Section 86 Rollover—Exchange of Shares in a Reorganization

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 86 of the Income Tax Act. For section 86 to apply, the taxpayer must have disposed of all their shares in a particular class of the capital stock of the corporation. Even retaining a single share from the class would prevent these rollover provisions from applying. The disposition must also be part of a reorganization of the capital of the corporation. While this is not clearly defined in the ITA, it is generally considered that the articles of the corporation should be amended when a reorganization takes place, such as to add a new class of shares or amend the rights of certain classes. Finally, the taxpayer must receive new shares from the same corporation as part of the reorganization. As part of a section 86 rollover, the taxpayer can receive non-share consideration such as cash as part of the transaction. However, if the FMV of the non-share consideration received exceeds the cost of the old shares, a portion of the transaction will be taxable. Another rollover provision may be a better option in this situation.

An election is not required to complete a rollover under section 86. The rollover automatically occurs if all conditions are met.

A rollover under section 86 can be an effective part of an estate plan. Taxpayers are subject to a deemed disposition of all their assets at the time of their death. Any accrued capital gains become taxable at this time, and this can create a large tax balance owing by the estate. The taxpayer can lock in the value of their shares prior to this time by completing a rollover and plan for the tax balance owing accordingly. The capital gain on any future increase can be deferred until a future disposition by the recipients of the new common shares.

Rollover transactions are complex and require proper planning to ensure adverse tax consequences don’t occur. Please contact me if you would like to discuss further.