Introduction: S.51 rollovers
S.51 rollovers are one of the many tax-free rollovers the Income Tax Act provides taxpayers. A s.51 rollover allows a taxpayer to convert debt or shares in a corporation to new shares of that corporation on a tax-free basis. S.51 also allows taxpayers to do this without an election, unlike other rollovers, making it a useful tool for knowledgeable Canadian tax lawyers advising taxpayers seeking to reorganize the share capital of a corporation.
The purpose of s.51 rollovers is to easily allow shareholders to convert their equity (debts or shares) into new shares without realizing any gains. A shareholder may desire to change the form of his or her ownership in a corporation, but doing so risks tax consequences if the exchange is treated as a disposition at fair market value. S.51 of the Income Tax Act provides a rollover mechanism that allows the shareholder to defer the recognition of any gains by deeming the exchange to occur on a tax-deferred basis, provided the conditions of the section are met.
Effect of section 51 rollover on a taxpayer
Under paragraph 51(1)(c), a successful rollover under s.51 produces no capital gains or capital losses. Paragraph 51(1)(d) provides that the taxpayer's cost of the new shares is deemed to be the original cost of the converted share.
So, if the adjusted cost base of a taxpayer's common shares was $50, when the shares are converted into preference shares, the adjusted cost base of the new shares will remain unchanged at $50. As there is also no disposition if done correctly, the taxpayer will not face any realization of gains or losses. For a tax-deferred conversion of shares or debt, the fair market value of the converted property must be equal to the fair market value of the new shares received.
However, if a taxpayer is not careful with implementing subsection 51(2), the section can apply to produce negative tax consequences through realizing any gains instead of deferring taxation.
Subsection 51(2) Indirect Benefits
Subsection 51(2) is designed to stop shareholders from conferring an indirect benefit on related parties. Subsection 51(2) applies when (1) the fair market value of a converted share or debt is greater than the fair market value of the received share; and (2) it is reasonable to conclude that the shareholder intended to confer a benefit on a related person.
By converting shares of higher value for lower value shares, a shareholder is seen as artificially increasing a corporation's value, benefiting the other shareholders, who in this case are related people. Subsection 51(2) stops the use of these rollovers to produce these benefits and limit income splitting.
For example, a husband owns common shares in a company that he originally bought for $50 but are now worth $150. He decides to exchange those shares for preferred shares in the same company that are worth $100. His wife also owns shares in the company, which can trigger subsection 51(2) because he is (1) converting higher-value shares for lower-value shares; and (2) he is doing this in a corporation where someone related to him is also a shareholder.
According to paragraph 51(2)(d) of the Income Tax Act, he is treated as having sold his original shares for $100, not the full $150 per market value. That $100 is made up of his original $50 investment plus the $50 benefit he is considered to have conferred on his wife in the transaction. Because of this, he is taxed on a capital gain of $50, the difference between the $100 deemed proceeds and his $50 original cost. The rule also says that if this kind of transaction would result in a loss instead of a gain, that loss is ignored for tax purposes.
The husband's new cost will be the lesser of his original cost of the converted shares ($50) or the fair market value of the new shares less any denied capital losses under paragraph 51(2)(d). A top Canadian tax lawyer has experience with tax planning and tax-deferred rollover transactions and can ensure that you do not face any unnecessary taxation.
Pro Tax Tip – Understand what you are rolling over and how
Given the purpose of this provision, s.51 transactions are generally limited only to shares and debt. A taxpayer generally cannot convert other property, such as cash, into new shares. To achieve a tax-deferred rollover, a taxpayer must always ensure that his or her converted property matches the value of the new shares.
If a taxpayer attempts to add cash or other property on top of any debt or shares, the transaction will not qualify as a s.51 rollover (except where the exchange involves fractional shares). So, if the fair market value of shares is $150, the taxpayer must receive new shares with a fair market value of $150.
Additionally, s.51 rollovers are subordinate to s.85 and s.86 rollovers. If a taxpayer is using a s.85 or s.86 rollover, then those provisions will apply instead of s.51. As such, the rollover will be subject to the specific rules of that section and not the rules of s.51. Contacting an experienced Canadian Tax lawyer will help you understand and use the rollover that is best for your business or succession planning.
FAQ
What if the value of shares received as part of a section 51 rollover is greater than the value of the shares converted?
If the value of the new shares is greater than the shares converted, then that shareholder is deemed to have a shareholder benefit under s.15 for the excess. If the value of shares is $100 and a shareholder receives new shares worth $150, then the shareholder will have $50 added to his or her tax liability for the year as a shareholder benefit.
Can I convert fractional shares as part of a section 51 rollover?
Taxpayers can include fractional shares in their section 51 conversion. Fractional shares are included in the definition of shares in subsection 248(1) of the Income Tax Act. The CRA has stated that cash may be given under a s.51 rollover, provided the amount does not exceed $200.