85.1(1) Share for Share Exchange – A Toronto Tax Lawyer Analysis
The purpose of subsection 85.1(1) of the Income Tax Act is to defer the recognition of capital gains and losses that would have otherwise been realized in a share for share exchange between a Canadian purchaser corporation and a taxpayer. A share for share exchange is when the taxpayer exchanges his or her shares in a corporation for shares of another corporation. The general legislative objective of rollover provisions such as subsection 85.1(1) is to encourage the movement of assets by only recognizing taxable gains and losses when they are fully realized in a future transaction where s. 85.1(1) does not apply. That means providing for tax-deferred treatment when capital assets such as stocks, are moved around between affiliated corporations. While section 85(1) deals with tax-deferred treatments of transfer of assets generally between a Canadian purchaser corporation and a taxpayer, subsection 85.1(1) provides tax-deferred treatments when the vendor is a corporation or an individual and only shares of the two corporations are being exchanged. Since a share for share exchange is one way for two corporations to integrate their businesses, it is important to understand the application of subsection 85.1(1) in order to carry out the corporate integration in a tax efficient manner.
Conditions for a subsection 85.1(1) Rollover
In order for subsection 85.1(1) to apply, each of the following conditions must be met:
- The purchaser corporation acquiring the shares must be a Canadian corporation. Canadian corporation is defined in subsection 89(1).
- The shares given up by the vendor must be capital property. Whether a particular share is a capital property or inventory is a factual determination.
- The shares given up in exchange by the purchaser corporation must be shares of a taxable Canadian corporation.
- The Canadian purchaser corporation must issue its shares as consideration for the acquisition of the vendor's shares; this means the Canadian purchaser corporation cannot issue shares it had previously acquired that are not its own shares. Furthermore, this means the Canadian purchaser corporation cannot issue non-share consideration.
- The vendor must receive as shares of the Canadian purchaser corporation back as consideration.
Limitation of s. 85.1
Subsection 85.1 (2) describes five circumstances where subsection 85.1(1) does not apply.
First, paragraph 85.1(2)(a) provides that subsection 85.1(1) does not apply if the purchaser Canadian corporation and the vendor are not dealing at arm's length immediately before the exchange. If the two parties are not dealing at arm's length to begin with, they could only jointly file a subsection 85(1) election. The definition of non-arm's length is defined in paragraph 251(5)(b).
Second, paragraph 85.1(2)(b) provides that subsection 85.1(1) does not apply if the taxpayer vendor, persons with whom the taxpayer does not deal at arm's length, or a combination of both, acquire control of the Canadian purchaser corporation as an immediate result of the transaction, or they beneficially own enough of the purchaser's shares that they have a fair market value exceeding 50% of all outstanding shares of the purchaser's corporation. Control here means de facto and de jure control. De jure control is determined by looking at whether the taxpayer or his or her affiliated group control more than 50% of the voting shares. De facto control is a multi-factored determination based on all relevant facts.
Third, paragraph 85.1(2)(c) provides that subsection 85.1(1) does not apply if the parties already filed for section 85(1) or (2) elections.
Fourth, paragraph 85.1(2)(d) provides that subsection 85.1(1) does not apply if the vendor received non-share consideration or if the vendor received shares belonging to more than one class. Therefore the vendor must receive only one class of shares and only those shares as consideration for giving up its shares to the purchaser corporation.
Finally, for exchanges occurred after 1995, subsection 85.1(1) will not apply if two conditions are met; first, the vendor is a foreign affiliate of a Canadian purchaser corporation at the end of the taxation year of the vendor in which the exchange occurred. Second, the vendor has included any portion of the gain or loss from the disposition of the exchanged shares in computing its foreign accrual property income for the taxation year of the vendor in which the exchange occurred.
Tax Consequences of Subsection 85.1(1) for the Vendor
Once the above conditions are met, subsection 85.1(1) operates by deferring the capital gains consequences via deeming the proceeds of the transfer for the vendor's shares to be equal to the adjusted cost base of those shares for the vendor. That same amount which is the adjusted cost base of vendor's shares is also deemed to be the vendor's cost in acquiring the purchaser's shares. Adjusted cost base is defined in section 54 of the Income Tax Act as the capital cost of a property. CRA's own position in IT-285R2 is that the adjusted cost base of a share will include the money a shareholder paid to acquire the shares, as well as additional legal and accounting fees. However, in The Queen v Stirling 85 DTC 5199, the Federal Court of Appeals ruled that the adjusted cost base of a property does not include the expense incurred to put the purchaser in the position of acquiring the property. Therefore it is not clear that besides brokerage fees, to what extent can other transactional costs be included in the adjusted cost base of a share.
Putting aside the issue of what could be included in the adjusted cost base of a share, since the vendor is deemed to have disposed of its shares for proceeds at the same value the vendor acquired the purchaser's shares, the practical consequence for the vendor is that regardless of the adjusted cost base of its own shares or the purchaser's shares, the vendor does not realize any capital gains.
Canadian corporation Aco acquires 1,000 shares of Class B shares of Bco in exchange for 2,000 shares of Aco's Class A shares. Bco's 1,000 shares have an adjusted cost based of $10,000 and a fair market value of $10,000. Aco's 2,000 shares have an adjusted cost base of $20,000 and a fair market value of $20,000. But for the subsection 85.1(1) election, Bco would have disposed the shares for $20,000, thereby realizing a taxable capital gain of $10,000. Subsection 85.1(1) deems Bco to have disposed the shares at $10,000 and acquired Aco shares at $10,000. Bco therefore realizes no capital gains.
Unlike subsection 85(1), subsection 85.1(1) does not allow for partial deferral of the capital gain. Subsection 85(1) allows the parties to elect for any amount between the adjusted cost base for the vendor and the fair market value of the transferred property. Therefore it is possible for the parties to elect an amount in between the adjusted cost base and the fair market value to achieve partial deferral. Subsection 85.1(1) contains no such mechanisms. The parties have to elect for full deferral or no deferral at all.
Tax Consequences of s. 85.1(1) for the Purchaser
Interestingly, the tax consequence for the purchaser is not determined with reference to the adjusted cost base of the shares of the vendor. Rather, for the purchaser, the cost of acquiring the vendor's shares is deemed to be the lesser of the paid-up capital of those shares or their fair market value. Paid-up capital is the total amount of money the corporation initially received for the issuance of an entire class of shares divided by the total number of shares of that class. When the corporation initially issues a class of shares to its shareholders for cash, the paid-up capital of a share will equal to its adjusted cost base for the shareholder. However, if the corporation repurchases its own shares from its shareholder at fair market value, then the adjusted cost base will be the fair market value but the paid-up capital will remain the same, which may be more or less than the adjusted cost base.
By deeming the purchaser's cost of the shares which the purchaser receives from the vendor without reference to the vendor's adjusted cost base, subsection 85.1(1) prevents what Parliament considers to be inappropriate tax deferral by increasing the adjusted cost base of the vendor's shares to its fair market value without a corresponding increase of paid-up capital. Since subsection 85.1(1) defers any capital gains for the vendor regardless of the adjusted cost base of the exchanged shares, the vendor would be in the same financial position while the purchaser realizes a smaller amount of taxable gains if vendor's shares increase in value later on.
Seek Tax Planning Advice Before Conducting a Share for Share Exchange
If your Canadian corporation is considering a merger with another corporation, our expert Toronto Tax Lawyers can provide you with advice on whether the two corporations are eligible for a subsection 85.1(1) election, and whether a merger through a subsection 85.1(1) share for share exchange is the most cost-effective way of achieving your business goals.
If you are planning to conduct a share for share exchange through subsection 85.1(1), our top Toronto Tax Lawyers can provide you with tax planning advice to make sure the adjusted cost base and paid up capital of the exchanged shares are properly adjusted as to minimize the future tax consequences if those shares are disposed on a full realization basis.