be less than the lesser of the FMV of the property and the cost amount of the property to the transferor at the time of disposition.
- Where ii. and iii. differ, the greater of the two amounts represents the lower limit.
For example, John is a sole proprietor and owns a building with a cost amount of $100,000, and FMV of $400,000. He would like to transfer the building to a taxable Canadian corporation, JCo, for Class A common shares and a note for $90,000 and file a subsection 85(1) joint election. The upper limit of the elected amount would be the FMV of the property, which is $400,000. The lower limit of the elected amount would be $100,000, which represents the cost amount of the property to the transferor at the time of disposition. The parties can choose an elected amount between $100,000 and $400,000. If the parties choose an elected amount of $100,000, the transfer will not immediately trigger capital gains tax liability for John because the proceeds of disposition would be equal to his cost amount for the building. For John, the cost of the JCo shares is the difference between the elected amount and the FMV of the non-share consideration.
Price-Adjustment Clauses in Section 85 Transfer Agreements
Selecting the appropriate elected amount is crucial, because the CRA can reassess the transfer and change the elected amount if it is incorrect. A reassessment of the elected amount may impose significant and immediate tax liabilities on the transferor. For this reason, agreements between non-arm’s length parties for transfers of property should include a Price-Adjustment Clause to provide for an adjustment in the transaction price in the event that the CRA or a court of law determines that the FMV or the cost of the property is greater or less than what was determined by the parties.
Pro Tax Tip – Valuation of Eligible Property
In preparing to file a joint election under subsection 85(1), it is wise to have a valuation done on the assets being transferred, particularly with respect to intangible assets. Intangible assets, like goodwill, patents, and trademarks are often transferred between sole proprietors and corporations but their value may not be accurately reflected on the balance sheet, if at all. A reasonable assessment of their FMV may help avoid reassessment by the CRA down the line. The section 85 rollover agreement is a technical tax document and our experienced Canadian tax lawyers can assist you with structuring and documenting the section 85 rollover agreement.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."