As we have just entered the New Year, it is a good idea to become familiar with the updated 2018 tax rates as the rates may impact the financial decisions you make for you and your business. We will cover the updated rates for GST/HST, corporate income tax, Canada Pension Plan (CPP) and Employment Insurance (EI).
Have you been in business for a while now and are ready to incorporate? If you have built a customer list or the value of your business assets has appreciated, you need to have proper planning in place to ensure that you are not faced with adverse tax consequences upon incorporation. This is because you are considered to have transferred these assets to the corporation at fair market value and any accrued gain on the assets is taxed on your personal tax return.
This may seem unfair because you technically still own these assets through the corporation. However, from the Canada Revenue Agency’s (CRA) perspective, an individual and a corporation are two separate legal persons, thus any transfer of properties between the two may trigger a capital gain tax liability. By applying Section 85, you could avoid the immediate negative tax impact upon transfer and defer the gain until disposal.
What is Section 85 rollover?
Section 85 rollover is a joint tax election made by the transferor and the transferee on the transfer of properties. For entrepreneurs, the main purpose of Section 85 is to defer tax upon transfer of properties. Without this election, all properties are deemed to be sold at fair market value, which may result in a substantial tax liability. Section 85 allows assets to be transferred at cost to completely defer the gain on assets until the ultimate disposition.
In order for you to utilize Section 85 rollover to avoid the immediate adverse tax consequences upon incorporation, the following five criteria must all be met:
- Eligible transferor
If you are the one transferring the property, then you must be qualified as an eligible transferor. The Income Tax Act defines an eligible transferor to be any taxpayer that is an individual, a corporation, or a trust.
- Eligible transferee
The recipient of the property must qualify as an eligible transferee. This only applies to “Taxable Canadian Corporation,” which is defined as a corporation that is a resident of Canada. In other words, if the recipient is an individual, a partnership, or a trust, then this election cannot be applied.
- Eligible property
Not all properties are eligible for Section 85 rollover. The three main types of properties that would qualify for the tax election are:
- Capital properties – including depreciable and non-depreciable assets
- Intangible properties – including goodwill, customer lists, intellectual property, trademarks etc.
Properties that are not ideal to utilize Section 85 rollover are:
- Accounts receivable – Section 22 should be applied instead to achieve better results
- Depreciable assets with a terminal loss
- Non-depreciable assets with accrued capital losses
The term “consideration” for the purpose of Section 85 rollover is defined as anything given by one party in exchange for the promise or undertaking by another party.
One of the conditions for this election is that the consideration the transferor receives must include at least one share of the capital stock of the transferee corporation. For example, if you transfer equipment to the corporation, you must take back at least one share of that corporation in exchange for the equipment.
- Elected transfer price
One of the main reasons for using Section 85 is to defer gain on transfer of property. To achieve maximum gain deferral, you would elect the proceeds (known as the “elected transfer price”) equal to costs, so that there is no capital gain to report. However, for more advanced users who are using Section 85 for other tax planning purposes, the elected amount must be within the three limitations listed below:
- The elected transfer price cannot exceed the fair market value of the property
- The elected transfer price cannot be lesser than the fair market value or its tax cost
- The elected transfer price cannot be lesser than the fair market value of any boot. The term “boot” for the purpose of Section 85 is defined as a non-share consideration. For example, cash, loan payable, etc.
Putting things into perspective
Let’s suppose you are in the car parts installation business. You have been running your business for a year and have built up a good brand reputation during this period. Your business goodwill and client list are currently worth $50,000. You had purchased car parts at a heavily discounted price at $1,000 and they are now worth $20,000. You are ready to take your business to the next stage – incorporation.
When you transfer the asset to the business upon incorporation, you are considered to have sold these assets and would be reporting a gain of $69,000 on your personal tax return. By filing an election under Section 85, you could effectively avoid the immediate adverse tax impact by deferring the entire capital gain upon incorporation. The calculations are illustrated in the tables below.
Without Section 85
|Property||Fair Market Value||Tax Cost||Capital Gain|
With Section 85
|Property||Fair Market Value||Tax Cost||Elected Transfer Price||Common Shares||Capital Gain|
* Note that the transfer of goodwill must have an elected amount at minimum of $1 in order for the election to be valid.
**The shares taken back in exchange for the car parts and goodwill transferred are worth $70,000.
Becoming aware of the benefits and having a general understanding of the analysis required put you in the right frame of mind when incorporating your business. In order for Section 85 to be applied, you need to file a joint election Form T2057 to the CRA. Because the rules surrounding Section 85 are complex, you should speak with a tax specialist to ensure the tax election is being applied appropriately.