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Tax Article

Tax-deferred transfer of Assets Section 85 Rollovers

Published: 2011-06-23

A Section 85 rollover allows for a tax-deferred transfer of assets to a corporation provided the consideration received includes shares of the corporation. The following are some tips and traps to consider when using Section 85.

Incorporate for tax deferral - The profits of a corporation are subject to a 15.5% small business tax rate whereas highest personal tax rate is 46%. The taxpayer could transfer the business assets to a corporation using Section 85 and retain 30% more of its profits each year to fund capital expenditures and pay down debt.

Sale of proprietorship - If a prospective purchaser were willing to buy shares, a proprietor could transfer business assets to a corporation using Section 85 immediately before the sale and claim the $750,000 capital gains deduction on a sale of shares.

Goodwill and other unrecorded assets - Any asset not included on a Section 85 rollover is deemed disposed of at fair value. A late-filed or amended election can be filed in certain circumstances. If transferring a business, advisable to elect on goodwill and other assets for at least $1 and include a price adjustment clause in the agreement.

Depreciable property - Where multiple properties of the same depreciation class are disposed of, the order of disposition designated can have an impact on taxes. A detailed numerical example is provided by the Canada Revenue Agency in paragraph 15 of Information Bulletin 291R3.

Accounts receivable - An election under Section 22 on the transfer of a business allows a corporation to claim a fully deductible bad debt in the future as opposed to capital loss treatment for an election made under Section 85.

Eligible property - Real property inventory is not eligible for Section 85 rollover. Liabilities assumed exceed tax cost of assets - The elected amount can not be lower than greater of non-share consideration (`boot`) or tax cost. If liabilities exceed the tax basis of assets, the elected amount equals the liabilities and tax consequences will arise.

Shifting cost basis of shares - The cost basis of consideration received on Section 85 rollover is allocated firstly to non-share consideration, secondly to preference shares and finally to common shares. If a particular class of shares is to be sold, it may be advisable to isolate the total cost basis in that particular class of shares using Section 85.

Consideration received - The fair value of property disposed of to a corporation must equal the fair value of consideration received. If excess consideration is received, it is considered a shareholder benefit. If insufficient consideration is received and there are other shareholders related to the transferor, the elected amount is increased to reflect the amount of value gifted.

Reduction of paid-up capital - Where a taxpayer transfers shares of a corporation back to it in exchange for new shares, the paid-up capital reduction provisions in Section 85 are not always effective. A numerical example of how a taxable deemed dividend can result is provided in paragraph 29 of Information Bulletin 291R3. In a non-arm's length situation, this problem can be remedied by having the directors pass a resolution setting the paid-up capital. In an arm's length situation, the answer is not as clear.

Section 84.1 - A taxpayer can not sell his shares to a non-arm's length corporation (whether under Section 85 or not) and extract the proceeds tax-free if the tax basis of the shares have been increased as a result of claiming the capital gains deduction or v-day appreciation. That portion of the proceeds would be deemed to be a taxable dividend.

Section 85 freeze - If crystallizing capital gains deduction on transfer, ITA 110.6(6) mandates that the disposition be reported on transferee's personal tax return in order to use the capital gains deduction.

Offsetting personal / corporate tax attributes - An asset with an accrued gain can be transferred by a taxpayer to a corporation under Section 85 and the gain can be recognized and offset by losses of the corporation. Alternatively, a taxpayer can transfer a property with an unrealized loss to a corporation and the corporation can trigger that loss to offset its own gains. These techniques are only effective when the individual and corporation are affiliated.

Date updated: June 23, 2011

This information is provided by Crawford, Smith and Swallow Chartered Accountants LLP for informational purposes only and must not be relied upon as professional advice. Readers should not initiate any action on the basis of this information without the consultation and direction of a qualified professional advisor.