What is Section 85 Rollover?

Many a times business owners need to transfer assets from their sole proprietorship to a corporation to upscale their business or from an existing corporation to a new corporation, a case of corporate reorganization.

Corporate reorganization can include the induction of new shareholders, while existing shareholders may choose to retain control or pass it on to the new shareholders. There are various reasons for corporate reorganization, such as preparing the business for sale, splitting of assets (for protection from creditors), implementing an estate freeze to pass on future growth to the next generation, and facilitating income splitting, among others.

In either case (incorporation of a sole proprietor or a corporate reorganization), when you transfer assets to a new corporation (sometimes called a holding company), the transferor will be assumed to have sold the property to the transferee. This, in most cases, triggers capital gain and other tax consequences.

The Income Tax Act (ITA) offers a solution to this issue, commonly referred to as a Section 85 rollover, by permitting a tax-deferred transfer of assets to a Canadian corporation. Under this route, the tax consequences of an outright sale of assets can be avoided or deferred until the corporation subsequently sells the assets to a third party.

This article will provide a basic overview of the section 85 rollover and why, when, and how small business owners can use it. 

Requirement

To utilize the option of Section 85 rollover, the following requirements must be met:-

1. The assets must be transferred to a taxable Canadian corporation.
2. The assets transferred must be eligible assets.
3. The transferor must take back a share (or shares) of the corporation as consideration for the transfer of the property to the corporation.
4. The transferor may also take back non-share considerations (NSC). NSC is normally made up of the promissory notes of the corporation or proprietorship debt assumed by the corporation.
5. Consideration for the transfer must equal the fair market value (FMV) of the property transferred and can include both shares and NSC.
6. An election must be filed by one taxpayer and select an elect price, the price at which an asset is assumed to be sold by the seller and bought by the purchaser.

Eligible Property

The types of property that may be transferred under Section 85 are defined by the ITA. The most common types of property are:

• Inventories: raw materials, work-in-progress, finished goods (note that inventory consisting of land can not be transferred using Section 85)
• Non-depreciable capital property: marketable securities, land.
• Depreciable capital property: equipment, buildings, limited-life intangibles, goodwill, customer lists, unlimited-life intangibles.

Assets with accrued losses are not transferred under Section 85. If such assets are required in the corporation, they are sold to the corporation at fair market value (FMV).

Section 85 Elected Amount

When using section 85 rollover, the transferor and transferee must choose an elected amount, which represents the proceeds of disposition for the transferor and the cost to the transferee corporation.

The ITA prescribes the following upper and lower limits on the elected amount:

1. Ceiling for elected amount: The elected amount cannot exceed the FMV of the property at the time of the transfer.
2. Floor for elected amount:  The floor, or minimum amount that may be elected, will equal the greater of:
   • The FMV of any NSC
   • The tax value of the asset being transferred.

Asset we Should and Should not Rollover

A Section 85 rollover would not benefit all assets; and only eligible property can be transferred. The assets that should be rolled over are those that have increased in value. Using section 85 rollover you can avoid paying taxes that you would have otherwise paid when transferring assets to the corporation. Assets that shouldn’t be rolled over are the ones that have decreased in value or have remained on the same value.

Receivables

Receivables may be transferred under Section 85. However, the FMV of the receivables will always be either equal to or less than the tax value. In case FMV is equal to tax value there is no benefit in transferring assets under Section 85. On the other hand, if the FMV of receivables is less, they are not eligible under Section 85.

Accordingly, receivables are more suitable for transfer to the corporation under section 22, using a joint election between seller and purchaser. This allows the seller to realize any losses. If the purchaser collects more than the amount paid, the additional amount will be included in the business income of the purchaser.

Goodwill

When a proprietorship is incorporated, any internally generated goodwill of the proprietorship is transferred to the corporation. The tax value of internally generated goodwill is nil. To make the election valid, an elected amount of nil cannot be chosen. Usually, an elected amount of $1 is chosen to minimize taxes.

Tax Tip 1: Valuation of Assets

When filing a joint election, it is recommended to have a valuation ready for the assets, especially intangible assets like goodwill, patents, etc. A reasonable assessment would avoid challenges from the CRA and potential reassessment that could result in serious penalties and tax bills.

Tax Tip 2: Price-Adjustment Clauses in Transfer Agreements

When assets are being transferred, significant judgment is required in determining the FMV of assets, and in many cases, the Canada Revenue Agency (CRA) may disagree with the market value determined. This poses significant tax consequences. Therefore, it is highly recommended that the legal agreement for the rollover of the assets to the corporation should include a price adjustments clause allowing the transferor and transferee the flexibility to adjust the consideration agreed retroactively, should the CRA or a court of law dispute that it is not in line with the FMV.

Procedural Requirements for Election

When you decide to elect for a Section 85 rollover, you must file the election using CRA’s prescribed form before the tax return deadline for either the transferor or the transferee, whichever is earlier. The CRA accepts the election within three years from the original deadline, but it will impose a late filing penalty. Beyond three years, a request can be made with a valid justification; however, it will be at the CRA’s discretion to accept such a request.

Conclusion

Section 85 rollovers can be very beneficial when you want to transfer assets from your own name or from an existing corporation to a new corporation and avoid the tax bill that comes with it. However, it does not eliminate the tax liability; instead, it defers it to a future date when the corporation will sell the asset. 

Consultation With Tax Professionals

While Section 85 rollovers are beneficial, they are complex in nature. It is advisable to consult with tax professionals, such as a Chartered Professional Accountant (CPA) or a tax lawyer, who can provide guidance specific to your situation and ensure compliance with the relevant tax laws.

If you require help with Section 85 rollovers or other corporate tax planning matters, please schedule a consultation with Source Accounting Professional Corporation, CPA by dialing 647-930-8130.

Source Accounting Professional Corporation (CPA) is a full-service accounting firm in Mississauga, helping business owners, investor, trading company, immigration consultants by providing tax preparation, corporate tax filing, accounting, bookkeeping services, payroll solutions, etc. If you are a business owner, trading company, or investor interested in leveraging tax laws through the establishment of a holding company, we invite you to give us a call at 647-930-8130.

Disclaimer: The above contents are provided for general guidance only, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. It does not provide legal advice, nor can it or should it be relied upon. Please contact/consult a qualified tax professional specific to your case.