Generally when a disposition of capital property occurs, a gain or loss is recognized. Occasionally the disposition results in no real change to the economic interest of the property, like when an individual transfers property to a corporation they own. A rollover provides a way to defer the gain or loss.
Section 85 of the Income Tax Act is where the magic happens. One caveat: The transferor must take back shares in the tranferee corporation in consideration, at the fair market value of the assets transferred. The adjusted cost base of the shares will equal the ACB of the assets. Now if the shares are sold to an unrelated third party (an “arm’s length transaction”) they will fetch the FMV and the gain will be realized. Until that happens though, the gain and tax is deferred.
This works even if the asset being transferred is shares in an operating company. The beauty of Section 85 is it is an election – the transferor can decide and elect the cost of the asset being transferred anywhere between the ACB and FMV. For example, shares with an ACB (or “tax value”) of $100 and FMV of $150 can be transferred at $125, to elect to recognize a gain of $25.
This is how the capital gains exemption is “crystallized”. You can transfer shares of an operating company into a holding company and elect to recognize a $500,000 gain, to use the CGE. The tax value of the shares is bumped up, you’ve utilized the tax advantage of the exemption, and you can go forward as normal, since you received back shares in the holding company worth the new value (the original cost of the operating company shares plus the $500,000 elected gain) in exchange.
As you can imagine this allows some flexibility when it comes to general tax or estate planning. For example, you could offset a capital loss that is expiring by recognizing the equal amount of gain. Or you could take back preferred shares in the holding company from the paragraph above after crystallizing the exemption, and have your children subscribe to common shares, so that future growth of the operating company accrues to the children.
The following conditions are required to be met for the rollover to apply:
- the transferee must be a taxable Canadian corporation
- consideration received must include shares in the corporation or a fraction of a share
- the property transferred can be depreciable or non-depreciable capital property, a resource property or inventory
- a joint election by both parties must be filed
This is just a summary of the very basics of this complex section of the Act. As with any general tax discussion, your personal situation is unique and requires the expertise of a Chartered Accountant. If you need a CA, please contact me and I can provide a referral.