When restructuring a business or transferring assets, Canadian business owners can benefit significantly from Section 85 of the Income Tax Act (ITA). This provision allows taxpayers to transfer eligible property to a taxable Canadian corporation on a tax-deferred basis, helping businesses manage tax liabilities effectively.
How Section 85 Enables Tax Deferral
Section 85 allows individuals and corporations to transfer property to a Canadian corporation without triggering an immediate taxable event. By making a joint election with the receiving corporation, the property can be transferred at an "elected amount," which can be as low as its tax cost, thereby deferring capital gains tax until the property is eventually disposed of by the corporation.
Example of Tax Deferral
Suppose an individual owns shares of a private company with a fair market value (FMV) of $500,000, but an adjusted cost base (ACB) of $200,000. If the shares are transferred to a newly incorporated company under Section 85 and an elected amount of $200,000 is chosen, no immediate taxable gain arises. The tax is deferred until a later disposition.
Using Section 85 to Create a Holding Company
A common application of Section 85 is during the creation of a holding company, especially when rolling over shares of an operating company. This strategy is often used for estate planning or to centralize corporate ownership.
Example of a Holding Company Roll
Consider an entrepreneur who owns an operating company valued at $1 million, with an ACB of $400,000. By setting up a holding company and transferring shares under Section 85, the entrepreneur can elect the transfer value to match the ACB, avoiding immediate tax consequences. The holding company then holds the shares, which can facilitate succession planning or creditor protection.
Importance of Asset Valuation in Section 85 Elections
A valuation of the transferred property is crucial to ensure compliance and to avoid future disputes with the Canada Revenue Agency (CRA). The elected amount cannot exceed the fair market value (FMV), and CRA may scrutinize the valuation to ensure that the transaction is not structured to avoid taxes improperly.
When Valuation is Required
Operating company shares: When rolling over shares to a holding company.
Capital property: Such as real estate or equipment being transferred to a corporation.
Intangible assets: Goodwill or intellectual property transferred to a corporation.
If the CRA determines that the elected amount is not reasonable based on the FMV, it may reassess the transaction and apply penalties or additional taxes.
Required Form for Section 85 Election
To formalize a Section 85 rollover, taxpayers must file Form T2057, "Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation." The form must be filed on or before the earliest due date of any party involved in the transfer for the taxation year in which the transfer occurred. Additionally, a written agreement must be in place outlining the terms of the transfer, including the consideration received and the elected value.
Key Information to Include in Form T2057:
Details of transferor and transferee (names, business numbers)
Description of transferred assets (ACB, FMV, elected amount)
Consideration received (e.g., shares issued)
Supporting documentation (valuation reports)
Late Filing and Penalties
If Form T2057 is not filed on time, CRA allows a late filing within three years, subject to penalties. A further extension may be available at the CRA’s discretion, but penalties may increase over time.
Conclusion
Section 85 of the Canadian Income Tax Act provides a powerful tax-deferral tool for business owners looking to transfer assets without immediate tax consequences. Whether forming a holding company, restructuring, or planning for succession, careful planning and proper documentation, especially asset valuation, are critical for compliance and optimizing tax outcomes.
For specific tax advice tailored to your business, consult a qualified Chartered Professional Accountant (CPA).
