TAX-FREE TRANSFERS TO YOUR CORPORATION
There are special rules in the Income Tax Act that allow you to transfer property to a Canadian corporation on a tax-deferred rollover basis. The rules effectively allow you to incorporate an existing business on a tax-free basis, without paying tax on any accrued gains on your business assets. These rules can apply to most transfers of property to a private corporation, not only at the time of incorporation.
This is called a "section 85 rollover", as the rules are found in section 85 of the Income Tax Act.
There are various conditions that must be met.
You and the corporation must file a joint election with the Canada Revenue Agency (“CRA”). The due date for filing the election is your tax filing date for the year of the transfer, or the corporation’s tax filing date, whichever comes first.
You do not have to be resident in Canada. However, the corporation must be resident in Canada.
In consideration for the transfer, you must receive at least one share in the corporation. You can receive other consideration as well, but you must receive at least the one share. The non-share consideration is sometimes called “boot” (think of getting the shares of the corporation, and then getting something else "to boot"), and can include money, a promissory note, and any property other than shares in the corporation.
In the joint election, you pick an “elected amount”. This point is central to the transaction, since
1) the elected amount becomes your proceeds of disposition of the property transferred to the corporation;
2) the elected amount becomes the cost of the property for the corporation; and
3) the elected amount, minus the value of any “boot” that you receive, becomes the cost of your share(s) in the corporation received on the transfer. The amount is allocated first to the cost of any “preferred” shares that you receive, and then to any common shares you get on the exchange.
As might be appreciated, in order to get a complete tax-free rollover, you need to elect an amount equal to the tax cost of the property transferred to the corporation. If you wish, you can elect at a higher amount to trigger a gain on the transfer (say, if you have unused losses that can offset the gain).
However, there are various limits on the elected amount. The elected amount
1) cannot be greater than the fair market value of the transferred property;
2) cannot be less than the fair market value of the boot you receive, if any; and
3) cannot be less than the lesser of the fair market value of the property and your tax cost of the property.
You transfer a capital property to your corporation. Your tax cost of the property was $10,000 and its fair market value is $100,000. In consideration for the transfer, you receive 10 common shares in the corporation, and a $20,000 promissory note (which is boot).
Applying the above limits, the elected amount cannot be greater than $100,000, cannot be less than $20,000, and cannot be less than $10,000. Assuming you elect at $20,000, you will have a capital gain of $10,000 and a taxable capital gain of $5,000.
Of course if you received back no boot, or boot of $10,000 or less, you could elect at $10,000, which would result in a complete tax-free rollover.
Normally, you cannot trigger a loss on the transfer by electing an amount less than the tax cost of the property (say, if the fair market value of the property is less than your cost). In particular, you cannot trigger a loss if you and the corporation are “affiliated”. For these purposes, you and the corporation will be affiliated if you or your spouse controls the corporation, either alone or together, or if you are part of an affiliated group that controls the corporation.
The property you transfer to the corporation must be an “eligible property”, which includes depreciable and non-depreciable capital property, and inventory other than land.
If you are not resident in Canada, land that is capital property used in a business carried on in Canada can qualify, if it is transferred to the corporation along with all or substantially all of the property used in the business.
Tips and Traps
Anti-avoidance rules to consider, suppose the fair market value of the property you transfer to the corporation exceeds the value of the consideration (shares and boot) that you get back from the corporation and also exceeds the elected amount. In other words, you have given more to the corporation than you received back. A special rule says that if it is reasonable to regard the excess as a benefit that you wished to confer on a person related to you (say, a related person who owns common shares in the corporation), the elected amount will be bumped up to the fair market value of the property. This will increase your gain on the transfer because of the increase in the elected amount.
On the other hand, if the fair market value of the consideration you receive from the corporation exceeds the fair market value of the property you transfer to the corporation, the excess will normally be taxable as a shareholder benefit and will be included in your income.
To illustrate another potential problem, the property you transfer to the corporation can include shares in another corporation. This is perfectly acceptable, and the transfer will be subject to the same rules applicable to other property. However, if you receive back boot on the transfer and the value of the boot exceeds the “paid-up capital” of the transferred shares, the excess may be included in your income as a deemed dividend. The “paid-up capital” of shares is the income tax version of the legal stated capital of the shares, and in very general terms, reflects the value used to purchase the shares when they were originally issued.