Byrd & Chen’s Canadian Tax Principles

2023–2024 Edition

Chapter 16
Rollovers under Section 85

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Overview
• The incorporation of investments or a business of an
individual requires the following:
1. Creation of a corporation
 Incorporated under 1 of 14 different corporate law
jurisdictions within Canada (the corporate law creates a
legal entity)
 As a legal entity, the corporation can purchase & sell
property, enter contracts, borrow money, etc .
2. Determine share structure & shareholders
 Individual can be the sole shareholder or add family
members (less costly to add from beginning)

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Overview
3. Incorporation of property
– Individual gives up (sells) property to the new
corporation
 Sale should take place in same manner as in arm’s
length transaction
 Courts recommend thorough documentation & evidence
for legal purposes
 Based on a tax principle, the sale of any property
between two legal entities must occur at FMV even if
non-arm’s length
– Sale could result in a capital gain (or loss depending on
property) to seller
– Corporation acquires property at FMV

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Overview
3. Incorporation of property
– Newly created corporations have minimal cash;
payment is made by issuing its own shares or
promissory note (or combination of both) – payment is
called “consideration”
– Consideration paid by corporation
 Share consideration
 Non-share consideration (NSC) [sometimes called
“boot”]

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Overview
• Example:
– Facts:
 Individual (seller) owns investments that cost $70,000
and have a FMV of $100,000
 The investments are sold to a recently incorporated
corporation for FMV
 The consideration paid by the corporation includes
$30,000 in shares and a $70,000 promissory note [non-
share consideration (NSC)]

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Overview
• Analysis
– Individual (seller)
 The disposition for $100,000 results in a capital gain of
$30,000 ($100,000  $70,000); a taxable capital gain of
$15,000 [(50%)($30,000)]
 The promissory note has a tax cost (ACB) of $70,000
 The shares have a tax cost (ACB) of $30,000
– Corporation (purchaser)
 Investments purchased for $100,000 (tax cost & ACB)
 Addition of $30,000 to legal capital (starting point for
PUC)
 A liability of $70,000 (promissory note)

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The ITA 85 Impact
• Problem: individual won’t receive cash as
consideration but will have to pay income tax on any
capital gains
– Section 85 is designed to eliminate any immediate
income tax consequences resulting from incorporation
– ITA 85(1) referred to as a “rollover”
 individual & corporation can elect amount of sale price
within certain range
– ITA 85(1) overrides the general FMV rule

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The ITA 85 Impact

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The ITA 85 Impact
• The power of the rollover lies in its flexibility meaning
an individual and corporation can elect the sale
amount within a certain range
– Example: initial range between the ACB ($70,000) of
an investment and its FMV ($100,000)
 If the elected amount is $70,000, there will be no capital
gain on the investment when rolled to the corporation
 The unrealized gain of $30,000 will be built into the share
consideration received by the seller (ACB & PUC = nil)
 If shares are subsequently sold/redeemed, there will be
a $30,000 capital gain or a $30,000 deemed dividend

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The ITA 85 Impact
• Common uses for ITA 85(1)
– Incorporation of business
– Pass future economic growth of corporation to family members
(estate freeze)
– Crystallize capital gains on shares for CGD
– Insert holding corporation
– Creditor-proof a corporation by moving property susceptible to
creditor claims from one company to another
– Use losses in one company against income in another company
(as long as affiliated)
– Remove property of a corporation that affects ability of shares to
qualify for CGD (purification)

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General Conditions – ITA 85(1)

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Rollovers Defined
• A transfer of property at elected tax values from one
party to a corporation
o A taxpayer can make the transfer
(individual, corporations, or trust)
o A partnership can also make the transfer (just not
under Section 85(1))
• The rollovers (transfers at elected values) covered in
this class are called Section 85 rollovers because the
relevant rules are found in ITA section 85
o There are other transfers of property defined and
regulated elsewhere in the ITA
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Standard Section 85 Scenario
• Example:
– An unincorporated business has property with tax
values of $800,000 & liabilities of $200,000
– FMV property  $2,000,000 (potential gain of
$1,400,000)
 Elect $800,000 (within range – ACB $800,000 to FMV
$2,000,000) for property & corporation assumes liabilities
 $800,000  POD  ACB (no capital gain on sale)
 NSC  $800,000 (including the $200,000 in assumed
liabilities)

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ITA 85(1): Seller and Purchaser
(Transferor and Transferee)
• Transferor
– Person who wishes to incorporate property owned by
that person
– Must be a taxpayer (individual, trust, estate or another
corporation)

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ITA 85(1): Seller and Purchaser
(Transferor and Transferee)
• Transferee
– Corporation that is purchasing property of the
transferor
– Must be a taxable Canadian corporation
 Resident in Canada
 Incorporated in Canada
 Not exempt from Part I tax
 Note: does not have to be a new corporation

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ITA 85(1): Eligible Property
• Eligible property
– Depreciable & non-depreciable capital property
– Canadian and foreign resource property
– Inventories held for producing income
– Real estate owned by non-residents used in a
Canadian business
• Exclusions:
– Inventories held for investment
– Real estate owned by non-residents (unless used in a
Canadian business)
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ITA 85(1): Consideration (Share & Non-
Share)
• Share consideration
– For each property transferred, share consideration is
required
– If shares are not issued, ITA 85(1) is invalid
– Use shares where the FMV is easily determined
 Common shares are rarely used since it is difficult to
establish FMV at a given point in time
 Fixed value preferred shares are used instead

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ITA 85(1): Consideration (Share & Non-
Share)
• Non-Share Consideration (aka the "Boot")
– Cash, other assets, taking on new debt or assumption
of old debt
– Important because it can be a tax-free distribution

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ITA 85(1): The Election
• Joint election in prescribed form
– Form T2057 (taxpayer – individual, corporation, or
trust) or T2058 (partnership)
– If property is not listed, there is no rollover benefit with
the result that the property is considered disposed of
at FMV
– T2057 contains 8 questions (yes or no answers),
certain responses can lead to a CRA audit

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ITA 85(1): The Elected Amount
• To the Transferor, the elected amount is
– Deemed POD for eligible property sold
– Cost, ACB, or capital cost of all consideration received
as payment from the corporation
– PUC of share consideration
• To the Transferee, the elected amount is
– Tax cost (e.g., cost, ACB, capital cost, UCC) of eligible
property purchased by corporation (transferee)

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Electing to Avoid Accrued Gains –
Example
• Facts
– Mr. Thompson owns land that is capital property
– FMV  $330,000
– ACB  $200,000
– In 2023, he wishes to sell the land to a corporation in
which he is the controlling shareholder
– Mr. Thompson wants to defer any tax implications &
recover as much cash as possible

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Electing to Avoid Accrued Gain –
Example
• Analysis
– The range for acceptable elected amounts is between
ACB ($200,000) and FMV ($330,000)
– To avoid any income tax on sale, elect ACB as sale
price: $200,000 (POD) – $200,000 (ACB)  nil

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Electing to Avoid Accrued Gain –
Example
• Analysis
– Consideration received must  FMV of land
 FMV Non-Share Consideration  $200,000 promissory
note (can receive up to the ACB of the land in cash
without tax implications)
 FMV share consideration  $130,000
 Mr. Thompson: ACB of promissory note  $200,000;
ACB & PUC shares  nil
– Transferee: Cost & ACB of property  $200,000

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Rules Applicable to All Eligible Property
• Rule #1: Proceeds and Cost – ITA 85(1)(a)
– Elected amount or deemed elected amount becomes
deemed POD to individual (transferor) and deemed
cost to corporation (transferee)

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Rules Applicable to All Eligible Property
• Rule #2: Non-Share Consideration or Boot –
ITA 85(1)(b)
– If elected amount is less than FMV of NSC, elected
amount is deemed  to FMV of NSC

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Rules Applicable to All Eligible Property
• Rule #3: FMV [ITA 85(1)(c)]
– Ceiling (maximum or "upper limit") for the elected
amount  FMV

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Rules Applicable to All Eligible Property
• Summary:
– Ceiling (maximum or "upper limit") for the elected
amount  FMV of eligible property sold to corporation
– Floor (minimum or "lower limit") for the elected
amount of eligible property  greater of
 FMV of Non-Share Consideration ("Boot"); or
 Tax cost (depends on classification of property – see
subsequent slides)

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Accounts Receivable – ITA 22
• Accounts receivable should not be transferred under
ITA 85
– Should use ITA 22 election instead
 Seller can treat a loss on the write-down of receivables
as a business loss (instead of capital loss)
 Purchaser includes in income amount of deductible loss
to seller
 Purchaser permitted to claim doubtful debt reserves &
bad debt deduction

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Inventories and Non-Depreciable
Capital Property
• Inventory:
– Any loss from a write-down of inventory is treated as
a business loss
• Non-Depreciable Capital Property (and Inventory):
– Ceiling (upper limit) = FMV
– Floor (lower limit) = Greater of:
 Boot (non-share consideration)
 Lesser of: FMV or ACB

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Inventories and Non-Depreciable
Capital Property
• Example: Land with the following attributes
– ACB of $10,000
– FMV of $15,000
– Boot of $12,000

– Ceiling = FMV = $15,000

– Floor = Greater of:
 Boot = $12,000 or
 Lesser of:
– FMV = $15,000 or
– ACB = $10,000
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Depreciable Capital Property
• Ceiling (upper limit) = FMV
• Floor (lower limit) = Greater of:
o Boot (non-share consideration)
o Lesser of:
 FMV of the individual asset OR
 Cost of the individual asset OR
 UCC of the class

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Depreciable Capital Property
• Example: Building with the following attributes
o UCC of $5,000
o ACB of $10,000
o FMV of $15,000
o Boot of $6,000

o Ceiling = FMV = $15,000

o Floor = Greater of:
The UCC of the
 Boot = $6,000 or class is the lowest of
 Lesser of: the three options,
• FMV = $15,000 but the Boot is the
greater of the four
• Cost = $10,000 options
• UCC = $5,000
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Allocating the Elected Amount
• Tax Cost of Consideration Received
– ITA 85(1)(a) says that the elected value is
 The proceeds of disposition to the Transferor and
 The adjusted cost base to the Transferee (recipient)
– Total consideration received by seller  elected
amount
 Consideration is broken down into 3 parts:
1. Non-Share Consideration
2. Share consideration that is preferred
3. Share consideration that is common shares

• The minimum election equals the maximum deferral

– Electing to transfer at a lower value creates a greater
tax deferral on the disposition
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Allocating the Elected Amount –
Sequential Process

Elected amount $ xxx

Less: FMV of Non-Share Consideration (Boot) (xxx)
Balance to be allocated to share consideration $ xxx
Less: preferred shares issued (maximum FMV) (xxx)
Balance to be allocated to common shares issued* $ xxx

*Usually Nil

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Example of a Section 85 Rollover
2 – In-Class Problem (Excel file on BrightSpace)

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Section 85 Rollover – PUC Reduction
• PUC (Paid Up Capital)
– PUC (tax-free) = FMV of consideration given for shares
= “Legal stated capital”
– PUC (before reduction) $489,000 ($225,000 +
$264,000)
– ACB = $289,000 ($225,000 + $64,000)
• The Problem:
– A share redemption would result in no deemed
dividend and a capital gain of $200,000 (FMV > ACB)
– PUC of $489,000 could be removed tax free

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ITA 85(2.1) – PUC Reduction Calculation
• The Solution:
– Reduce the PUC of the shares (prorated to each class)
• Where (A – B) x (C / A)
– A = Legal stated capital of all shares (FMV or PUC
before reduction)
– B = Elected amount, less the boot (non-share
consideration) [Elected amount – FMV of shares]
– C = FMV of the particular class of shares

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ITA 85(2.1) – PUC Reduction Example
Legal Stated Capital $489,000 (A)
Elected Amount $614,000
Boot (325,000) ($289,000) (B)
PUC Reduction $200,000
[(C) / (A) x PUC Reduction]
Preferred Shares [(225/489) x (200)] $132,975
Common Shares [(264/489) x (200)] 156,025
Total PUC* $289,000
*Equal to total ACB

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ITA 85(2.1) PUC Reduction - Example
• Note:
– The allocation of the PUC reduction is pro rata based
on the fair market value of the two classes of shares.
– ACB is allocated sequentially, starting with the boot,
followed by the preferred shares, ending with common
shares as a residual.

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Sale of Shares Following the Rollover
Proceeds of Disposition $489,000
Adjusted Cost Base ($225,000 + $64,000) (289,000)
Capital Gain $200,000

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Redemption at FMV Following the
Rollover
Preferred Common
Proceeds of Disposition $225,000 $264,000
Paid Up Capital (PUC) (132,975) (156,025)
Deemed Dividend $92,025 $107,975

Proceeds Received $225,000 $264,000

Deemed Dividend (92,025) (107,975)
Adjusted Proceeds of Disposition $132,975 $156,025
Adjusted Cost Base (225,000) (64,000)
Capital Gain (Loss) ($92,025) $92,025

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