What Is A Section 85 Rollover?

When you're running a business, there are always tax implications to keep in mind. One thing that might not be immediately clear to business owners is what a section 85 rollover is. In this blog post, we'll explain what a section 85 rollover is and how it might apply to your business. We'll also provide some tips on how to take advantage of this tax deferral election. So, let's get started!

What Is A Section 85 Rollover And When Can It Be Used?

A section 85 rollover allows a taxpayer to transfer eligible property to a taxable Canadian corporation on a tax deferred basis.

The election can be used by an individual, trust, or a corporation (transferor). The transferor is not required to be a resident of Canada, but it does restrict the types of property that can be transferred by the election.

The transferee must be a taxable Canadian corporation.

A section 85 rollover is commonly used by sole proprietors who have grown their business to a point where they are earning more income than they require to live on and incorporating provides a more advantageous tax structure. Check out our blog on the advantages and disadvantages of incorporating to find out more.

Without the election, a transfer of assets to the corporation would result in the sole proprietor being deemed to have disposed of the assets at fair market value (FMV) at the time of the transfer.

This could result in income being realized and taxes being incurred by the transferor on the transfer of assets. By using a section 85 rollover they can transfer eligible property from their sole proprietorship into their corporation and defer taxes until the corporation sells those assets in the future.

Eligible Property For A Section 85 Rollover

The main items listed in section 85 as eligible property include:

• Depreciable and non-depreciable capital property
• Eligible capital property (goodwill, trademarks, patents)
• Inventory (excluding real property held as inventory)
• Canadian and foreign resource property
• Real property (land and buildings)

Only assets that will receive a tax deferral should be included in a section 85 rollover in order to simplify the process.

Property You May Not Want To Transfer With A Section 85 Rollover

Accounts Receivable

The problem with including accounts receivable in a section 85 rollover is that any losses are considered capital losses rather than business losses.

If accounts receivable is transferred for consideration that is less than the face value of accounts receivable, then the loss is considered a capital loss to the transferor. However, because the transfer is to an affiliated person the loss is considered a superficial loss and cannot be used by the transferor.

A superficial loss occurs when both of the following criteria are met:

1. You or someone affiliated with you buys or has the right to buy identical property during the 30-day period before and after the date of sale.
2. You or someone affiliated with you still owns or has the right to buy identical property 30 days after the sale date.

In addition, since the transferee wasn't carrying on the business that gave rise to doubtful accounts, they cannot deduct any future bad debts on the accounts receivables that were transferred. The loss is treated as a capital loss by the corporation and can only be applied against capital gains.

If you have accounts receivable to transfer, a better option is to transfer it under section 22 rather than section 85. Form T2022 would need to be completed for accounts receivables transfers.

As long as at least 90% of the assets are transferred then a section 22 election can be used to transfer accounts receivable. By using this election, the full amount of the difference between the face value and the consideration given can be fully deducted from income by the transferor and is fully added to the income by the transferee. The transferee can then deduct bad debts on the transferred accounts receivable in the future.

Non-Depreciable Assets With Unrealized Losses

This situation is similar to what was discussed in the accounts receivable section above.

The issue is that the transferor and transferee are consider affiliated persons. When the transfer occurs, it results in a capital loss, which becomes a superficial loss that is deemed to be nil.

Ultimately, there is no benefit to including these assets in a section 85 rollover.

Depreciable Assets With Terminal Losses

A depreciable asset with a FMV that is less than the undepreciated capital cost (UCC) of the depreciable asset is not eligible for the section 85 election per ITA 13 (21.2).

If a depreciable asset with a terminal loss was to be transferred using section 85, the proceeds of disposition would be deemed to be the UCC of the asset, which would prohibit the terminal loss.

There is no tax deferral to the transferor in this situation and shouldn't be included in the section 85 rollover.

Fair Market Value

Because a section 85 rollover occurs between non-arms length parties, the FMV of each asset needs to be determined before transferring it. The parties can't just make up value for the assets being transferred.

The FMV of the eligible property being transferred must be equal to the FMV of the consideration received by the transferor.

Although not required, using a Chartered Business Valuator (CBV) would provide reassurance that a price adjustment clause would be recognized by CRA if needed. This would be especially important for assets being transferred where the FMV was difficult to reasonably determine such as intangible assets.

Elected Amount

The elected amount can be anywhere between a specified range. However, it cannot be less than the FMV of the non-share consideration received.

Ceiling value – the FMV of the assets being transferred to the corporation

Floor value – equal to the greater of:

• The FMV of the non-share consideration given to the transferor; and
• The tax value (adjusted cost base (ACB) or undepreciated capital cost (UCC)) of the assets being transferred

Consideration Received

Consideration received for the assets being transferred can either be share consideration only, or a combination of share consideration and non-share consideration (also called boot).

Share consideration is mandatory and must consist of at least one share or a fraction of a share of the transferee corporation.

Non-share consideration is not required but normally consists of cash or debt from the transferee corporation.

It's important to note that the FMV of non-share consideration should not be more than the elected amount or it will result in income for tax purposes.

For example, if the FMV of non-depreciable assets being transferred to the corporation is $250,000 and the ACB is $150,000, then the consideration received by the transferor would be:

Notice that the FMV of the consideration received equals the FMV of the assets transferred.

Since the non share consideration received equals the ACB of the asset transferred, there is no tax liability for the transferor. The shares of the corporation would only result in a tax liability when they are sold.

Filing Form T2057

Reporting Eligible Property On Form T2057

When completing form T2057, adequate descriptions of the assets being transferred must be entered. However, if there are multiple properties in one class you only need to provide the total FMV of the entire class rather than listing each asset within the class.

You must keep all documentation used to determine the FMV of the assets being transferred in the event CRA requires them to determine if the FMV is reasonable.

Deadline For Filing Form T2057

The deadline for filing form T2057 is the earliest date that any of the parties to the election need to file a tax return for the taxation year which the transfer occurred.

The election can be filed within 3 years of the due date; however, a late filing penalty will apply. The penalty is calculated on the T2057 form and must be paid to the Receiver General.

If the form is filed more than 3 years late, then a written letter needs to be submitted to the CRA justifying the reason for the late filing. CRA will then decide whether it will accept your late filed election.

T2057 Amendments

An amendment to form T2057 is allowed if it is to correct an error or omission, or to revise the agreed transfer amounts if it would cause unintended tax consequences without the amendment. These amendments are only accepted if the election that had been previously filed was valid. An example of an invalid election is if the transferor didn't receive share consideration on the original election.

Price Adjustment Clause

Having a price adjustment clause in the section 85 asset/share agreement can provide protection in the event that CRA comes back and provides a different FMV that was originally used for the transfer. It should allow for the elected amount to be higher or lower than the original elected amount.

The price adjustment clause must adjust the price of the asset and the consideration received; it can't change the quantity of the asset transferred.

CRA notes that there must be a real effort in determining the FMV of the assets reported on form T2057. If their FMV is significantly different from the FMV originally calculated by the taxpayers, they may not recognize a price adjustment clause.

Summary

The section 85 rollover election is a powerful tool to help entrepreneurs defer taxes when incorporating their businesses. It's important to understand the rules around it, as well as what assets should and should not be included in order to avoid any unwanted tax consequences. With a price adjustment clause in place, you can protect against changes in FMV that may be assessed by CRA. Are you incorporating your business? If so, have you considered making a section 85 rollover election?

Visit our corporate accounting services and plans pages to learn more about how we can assist you in reaching your goals. They provide an overview of our services, including information on the benefits and features of each. Feel free to contact us if you have any questions about our services.

Disclaimer

The author takes reasonable care to make sure the information on this blog is complete at the time it was posted. The information may not be comprehensive or current and is provided for general information purposes only.

This blog is not meant to be used as an alternative to professional advice. You should always consult with a professional to obtain advice on your specific situation.

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