Section 51 Rollover—Convertible Property

The disposition of capital property such as shares of a corporation generally results in a capital gain or loss to the taxpayer. However, the Income Tax Act (ITA) contains many provisions which allow for certain exchanges of property to be completed on a tax-deferred basis. These provisions are known as rollovers.

Rollovers are frequently used as part of a freeze transaction. The aim of a freeze is for the owner of an asset to retain the current value, while transferring the future growth of the asset to another person. Commonly the future growth is transferred to a family member such as a child, but unrelated individuals can be the recipient as well. For example, the sole shareholder of an operating business may be nearing retirement. They want to transfer ownership of the company to their child, but a sale of the company would trigger a capital gain and require income taxes to be paid. A properly executed rollover ensures current income taxes will not be paid and all assets can remain in the business.

The basic mechanism of a rollover is that an owner of capital property exchanges this property for other property that has the same fair market value (FMV). If the conditions of the specific rollover are met, any capital gain can be reduced or eliminated by transferring the property at an amount less than the FMV, but not less than the adjusted cost base (ACB). Income taxes can then be deferred to a future disposition. Expanding on the example above, the owner nearing retirement may own 100% of the common shares of the company. These shares have an ACB of $100 and a FMV of $1,000,000 for an accrued gain of $999,900. The individual can exchange their common shares for preferred shares that are redeemable for $1,000,000 and have an ACB of $100. Their child can then subscribe to new common shares of the company for a nominal value since the total current value of the company is payable to the owner of the preferred shares.

The rollover above can be achieved under section 51 of the Income Tax Act. Section 51 may apply if you are converting debt of a corporation to shares of the same corporation or exchanging shares of a corporation for a different class of shares of the same corporation. Other common rollover provisions exist under sections 85 and 86 of the ITA. Section 51 will not apply if these sections apply to the rollover.

One of the primary conditions that must be met is that you must not receive any additional consideration beyond the new shares. Therefore, another rollover must apply if you are seeking to receive additional assets such as cash in the transaction. Other rollovers must also apply if you wish to realize a portion of the capital gain. For example, the owner above may wish to defer a capital gain of $499,900 while recognizing a capital gain of $500,000. Section 51 does not permit this as the ACB of the shares received must be equal to the ACB of the shares exchanged. When debt is exchanged, it must meet certain requirements. It must be a bond, debenture, note or similar instrument. The terms of the debt instrument must also stipulate that the amount can be converted to shares of the corporation.

An election is not required to complete a rollover under section 51. The rollover automatically occurs if all conditions are met.

Adverse tax consequences may occur if the exchange is not structured correctly, such as if the FMV of the properties exchanged are not equal. It is imperative that you plan in advance for rollover transactions as planning can be the difference between a tax-deferred exchange and a taxable disposition. Please contact me if you would like to discuss further.