The section 85 “rollover” under the Income Tax Act is a provision that allows you to transfer property to your corporation without immediate tax consequences. That is, you can transfer it in without realizing a gain, or with realizing a partial gain.
When the rollover applies
The rollover applies if you transfer a property (eligible property, as described below), to a taxable Canadian corporation, and you receive at least one share back as consideration for the transfer.
You and the corporation must file a joint election, by the earlier of your filing-due date and the corporation’s filing-due for the year of the transfer. A late election is allowed if made within three years of the earlier date, or later if the CRA allows it. However, a late election is subject to monetary penalties.
Eligible property includes:
- Capital property, other than real estate owned by a non-resident (except a non-resident selling a business in certain circumstances);
- Inventory other than land inventory; and
- Canadian or foreign resource property.
Effect of rollover
In the joint election, you specify an “elected amount”, which becomes your proceeds of disposition of the property and the corporation’s cost of the property. Therefore, for example, if the elected amount equals your cost amount of the property for tax purposes, you will have no gain or loss on the transfer; this explains why the transfer takes place on a tax-free “rollover” basis.
However, there are limits on the elected amount and other rules come into play as discussed below.
In addition, the elected amount forms your cost of the property received from the corporation in consideration for the transfer of the property. If you receive shares and non-share-consideration (the latter is often called “boot”) from the corporation, the elected amount is first allocated to the boot, next to any preferred shares received, and last to any common shares received from the corporation.
Example 1
You transfer eligible property to a taxable Canadian corporation. Your tax cost of the property was $100,000 and its fair market value is $300,000. You receive back from the corporation $40,000 worth of boot and 100 common shares.
If your elected amount is $100,000, you will have no gain or loss on the transfer, since your tax cost of the property was $100,000.
The corporation’s cost of the property is $100,000.
Your cost of the boot is $40,000. Your cost of the common shares is $60,000 (the $100,000 elected amount minus the $40,000 allocated to the cost of the boot).
Basic limits on the elected amount
There are three basic limits, although other rules can apply to adjust the three limits.
First, the elected amount cannot exceed the fair market value of the property that you transfer to the corporation.
Second, subject to the first rule, the elected amount cannot exceed the fair market value of the boot that you receive from the corporation. Since this rule is subject to the first rule, if the fair market value of the boot exceeds the fair market value of the property transferred to the corporation, the elected amount cannot exceed the latter amount (but this may cause tax problems; see “Other considerations”, below).
Third, the elected amount generally cannot be less than the lesser of the fair market value of the property and the tax cost of the property. In the case of non-depreciable property, the cost is the adjusted cost base, and for inventory it is the cost. For depreciable property of a class (i.e. property subject to capital cost allowance or tax depreciation), it is the lower of the undepreciated capital cost of the class and the cost of the property (with possible adjustments).
Example 2
Like Example 1, you transfer eligible property to a taxable Canadian corporation. Your tax cost of the property was $100,000 and its fair market value is $300,000. You receive back from the corporation $40,000 worth of boot and 100 common shares.
If you try to elect an amount of $80,000, under the third rule above it will be increased to your tax cost of the property of $100,000. Therefore, the results will be the same as under Example 1.
If you try to elect an amount of $320,000, under the first rule the elected amount will be reduced to the fair market value of the property of $300,000. In such case, your proceeds and the corporation’s cost of the property will be $300,000 (so you will realize a $200,000 capital gain). Your tax cost of the boot will remain $40,000, and the tax cost of your common shares will be $260,000 (the $300,000 elected amount minus the $40,000 allocated to the cost of the boot).
Other considerations
As noted above, if the fair market value of the boot you receive from the corporation exceeds the fair market value of the property you transferred into the corporation, the elected amount limit is the latter amount rather than the former amount. However, in such case, you will be required to include the excess of the fair market value of the boot over the elected amount as a “shareholder benefit”, which is fully included in income and not treated as a capital gain. That is not good, to say the least.
For example, say you transfer property to the corporation whose fair market value is $100,000, and elect $100,000 and receive back $120,000 of consideration from the corporation. In such case, the excess $20,000 will be added to your income as a shareholder benefit (essentially, you’ve extracted an extra $20,000 in value from the corporation and you have to pay tax on it).
On the other hand, if the fair market value of the property you transfer to the corporation exceeds the greater of the elected amount and the fair market value of the total consideration received from the corporation, and it is reasonable to conclude that the difference is a benefit that you wished to confer on a related person, the elected amount is bumped up to the fair market value of the property.
For example, say you and your spouse (a related person) are each 50% shareholders of a corporation. If you transfer property to the corporation that is worth $100,000 and elect $80,000 and receive back only $80,000 of consideration, it may be reasonable to conclude that the $20,000 difference is a benefit you wished to confer on your spouse as the other common shareholder. If so, the excess $20,000 will be added to the elected amount to increase it and your proceeds of disposition of the property to $100,000.
Transfer of shares in one corporation to another corporation
The definition of “eligible property” includes capital property, which can include shares in a corporation.
Thus, you can use the section 85 rollover if you sell shares in one corporation (“subject corporation”) to another corporation (“purchaser corporation”).
However, adverse tax consequences may result if you are non-arm’s length with the purchaser corporation, and after the transfer the purchaser corporation controls the subject corporation or owns more than 10% of the shares of the subject corporation on a fair market value and votes basis. A non-arm’s length purchaser corporation can include a corporation that you control, a corporation that a related person controls (such as your spouse, child, or parent), among others.
In such case, if you receive boot from the purchaser corporation as part or whole consideration for the sale of the subject shares, you may have a deemed dividend instead of a capital gain. Generally, instead of a capital gain, you will have a deemed dividend if the fair market value of the boot exceeds the greater of the paid-up capital and your “hard” adjusted cost base in respect of the subject shares that you transferred. (There may be other calculations involved; this is a simplified explanation.) The paid-up capital of the subject shares is generally the after-tax amounts paid for the shares on their original issuance. To avoid double taxation, the amount of the deemed dividend is subtracted from your proceeds of disposition of the subject shares.
Example
You own shares in XCorp with an adjusted cost base and paid-up capital of $100, and a fair market value of $100,100. You transfer the shares to a non-arm’s length YCorp and elect at $100,100, thus apparently triggering a $100,000 capital gain (you might do this if you had capital losses to offset the gain, or the shares were eligible for the capital gains exemption). YCorp then controls XCorp.
For consideration on the transfer, you receive back shares in YCorp and boot worth $100,100.
The $100,100 value of the boot in excess of $100, or $100,000, is a deemed dividend. Your proceeds on the disposition of the XCorp shares are reduced to $100.