Under the Income Tax Act, you are allowed to transfer property to your corporation (actually, to any taxable Canadian corporation) on a tax-free “rollover” basis. It is called a rollover because your tax cost of the property becomes your proceeds of disposition, resulting in no gain for you, and the corporation takes over your tax cost of the property – hence the tax cost basically “rolls over”.
You need to receive at least one share in the corporation as consideration for the transfer. There are other conditions. The main conditions are described below.
The rule, found in section 85 of the Income Tax Act, allows you to elect an amount (“elected amount”), which becomes your proceeds of disposition. Often, you would elect an amount equal to your tax cost of the property. But you can elect a different amount, subject to certain limits.
The election is actually a joint election between you and the corporation. The election must be filed by the earlier of your tax filing date and the corporation’s tax filing date for the year of the transfer. Late elections are allowed, but typically with penalties.
Elected amount
The limits on the elected amount are as follows.
- It cannot be greater than the fair market value of the transferred property;
- It cannot be less than the fair market value of non-share consideration you receive from the corporation, if any; and
- It cannot be less than the lesser of the fair market value of the transferred property and your tax cost of the property.
The elected amount becomes your proceeds of disposition of the property transferred to the corporation. The elected amount also becomes the cost of the property for the corporation. Furthermore, the elected amount, minus the fair market value of any non-share consideration you receive from the corporation, becomes the cost of your share(s) in the corporation received on the transfer.
So if you elect at your tax cost of the property, you will have no gain and no tax payable on the transfer.
Why would you elect an amount greater than your tax cost of the property, since that will trigger a capital gain or perhaps other income inclusion? There are at least a couple of reasons. First, you may have capital losses that could offset those gains, resulting in no tax for you, but with a bumped-up cost of the property for the corporation and bumped-up cost of the shares you receive from the corporation (and thus a lower capital gain some time in the future). Second, if you transfer “qualified small business corporation shares” or “qualified farm or fishing property” to the corporation, you may be eligible for the capital gains exemption, which would shelter your tax on the transfer, while again bumping the cost of the property for the corporation and the shares you receive back from the corporation.
Unfortunately, you normally cannot trigger a loss on the transfer by electing an amount less that the tax cost of the property (if the fair market value of the property is less than the tax cost). In particular, you cannot trigger a loss if you and the corporation are “affiliated”. For these purposes, you and the corporation will be affiliated if you or your spouse controls the corporation, either alone or together, or if you are part of an affiliated group that controls the corporation. Affiliation can also occur in other circumstances. “Control” normally means owning more than 50% of the voting shares in the corporation, although for the affiliated rules it also includes so-called de facto control (control in fact).
Eligible property
To qualify for the rollover, the property you transfer to the corporation must be an “eligible property”. This includes most types of depreciable property used in a business, and non-depreciable capital property, which includes things like real estate and shares in another corporation. It also includes inventory other than real estate inventory.
Example of rollover
You own all 100 shares in a private corporation (Opco). You transfer the shares to a holding corporation (Holdco) in exchange for 100 shares in Holdco and therefore own all the shares in Holdco.
The tax cost of your Opco shares was $10,000. The fair market value of the shares is $300,000 at the time of the transfer.
Assume you elect at $10,000. Your proceeds will be $10,000, resulting in no capital gain. Holdco’s cost of the Opco shares is $10,000, as is the cost of your shares in Holdco.
Deemed dividend trap
If instead you receive some non-share consideration from Holdco on the transfer of the Opco shares, you may have a deemed dividend instead of a capital gain. Generally, you will have a deemed dividend to the extent that the fair market value of the non-share consideration exceeds the greater of the paid-up capital and your tax cost of the Opco shares. (There may be some adjustments.) The paid-up capital of the Opco shares will normally reflect the after-tax amounts paid on for those shares when they were first issued.
The culprit is section 84.1, discussed in the previous article above. However, in this example, the Bill-208 amendments discussed in that article will not apply, so the deemed dividend will stand.
As noted, the deemed-dividend rule presents at least two potential problems. First, the highest marginal tax rates applicable to dividends are currently much higher than the highest tax rates on capital gains. Second, the deemed dividend is not eligible for the capital gains exemption.
Example of deemed dividend trap
Assume the same facts as above, except that you elect at $210,000. As noted earlier, you might think that you can use existing capital losses to offset any capital gain, or perhaps the Opco shares can qualify for the capital gains exemption.
Your cost of the Opco shares was $10,000, and assume that is also their paid-up capital. In addition to the 100 shares you receive in Holdco, you receive non-share consideration in the form of a $210,000 promissory note from Holdco (which would allow you to extract that much cash from Holdco at no tax cost in the future by having it pay off the note).
In this case, you will have a $200,000 deemed dividend ($210,000 promissory note minus the $10,000 amount).
The only consolation is that the deemed dividend reduces your proceeds of disposition on the transfer of the Opco shares, so you won’t have a capital gain as well.
The deemed dividend rule does not apply if you are “arm’s length” with Holdco, or generally if Holdco owns 10% or less of the shares in Opco on a votes and value basis (obviously, not the case in the example above).