Clients who own businesses often need to restructure their holdings to address changing financial and personal objectives. When that happens, there can be an embedded tax liability lying dormant in an asset that needs to be carefully considered before restructuring.
The Income Tax Act contains several provisions that allow a taxpayer to transfer title of an asset on a tax-deferred rollover basis. Section 85 is one such provision. It’s commonly used by taxpayers to defer all or part of the embedded tax liability that would otherwise arise when transferring eligible property to a taxable Canadian corporation (see “What is eligible property?”).
As part of the transfer, the transferor must become a shareholder of the receiving corporation, taking back at least one share of the transferee corporation as part of the consideration for the asset transferred. There’s a pre-determined range within which the parties can choose the elected transfer price (ETP).
Consider the following three scenarios where a section 85 transfer can be useful (see “Conditions for an S85 transfer”).
Scenario 1: Frank
He’s a dentist who is operating his practice as a sole proprietor. In the early years, this structure met his needs because he spent his entire net income on his lifestyle needs. Now, the practice’s net earnings exceed his personal spending.
Frank will incorporate a new corporation (ProCo), which he’ll operate as a professional corporation. He’ll transfer his equipment and office furniture to ProCo at an ETP equal to the tax cost of the assets, using section 85.
In exchange for his assets, Frank receives a promissory note from the professional corporation, equal to the tax cost of the assets, along with shares of ProCo.
Frank and ProCo must file a joint election (CRA form T2057), due by the earliest date either party must file an income tax return. Frank and his advisors will need to determine if any goodwill is attached to the dental practice, as it will also need to be transferred to the corporation at an elected transfer price.
The amount that Frank and ProCo choose as the ETP for each asset becomes Frank’s proceeds of disposition on the sale of each respective asset. The ETP also becomes ProCo’s tax cost of the assets. Table 1 shows how the Section 85 rollover would work.
Frank has transferred the dental equipment, office furniture and goodwill to ProCo in exchange for $75,000 of promissory notes and $65,000 of common shares.
The accrued gain (fair market value in excess of the tax cost) on each of these assets has been deferred and the gain is now embedded in Frank’s common shares of ProCo, which have a fair market value of $65,000 with an ACB of $1 (ETP less promissory notes).
Scenario 2: Betty
She’s an entrepreneur who has grown her marketing firm under a corporate structure, MarCo. MarCo’s success means the firm is accumulating capital in excess of its working capital needs. Betty fears that, soon, MarCo shares may no longer qualify for the capital gains exemption (CGE), so she’d like to crystalize her available CGE. She’d also like to protect accumulated assets from MarCo’s creditors. MarCo has a significant level of retained earnings.
Betty can use a section 85 rollover to crystalize her available CGE and protect excess cash from MarCo’s creditors. To do this, she’d incorporate a holding company (HoldCo) and transfer her MarCo shares to HoldCo, taking back HoldCo shares as consideration. Betty and Holdco jointly elect under section 85, choosing an ETP that triggers a capital gain on the disposition of her MarCo shares.
Let’s assume that the adjusted cost base (ACB) of Betty’s MarCo shares is $1,000. She would jointly elect, with Holdco, a transfer price of $814,600 (2015 capital gains exemption of $813,600, plus her $1,000 ACB). Since the ETP is Betty’s proceeds of disposition, she will realize a capital gain of $813,600, which is sheltered from tax by claiming $813,600 of available CGE.
Betty then causes MarCo to liquidate its investments and pay a dividend to HoldCo, where intercorporate dividends from a subsidiary to its parent are tax-free (with some exceptions). The value of the dividend depends on how much excess cash the company has and wants to protect. This has shifted assets upwards, protecting the excess cash from MarCo’s creditors. She should be aware of two issues.
- She needs to make sure her MarCo shares qualify for CGE before doing this manoeuvre. CGE-qualified shares have a complex definition that should be supported by sufficient documentation.
- She may be exposed to alternative minimum tax (AMT), which can create an unexpected tax liability. While AMT is refundable, it’s only refundable when regular income taxes are in excess of the AMT calculation, which could mean recovery over several years.
Table 2 shows how the Section 85 rollover would work.
Scenario 3: Patrick
He’s the sole shareholder of PatCo, an intergenerational business he acquired from his mother. It’s time to introduce the next generation, his daughter Kerry, into a shareholder position at nominal cost. Patrick plans to retain control, but pass on future growth to Kerry. Patrick would like to use a holding company to accumulate assets for retirement.
An estate freeze of Patrick’s current shares allows him to make Kerry a shareholder and shift all future growth to her. Freezing his current position limits the income tax liability arising from the deemed disposition of PatCo shares upon his death. Patrick could transfer his PatCo shares to a new holding company (Holdco), taking back Holdco shares as consideration and jointly electing under section 85 in order to defer the embedded income tax liability. Once Holdco is the sole shareholder of PatCo, it can exchange all its common shares in PatCo for fixed-value retractable, redeemable, voting preferred shares of the same value, utilizing section 86 to defer the gain. Kerry can subsequently subscribe to new common shares of PatCo, at nominal cost. Table 3, shows how the Section 85 rollover would work. While there are many ways of structuring transactions, these are examples of how section 85 can address a range of restructuring needs. Business affairs constantly change. Being able to restructure on a tax-deferred basis is important.
Table 1: Frank
|Fair Market Value||$55,000||$35,000||$50,000||$140,000|
|Elected Transfer Price||$45,000||$30,000||$1|
|Common Shares of ProCo||$10,000||$5,000||$50,000||$65,000|
* Assume goodwill valued at $50,000
Table 2: Betty
|Shares of MarCo|
|Fair Market Value**||$3,000,000|
|Elected Transfer Price||$814,600|
|Common Shares of ProCo||$3,000,000|
** Assume MarCo shares have a FMV of $3 million and ACB of $1,000
Table 3: Patrick
|Shares of PatCo|
|Fair Market Value†||$5,000,000|
|Elected Transfer Price||$1,000|
|Common Shares of ProCo||$5,000,000|
† Assume PatCo shares have a FMV of $5 million and ACB of $1,000
What is eligible property?
In broad terms, eligible property includes:
- capital property* (depreciable and non-depreciable);
- eligible capital property;
- resource property; and
- inventory (excluding real or immovable property).
*Generally excludes real or immovable property owned by non-resident.
Conditions for an S85 transfer
- Transferee must be a taxable Canadian corporation
- Consideration must include shares of the transferee corporation
- Property being transferred must be eligible property
- The transferor and transferee must jointly elect
by James W. Kraft, CPA, CA, MTax, CFP, TEP, and Deborah Kraft, MTax, LLM, TEP, CFP. Deborah is faculty and director, Master of Taxation Program, School of Accounting & Finance, University of Waterloo. James is vice-president, Head of Business Advisory & Succession, BMO Nesbitt Burns.