Differentiating Tax Strategies: Sec. 85 vs. Sec. 85.1

Neufeld Legal: Chris@NeufeldLegal.com - 403-400-4092 / 905-616-8864

The primary distinctions between Section 85 and Section 85.1 of the Income Tax Act (Canada) lies in their scope and how they are put into effect in specific commercial transactions. Section 85 is a broad "rollover" provision that allows taxpayers (individuals, trusts, or corporations) to transfer a wide variety of "eligible property", including capital property, inventory, and resource property, to a taxable Canadian corporation in exchange for shares. It is the fundamental tool for internal reorganizations, such as incorporating a sole proprietorship or freezing an estate. In contrast, Section 85.1 is a specialized, narrower provision designed strictly for "share-for-share" exchanges. It is typically utilized in arm's-length corporate takeovers or mergers where a purchasing corporation issues its own shares to acquire the shares of a target corporation from a vendor. While Section 85 is an elective provision offering flexibility, Section 85.1 is a statutory default that applies automatically when specific conditions are met.

Procedural Mechanics - Election vs. Automatic: The procedural requirements for claiming the rollover differ significantly. To utilize Section 85, the transferor and transferee must jointly file a prescribed election form (Form T2057 or T2058) within strict deadlines. This election allows the parties to specify an "agreed amount" (the transfer price) anywhere between the tax cost and the fair market value (FMV) of the asset, subject to specific limits. This "elected amount" becomes the transferor’s proceeds of disposition and the transferee’s cost. Conversely, Section 85.1 requires no election form. If the transaction meets the statutory criteria, primarily that the vendor receives shares of the purchaser in exchange for shares of the target, the rollover applies automatically. Under Section 85.1, the vendor is deemed to have disposed of their shares at their Adjusted Cost Base (ACB), effectively forcing a full tax deferral without the option to "crystallize" a capital gain unless the vendor explicitly chooses to report the gain in their tax return to opt out.

Treatment of Non-Share Consideration ("Boot"): The flexibility regarding non-share consideration, often called "boot" (e.g., cash or notes), is a major differentiator. Under Section 85, a taxpayer can receive boot up to the amount of the tax cost (ACB) of the transferred asset without triggering immediate tax. The election mechanics allow the boot to be allocated against the cost base first, meaning a vendor can extract tax-free cash up to their original investment. Under Section 85.1, the rules are more rigid. The rollover applies strictly to the extent that shares are exchanged for shares. If a vendor receives cash or other non-share consideration, that portion of the exchange does not qualify for the rollover and is treated as a taxable disposition at FMV. Unlike Section 85, Section 85.1 does not permit a "boot-first" allocation to shelter cash receipts from capital gains tax.

Relationship and Control Constraints: A critical restriction in Section 85.1 is the requirement for the parties to deal at arm's length. Subsection 85.1(2) specifically denies the rollover if the vendor and purchaser are non-arm's length immediately before the exchange, or if the vendor (or non-arm's length persons) acquires control of the purchaser immediately after. This makes Section 85.1 unsuitable for most private client reorganizations (like transferring shares to a holding company owned by the same person). Section 85 has no such arm's length restriction; in fact, it is specifically designed to facilitate transfers between related parties. Consequently, any share exchange involving a related vendor and purchaser must utilize Section 85 and its election filing requirements to achieve tax deferral, as Section 85.1 will be statutorily barred.

Tax Consequences for the Purchaser (ACB and PUC): The implications for the purchasing corporation are perhaps the most technically distinct area. Under a Section 85 election, the purchaser's tax cost (ACB) of the acquired asset is equal to the "agreed amount" (typically the vendor's ACB). This preserves the tax basis of the asset inside the new corporation. However, under Section 85.1, the purchaser's tax cost for the acquired shares is the lesser of their FMV and their Paid-Up Capital (PUC) immediately before the exchange. Because PUC is often significantly lower than ACB, the purchasing corporation in an 85.1 transaction often inherits a very low tax cost base. Additionally, while Section 85 reduces the PUC of the new shares to match the tax cost (preventing surplus stripping), Section 85.1 reduces the PUC of the new shares to match the PUC of the old shares, ensuring that the cross-border or cross-entity paid-up capital remains constant.

For knowledgeable and experienced tax law representation for corporate tax rollovers and other tax planning strategies, as your business enterprise strives to optimize the financial advantages of legal tax structuring, contact tax lawyer Christopher R. Neufeld at Chris@NeufeldLegal.com or call 403-400-4092 (Calgary, Alberta) / 905-616-8864 (Toronto, Ontario).

Differentiating: Sec. 85 vs. Sec. 85.1  |  Sec. 85 vs. Sec. 86  |  Sec. 85 vs. Sec. 87  |  Sec. 85 vs. Sec. 51(1)

NOT LEGAL ADVICE. Information made available on this website in any form is for information purposes only. It is not, and should not be taken as legal advice or tax advice. You should not rely upon, or take or fail to take any action, based upon this information. Never disregard professional legal advice or delay in seeking legal advice because of something you have read on this website. The law firm of Neufeld Legal PC would be pleased to discuss legal matters referenced in this website upon their retention in accordance with applicable requirements pertaining to client retention by this law firm. Thank you.