Section 85 rollover (Canada)

Why section 85 exists

Without section 85, transferring appreciated property to a corporation would trigger immediate capital gains tax, even though the transferor receives shares of the corporation rather than cash. This would make basic restructuring transactions, incorporating a business, reorganizing share classes, setting up a holding company, prohibitively expensive.

Section 85 solves this by allowing the parties to jointly elect a deemed transfer value (the 'elected amount') for tax purposes. The corporation takes the property at the elected amount as its tax cost, and the transferor takes the shares at an amount derived from the elected amount. The unrealized gain follows the shares, deferred until the shares are eventually sold.

The mechanics

A section 85 rollover requires:

1. The transferor and the transferee corporation are both Canadian-resident. (Section 85 also accommodates some non-resident transferors, but the rules are more complex.)
2. The transferor transfers eligible property, typically capital property, eligible capital property, inventory, or shares, to the corporation.
3. The transferor receives shares of the corporation in consideration (and optionally also non-share consideration, called 'boot,' up to the elected amount).
4. The parties file a joint T2057 election by the earlier of their respective tax return deadlines for the year of transfer.
5. The elected amount is set within the statutory range, typically at the property's tax cost to achieve full deferral.

Estate freezes: a common use case

The classic estate freeze runs as follows. The parent transfers their growth-stock common shares in a family-owned operating corporation to a new holding corporation in exchange for fixed-value preferred shares of the holdco, electing under section 85 at the tax cost of the common shares. The next generation subscribes for new common shares of the holdco at a nominal amount. From that point forward:

• The parent's estate value is 'frozen' at the redemption value of the preferred shares.
• All future growth in the underlying business accrues to the next-generation common shares.
• The parent retains control (preferred shares typically carry voting rights or board-appointment rights).
• Capital gains tax on the original growth is deferred until the parent redeems or sells the preferreds.

Estate freezes are a major reason private Canadian corporations restructure their share classes, and section 85 is what makes the restructuring tax-efficient.