Are you wondering what is section 85 election in Canada? Is it important for you to know? If you are moving your business from self-employed to Incorporated you must know about this election before you make any move. It could be a huge implication of the Capital gain tax issue if you fail to plan this properly.
Section 85 tax Rollovers – Canadian taxation
You are starting a new business or already in a business entity and now want to incorporate or form a new corporation. You want to transfer your personal assets or assets in your self-employed business to the corporation, you need to be aware of tax implications and reporting requirements to avoid taxable events.
In general, a transaction between the shareholder and its corporation is considered a non-arm’s length transaction, and the transfer price is usually considered to be the fair market value of the property involved in the transfer. When you transfer your personal property to a corporation is considered as if you are selling (deemed disposition) your properties, and hence it will attract capital gain or loss. If you make a transfer based on the property’s market value at the time of transfer to the corporation, less the original costs when you acquired it, you will have a taxable event on the gains or loss.
As per the Canadian Income Tax Act you have been given an option to defer such taxes on these deemed capital gains. The details of such provision have been defined in section 85 of the Income Tax Act of Canada.
Transfer of property to the corporation
Section 85 of the Canadian Income Tax (“Tax Act”), also referred to as rollover provisions, describes the conditions required to defer the tax on the transfer of eligible property by a taxpayer. Understanding rollover provision offers significant help in tax planning as tax liability gets deferred due to rollover.
Subsection 85(1) of the act is relevant for the sole proprietors who have successfully built the business and intend to transfer the assets to the corporation. It helps them take advantage of deferring tax and the protection for the limited liability by incorporating their business. Additionally, this provision is also helpful in reorganizing the assets and transferring them to holding companies.
Let’s see the importance of section 85 rollovers as relevant for the deferred tax on the transfer of property to a corporation Vs. the implication of section 69?
Section 69(1) of the Tax Act, if the taxpayer acquires eligible property from the related party on a non-arm length basis by paying a higher amount than fair market value, it’s deemed to have been acquired the property on the fair market value (FMV) for the purpose of taxation. Similarly, disposal is deemed at fair market value irrespective of the fact that consideration received is lower than fair market value. Likewise, acquisition of the property via inheritance/gift is deemed to have been acquired on the fair market value. This is by default and the transferor has a capital gain if the fair market value of the transfer exceeds the cost of acquisition. In which case the transferor will have the capital tax liability.
In the above situation, you have the option to elect under section 85 and the detail of this election is described below.
Application of section 85(1)
This section is about the transfer of the eligible property from the taxpayer to the corporation. If they both (the shareholder and the corporation) elect to opt for section 85(1), the deeming rules of section 69(1) are exempted and gain on transfer to the corporation can be deferred. The deferral is valid till the corporation receives consideration for the assets received. In other words, until the corporation sells the property acquired from its shareholders/shareholders.
Requirements for complying with section 85(1)
There are five requirements to get deferral under section 85(1) of the income tax rules.
Eligibility of transferor – Eligible transferor, can be an individual, corporation, trust, and partnership (all partners need to be Canadian national). Generally, there is no requirement to be an eligible transferor for residency. However, restrictions are there on the eligibility of the property for the non-residents.
Eligibility of transferee – The transferee of the property should be a taxable Canadian corporation. This helps to ensure that gain on disposal of the asset is subsequently collected in Canada.
Eligibility of property – Eligible property includes resource property, inventory, and capital property. The property’s eligibility is defined under the tax act, and however, real property inventory is not included in the list of eligible assets.
Consideration for the shares – The transferor of the property must receive a stake in the corporation. The consideration may be in the form of shares and non-shares, and Share-based consideration needs to be at least one share of the corporation. On the other hand, non-share-based consideration (also called boot) is added to the shares-based consideration. However, it’s not mandatory.
Joint election by transferor and transferee – Joint election must be made by both transferor and transferee of the property. This joint election needs to be filed on or before the date of the tax return. However, there are some exceptions regarding the date of the joint election. The joint election needs to be made by filing the forms T2057 and T2058 in partnership with the Canada Revenue Agency (CRA).
For further information regarding joint filing and taxation matters, contact us.
Section 85 for the elected amounts
At the time of a joint election, the transferor and transferee need to elect an amount. This elected amount serves as proceeds for the disposition of the assets and costs to be recorded for the transferee (a Canadian corporation).
Following upper and lower limits for the elected amount have been mentioned by the Tax Act.
(i) The elected amount of the eligible property should be less than the fair market value of the eligible asset at the time of transfer.
(ii) The elected amount needs to be either equal or more than the fair market value of the non-share consideration received by the transferor.
(iii) The elected amount needs to be either equal or more than lesser of the fair market value of the property and the cost of the property for the transferor at the time of transfer.
Example for understanding the lower and upper limits for the elected amount.
Suppose Mr. Mark is a sole proprietor and owns a building, the cost of the building amounts to $100,000, and the fair market value amounts to $400,000. Mr. Mark intends to transfer his building to the Mark Inc. (A Canadian Taxable Corporation) for common shares and a note for $90,000. Mr. Mark needs to file an election under subsection 85(1).
In this scenario, the upper limit of the transaction would be the fair market value of the building amounting to $400,000. On the other hand, the lower limit for the transaction will be $100,000; the reason is that it’s the cost of the asset in the books of the transferee.
So, if the elected amount is fixed between the upper and lower limit, which is $100,000 and $400,000, these are the limits for the joint amount in the case of transfer of building from Mr. Mark to Mark Inc. If the parties make a joint election on the $100,000, the capital gain tax will not be triggered immediately, since the transfer price is equal to cost.
Need for the price adjustment clause in section 85 for the transfer agreements
Canada Revenue Authority – (CRA) can review and reassess the amount for the selected amount. This can result in immediate taxes and the liabilities that fall on the business. That’s why agreements for the non-arms-length transaction should include a price adjustment clause in the future. The price adjustment clause opens the space for the adjustment in the transaction price if a court of law/CRA determines that there needs to be adjusted by the transferor and the transferee.
Consideration in the valuation of the eligible property
Item-wise valuation of the assets to be transferred helps in calculating valuation, especially in case of the intangible assets like patents, goodwill, trademarks, and other intangible assets of the business. These assets are subject to more scrutiny. So, it’s advisable to get a valuation on these subjective items.
Further, section 85 rollover technical relief is a complex document, and our experienced team of tax professionals can help accurately assess elected amounts and matters related to rollover relief.
RKB Accounting has expertise in cross-border taxation and has been providing accounting and taxation services for the last fifteen years in Canada and USA. RKB services include incorporating a business on both sides of the border, bookkeeping, sales tax, payroll, and corporate and personal income tax. RKB’s expertise includes cross-border tax planning, long-term tax planning, helping business start-ups, business structure planning, and resolving complex tax matters. RKB a CPA(Delaware), CA(India), and CIA(USA) has over 25 years of experience in accounting and taxation in dealing with various countries in the world.
Disclaimer: Information in the blog/post/article has been presented for a broad and simple understanding. This is not legal advice. RKB Accounting & Tax Services does not accept any liability for its application in any real situations. You need to contact your accountant or us for further information.