One of the most commonly used tax planning tools available to Canadian taxpayers is a section 85 rollover and it should be considered whenever there is a disposition of property, which has appreciated in value, to a corporation. Section 85 permits eligible transferors to elect jointly with a transferee corporation, on the transfer of property, to fix an “agreed amount” which both parties use to account for the transfer for income tax purposes. It is most useful where the value of the property is greater than its tax cost and the parties wish to defer recognition of the income or gain that would otherwise be realized on the transfer. By electing under section 85, and subject to the limits it imposes, the agreed amount becomes the proceeds of disposition to the transferor and the starting point in determining the tax cost of the property to the transferee. The election therefore allows the parties to manage (and typically defer) the tax that would otherwise arise on transfers to corporations. The key considerations in determining whether an election under section 85 is available are outlined below.
Eligible transferor
The election is available on a transfer of property by an individual, a trust or a corporation. There is no requirement that any of these transferors be resident in Canada, but there are restrictions on the types of property on which a non-resident can elect under section 85. The election is also available where the transferor is a partnership, provided that all of the partners are Canadian residents. The types of property which are eligible for the election on a transfer by a partnership differ slightly from those that qualify otherwise.
Eligible transferee
The transferee must be a taxable Canadian corporation. This limitation ensures that the transferee will be taxable in Canada on a subsequent disposition of any property transferred via a section 85 election.
Eligible property
The election can only be made with respect to eligible property, which includes, but is not limited to, both depreciable and non-depreciable capital property, resource property, and inventory.
Consideration
The election is only available if the consideration the transferor receives for the transferred property includes at least one share of the capital stock of the transferee corporation. Beyond this limitation, there is a great deal of flexibility in the type of consideration that can be received. There are anti-avoidance rules to prevent the removal of corporate surplus on a section 85 transfer, most notably section 84.1 noted below and the possible application of section 84.1 should be checked anytime section 85 is used.
Examples
A section 85 rollover is most useful in the following situations:
Incorporation of a business – Used when a sole proprietor business has become profitable and the business owner no longer needs all the after-tax cash flow that is generated by the business. The taxpayer can incorporate and transfer the business assets into a corporation in order to take advantage of the lower small business tax rates (12.2% in Ontario). By electing under section 85, the taxpayer can transfer the business assets to the corporation at cost so that no income tax will arise on the transfer.
Family business planning – Used when shareholders of a profitable family business would like to introduce their children as shareholders so as to be able to pay dividends to them and to allow them to participate in the future growth of the company. As shares need to form part of the consideration for a section 85 to be valid, this strategy would involve setting up a holding company prior to performing the rollover.
The splitting-up of an incorporated business into separate corporations to allow shareholders to manage their interests independently – While there is no equivalent to section 85 permitting the direct tax-deferred split-up of a corporation, planning is available using corporations and section 85 which will accomplish this result indirectly. The planning is referred to as a “butterfly” as when the various transactions involved are drawn on a piece of paper, the result resembles a butterfly.
It is important to note that you must be mindful of section 84.1 of the ITA anytime the use of section 85 is considered as this may limit the amount of consideration that can be received. In addition to section 84.1, there are a lot of complex rules associated with section 85 rollovers and as such it comes as no surprise that the filing of improper section 85 elections is one of the major sources of claims against tax professionals.
