DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Top 10 Rollover Traps

In Canadian Income Tax on July 13, 2010 at 3:51 pm

The provisions of section 85 of the Income Tax Act govern transfers of property into a Canadian Corporation on a tax-deferred basis. These rules can be complex, and advisors who are asked to implement them can fall into common traps. The following is my list of ten pitfalls to avoid:

  1. Share consideration: Failing to include a share of capital stock in the transferee corporation will automatically disqualify the transaction from rollover treatment.
  2. “Boot” in excess of agreed amount: The rules prevent the transferor from receiving more than the original cost of the assets transferred in the form cash or other non-share consideration (commonly referred to as “boot”) without being taxed. Therefore, a capital gain is triggered if boot exceeds the agreed amount.
  3. Pre-1972 property: Property acquired prior to 1972 (or after 1972 in a non-arm’s length transaction) will have a V-Day value which must be taken into account when setting the agreed amount. However, in certain non-arm’s length rollovers, boot should not exceed original cost. Identical properties must be segregated as to pre-V-Day and post-V-Day. Ignoring V-Day value could result in a loss of tax-sheltered cost base.
  4. Benefit conferred on related shareholder: The fair market value of consideration issued by the corporation should not be less than the value of the assets transferred in. This would result in the transferor conferring a benefit on related shareholders (if any). Under paragraph 85(1)(e.2), the result would be a capital gain in the hands of the transferor equal to the amount of the benefit conferred. For this reason, it is often recommended that fully retractable shares be issued by the transferee.
  5. Shareholder benefit: If the transferee corporation issues total consideration with a fair market value greater than the value of the property transferred in, a taxable benefit would be triggered in the hands of the transferor under subsection 15(1).
  6. Hidden values: In cases where all the assets of a business are the subject of a rollover, the taxpayer should always elect a nominal amount for goodwill or fully depreciated assets. Should a subsequent valuation of the business reveal the existence of goodwill, failure to elect a nominal amount could result in taxable proceeds to the transferor.
  7. Accounts receivable: Trade receivables are generally considered capital property. If they are acquired by a corporation on the sale of a business, any subsequent bad debts would trigger capital losses. If a section 22 election is filed, however, the receivables would be deemed to have been acquired under normal business conditions, and the related bad debts would be fully deductible.
  8. Non-eligible property: Certain assets are not eligible for section 85 rollover treatment. Real property inventory or real property of a non-resident are not eligible property under subsection 85(1.1).
  9. Non-residents: Where the transferor is a non-resident, withholding taxes may apply based on the fair market value of the transferred assets. The Canadian purchaser is ultimately responsible for these taxes if they are neglected. Section 116 provides a system for exemption certificates and/or information reporting requirements which may be required. This would allow for the reduction or elimination of these withholding taxes.
  10. Sales tax implications: Unless it qualifies for an exemption, the transfer of assets is considered to be a supply for sales tax purposes. Capital stock is considered a financial instrument and would be exempt from GST/HST/QST. Exemptions may also be available for the transfer of assets that form all or substantially all of an active business, and for transfers between closely related corporations.

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