Differentiating Tax Strategies: Sec. 85 vs. Sec. 86

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

Both Section 85 and Section 86 of the Income Tax Act (Canada) act as critical tax-deferral mechanisms that allow taxpayers to restructure their holdings without triggering immediate capital gains tax. While they share the goal of a "rollover", deferring tax until a future disposition, they differ fundamentally in their scope and application. Section 85 is an elective provision primarily designed for transferring various types of property to a corporation (often creating a parent-subsidiary relationship), whereas Section 86 is an automatic provision strictly for exchanging shares within the same corporation during a reorganization of capital.

Procedural Mechanism and Flexibility: The most distinct procedural difference is that Section 85 is elective, while Section 86 is automatic. To utilize Section 85, the transferor and the transferee corporation must jointly file a specific election form (T2057) within a prescribed timeline. This election grants the taxpayer granular control, allowing them to choose an "agreed amount" between the property's cost base and its fair market value, effectively letting them crystallize capital gains exemptions if desired. In contrast, Section 86 applies automatically by operation of law whenever its conditions are met; no election form is filed. While simpler administratively, Section 86 lacks the flexibility to manually set an elected amount, as the rollover occurs at the adjusted cost base (ACB) of the old shares unless non-share consideration is involved.

Eligible Property and Scope: The scope of eligible property varies significantly between the two sections. Section 85 is broad, applying to "eligible property" which includes capital property (real estate, portfolio investments), Canadian resource property, inventory, and shares of other corporations. This makes Section 85 the go-to tool for incorporating a sole proprietorship or moving personal assets into a corporation. Conversely, Section 86 is highly specific: it only applies to the exchange of shares of the capital stock of a corporation for new shares of the same corporation. You cannot use Section 86 to transfer real estate or inventory, nor can you use it to transfer shares of Company A to Company B.

Transaction Requirements - The "All or Nothing" Rule: A critical constraint of Section 86 is the requirement that the taxpayer must dispose of all shares of a particular class owned by them in that corporation to qualify for the rollover. If a shareholder wishes to exchange only 50% of their common shares for preferred shares, Section 86 will not apply. Section 85 has no such "all or nothing" restriction; a taxpayer can transfer any specific quantity of shares or assets they choose. This makes Section 85 the necessary choice for partial rollovers or when a shareholder wishes to retain some of their original equity outside the reorganization.

Consideration and Boot: Both sections allow the taxpayer to receive non-share consideration (cash or promissory notes), often referred to as "boot," but they handle it differently. Under Section 85, the "agreed amount" (proceeds of disposition) cannot be less than the value of the boot received. If the boot exceeds the tax cost of the asset, immediate capital gain is triggered. Section 86 operates similarly in principle, the cost of the new shares is reduced by the value of the boot received, but because there is no "elected amount," the math is rigid. Furthermore, Section 85 requires the taxpayer to take back at least one share of the transferee corporation to qualify, whereas Section 86 requires the receipt of shares but focuses on the exchange of old shares for new shares as part of the capital reorganization.

Strategic Application - Holding Companies vs. Internal Freezes: Practically, these differences dictate distinct strategic uses. Section 85 is typically used to insert a Holding Company between an individual and an Operating Company (an "external freeze"). This is because the shares of the Operating Company are being transferred to a different entity (the Holdco). Conversely, Section 86 is the standard tool for an "internal" Estate Freeze, where no new corporation is introduced. In this scenario, the founder simply exchanges their common shares for fixed-value preferred shares within the existing Operating Company to allow new family members to subscribe for growth shares. Because Section 86 is automatic and requires no election forms, it is often preferred for these simpler, single-entity reorganizations to reduce compliance costs.

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).

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