What are the tax advantages of a section 51(1) Share Conversion?

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A section 51(1) share conversion allows for a tax-deferred "rollover" when a taxpayer exchanges a "convertible property" (which can be another share of the corporation, or a bond, debenture, or note of the corporation with a conversion privilege) for shares of the same corporation, provided no other consideration is received.

As a tax-driven legal arrangement, the primary tax benefits that are attainable through the appropriate implementation of a section 51(1) share conversion include:

A. Tax Deferral (Avoiding Immediate Capital Gains):

• Estate Freezes: This is a very common and powerful application. Business owners (often in family-owned businesses) may hold common shares that are appreciating in value. To freeze the current value of their estate for tax purposes, they can convert these common shares into fixed-value preferred shares under Section 51(1). The accrued capital gain on the common shares is deferred, not triggered, until the preferred shares are eventually sold or redeemed (e.g., upon death). Any future growth of the company is then allocated to new common shares issued to the next generation or a family trust, minimizing the tax burden on the original owner's estate.

• Corporate Reorganizations: Companies may need to restructure their share capital for various reasons (e.g., to simplify the capital structure, to prepare for a sale, to bring in new investors, or to adjust voting rights). Section 51(1) allows for such internal reorganizations without immediate tax consequences for the shareholders. The adjusted cost base (ACB) of the old shares simply carries over to the new shares.

• Converting Convertible Securities: If a corporation has issued convertible bonds, debentures, or preferred shares with a conversion feature, Section 51(1) allows the holder to convert these into common shares (or other shares of the same corporation) without triggering a taxable event at the time of conversion.

B. Succession Planning:

• As with estate freezes, Section 51(1) is a crucial tool for smoothly transferring ownership and future growth of a business to the next generation or key employees while deferring the tax liability for the current owner.

C. Simplicity and Minimal Paperwork:

• Compared to other rollover provisions in the Income Tax Act (like Section 85), Section 51(1) often involves less paperwork and doesn't require a joint election with the corporation, making it a relatively straightforward process when applicable.

D. Modifying Share Rights:

• While directly amending share rights can sometimes trigger a disposition, a formal exchange of shares under Section 51 can be used to achieve desired changes in voting rights, dividend entitlements, or other share characteristics without immediate tax implications.

Yet, as with every tax-driven legal arrangement, there are important considerations, and potential drawbacks, including, but not limited to:

• No Other Consideration (Boot) Permissible: A crucial requirement for Section 51(1) to apply is that no consideration other than shares of the corporation can be received by the taxpayer for the convertible property. Small amounts of cash received in lieu of fractional shares are generally permissible without invalidating the rollover.

• Same Corporation: The exchange must be for shares of the same corporation that issued the convertible property.

• Capital Property: The "convertible property" must be a capital property of the taxpayer.

• Deferral, Not Elimination: It's important to remember that Section 51(1) defers the tax, it doesn't eliminate it. The tax liability is postponed until the newly acquired shares are eventually disposed of (e.g., sold, gifted, or upon death).

• Simple, But Still Prone to Legal Issues: Just because a section 51(1) share conversion is a relatively simple and straightforward legal process, is not without the possibility for legal issues and scrutiny from the Canada Revenue Agency, based on the particulars of the specific transaction, such that professional tax advice is strongly recommended.

In summary, a section 51(1) share conversion is undertaken primarily to facilitate tax-efficient corporate reorganizations, succession planning, and estate freezes by deferring the recognition of capital gains on the conversion of shares or convertible debt into new shares of the same corporation.

For knowledgeable and experienced legal representation when undertaking a corporate rollover or other tax-driven corporate re-structuring, contact corporate business lawyer Christopher Neufeld at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.

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