Introduction
The Section 85 Rollover is a tax-deferral mechanism in Canada that allows taxpayers to transfer eligible assets to a taxable Canadian corporation without triggering immediate tax consequences. Instead of realizing capital gains at the time of transfer, taxpayers can elect a transfer price that defers taxation until the assets are eventually sold.
This provision is widely used for estate planning, corporate reorganizations, business incorporations, and capital gains crystallization, making it a crucial tool for business owners, investors, and crypto entrepreneurs.
1. When Does Section 85 Apply?
A Section 85 election can be used in various situations, including:
- Estate Planning – Transferring assets to a family corporation to freeze capital gains and manage tax liabilities.
- Incorporating a Sole Proprietorship – A self-employed business owner can transfer assets to a corporation without triggering immediate capital gains tax.
- Transferring Business Assets Between Corporations – When one company acquires another, Section 85 allows for a tax-efficient transfer of assets.
- Capital Gains Crystallization – Taxpayers can trigger capital gains at a preferred rate while deferring full tax realization until a later date.
Using Section 85 in these scenarios ensures tax efficiency and structured asset transfers without unnecessary immediate tax liabilities.
2. What Assets Can Be Transferred Under Section 85?
Not all assets qualify for the Section 85 Rollover. Below is a breakdown of eligible and ineligible assets:
a. Eligible Assets (Tax-Deferred Transfer Possible)
- Depreciable and non-depreciable capital property (e.g., business equipment, investments).
- Inventories (excluding real estate inventory).
- Real estate used for business by non-residents in Canada.
- Canadian and foreign resource properties.
- Goodwill and other intangible business assets.
b. Ineligible Assets (Subject to Immediate Taxation)
- Cash and near-cash assets.
- Real property held as inventory (e.g., real estate developers’ land inventory).
- Prepaid expenses (e.g., rent, insurance, licensing fees).
To maximize tax deferral, taxpayers should ensure that the assets being transferred fall within the eligible category and structure the transaction correctly.
3. How Section 85 Works: The Mechanics of a Tax-Deferred Transfer
A Section 85 Rollover requires that both the transferor (seller) and transferee (corporation) agree on an elected transfer price that determines the tax treatment of the transaction.
a. Consideration for the Transfer: Shares & “Boot”
- The transferor must receive shares of the corporation in return for the asset transfer.
- The transferor may also receive additional consideration, called "boot", which can include cash, promissory notes, or other assets.
- If the boot exceeds the tax cost of the transferred assets, a portion of the transaction becomes taxable.
b. Establishing a Transfer Price
- The transfer price must be between:
- The tax cost of the asset (adjusted cost base or undepreciated capital cost) and
- The fair market value (FMV) of the asset.
- The transfer price cannot be higher than FMV or lower than the boot received.
This ensures that the transfer is legally recognized by the CRA while deferring any taxable gains.
4. Section 85 Rollover Example
To better understand how a Section 85 election works, consider the following example:
Scenario: Transferring Capital Property from a Sole Proprietorship to a Corporation
- A sole proprietor owns capital property worth $300,000, with an adjusted cost base (ACB) of $100,000.
- The proprietor incorporates a new Canadian company and wants to transfer the asset to the corporation in exchange for common shares.
Tax Treatment Without Section 85 Rollover
- If transferred without Section 85, the CRA considers it a sale at FMV ($300,000), triggering a capital gain of $200,000 ($300,000 - $100,000).
- The taxpayer owes capital gains tax immediately.
Tax Treatment With Section 85 Rollover
- If the proprietor elects to transfer the asset at its adjusted cost base ($100,000) under Section 85:
- No capital gains tax is triggered.
- The asset’s tax cost in the corporation remains at $100,000, deferring taxation until it is sold in the future.
- If no boot is received, the cost base of the new shares will also be $100,000.
This allows the business owner to incorporate without incurring immediate tax liabilities.
5. Filing Requirements for Section 85 Rollover
To formalize a Section 85 election, taxpayers must file Form T2057 (Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation) with the CRA.
a. Key Filing Deadlines
- The form must be filed by the income tax return due date for the year the transfer occurs.
- If multiple transferors are involved, one can file on behalf of all.
- Late filings (up to 3 years past due date) may be accepted, but penalties may apply.
- If filed more than 3 years late, the CRA will accept the election only under exceptional circumstances.
6. Common Mistakes to Avoid When Filing a Section 85 Election
Mistakes in structuring or filing a Section 85 Rollover can lead to CRA audits, penalties, or immediate tax liabilities.
a. Incorrect Valuation of Assets
- Transferring at a value lower than FMV can lead to CRA reassessment.
- It is recommended to obtain a valuation report for high-value assets.
b. Receiving Excessive Boot (Cash or Other Consideration)
- If the transferor receives too much non-share consideration, a portion of the transaction becomes immediately taxable.
c. Failing to File Form T2057 on Time
- Missing the filing deadline can result in the loss of tax deferral benefits.
d. Not Structuring the Transfer with Long-Term Tax Planning in Mind
- Some taxpayers may want to crystallize capital gains (for capital gains exemption).
- Others may want to preserve loss carryforwards before finalizing the transfer price.
A tax professional can help strategically structure the transaction to minimize long-term tax liabilities.
Conclusion
The Section 85 Rollover is a powerful tool that allows business owners, investors, and estate planners to transfer assets to a corporation tax-efficiently while deferring capital gains tax. However, careful valuation, compliance with CRA rules, and timely filing are critical for maximizing tax benefits.
Given the complexities involved, consulting a tax professional is strongly recommended to ensure a properly executed rollover.
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