SECTION 86 REORGANIZATION - SHARE EXCHANGE

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A Section 86 reorganization enables a shareholder to exchange existing shares of one class for new shares of a different class within the same corporation without triggering immediate tax consequences (i.e., capital gains tax). The normal disposition of shares, would result in the immediate recognition of any capital gain, which would be subject to tax. Section 86 of the Income Tax Act (Canada) provides a specific exception to this rule, allowing for a "tax-deferred" exchange. By structuring the transaction in conformity with Section 86 of the Income Tax Act (Canada),  the tax liability is postponed until a later date, typically when the new shares are eventually sold.

Key Characteristics and Conditions of a Section 86 Reorganization

• Share Exchange within the Same Corporation: The fundamental condition is that the exchange must involve "old shares" for "new shares" in the same corporation.

• Reorganization of Capital: The exchange must occur "in the course of a reorganization of the capital of a corporation." While the ITA doesn't precisely define this, the Canada Revenue Agency (CRA) generally requires an amendment to the articles of incorporation to authorize the new share class, though some workarounds may exist if the corporation already has the authority to issue various share classes.

• All Shares of a Class: The taxpayer must dispose of all shares of a particular class that they owned in the corporation.

• Capital Property: The shares involved in the exchange must be considered capital property.

• No Election Required: Unlike some other rollover provisions (like Section 85), a formal election form is generally not required for a Section 86 exchange.

• Adjusted Cost Base (ACB) and Paid-Up Capital (PUC) Follow: The tax cost (ACB) and paid-up capital (PUC) of the old shares are typically transferred to the new shares received in the exchange.

Common Uses and Benefits of a Section 86 Reorganization

• Estate Freezes (Succession Planning): This is perhaps the most common use. A business owner might exchange their common shares (which typically appreciate in value) for fixed-value preferred shares. This "freezes" the current value of their ownership interest, and any future growth in the company can then accrue to newly issued common shares held by the next generation (e.g., children) or a family trust. This defers the capital gains tax on the frozen value until the preferred shares are eventually redeemed or sold, and shifts future growth to the successors, potentially reducing the overall tax burden on the original owner's estate.

• Corporate Restructuring: It allows companies to reorganize their share structure, for instance, to:

  • Introduce new classes of shares with different rights (e.g., voting vs. non-voting, dividend entitlements).

  • Bring in new shareholders without immediate tax implications for existing shareholders.

• Tax Deferral: The main benefit is the ability to defer capital gains tax that would otherwise arise from a disposition of shares. This provides flexibility for business owners and allows them to manage their tax liabilities more effectively.

Important Considerations when implementing a Section 86 Reorganization

• Professional Advice: Section 86 reorganizations can be complex. It is crucial to consult with tax advisors and corporate lawyers to ensure compliance with the Income Tax Act and to properly structure the transaction for your specific circumstances.

• Potential Pitfalls: While designed for tax deferral, improper execution can lead to unintended tax consequences, such as deemed dividends or immediate capital gains.

• Interaction with Other Provisions: Section 86 does not apply if Section 85 (another common rollover provision for transferring property to a corporation) applies. Section 85 often takes priority.

For advanced corporate structuring and tax planning, contact our law firm to schedule a confidential initial consultation with a knowledgeable corporate tax lawyer at Chris@NeufeldLegal.com or 403-400-4092 / 905-616-8864.

 

What is a Section 85 Rollover: A section 85 rollover enables a taxpayer (the transferor) to dispose of “eligible property” to a taxable Canadian corporation (the transferee), so that most, if not all, of the tax consequences which usually arise on such a disposition are shifted to the transferee corporation from the transferor. The transferor is permitted to dispose of the property to the transferee corporation for an “agreed amount” which may be other than the fair market value of either such property or the consideration received for it. Read more . . .

 

What is a Butterfly Transaction: A Butterfly Transaction, technically known as a Divisive Reorganization, is a tax-free method of dividing up assets in a corporation into separate corporate allocations, which is commonly implemented when the shareholders are seeking to go their separate ways and thus divide out the corporation’s assets. A Butterfly Transaction can also be carried out when the corporation consists of two different businesses with a view to separating the divisions so that they are each in a separate corporation; or alternatively, to “purify” a corporation of its non-active business assets . . . Read more . . .

  

What is a Section 51(1) Share Conversion Exchange: A section 51(1) exchange permits a taxpayer to exchange a convertible property issued by a corporation for shares of the corporation on the basis of a tax-free rollover. Convertible properties are capital property such as a share, bond, debenture or note of the corporation that contains a conversion privilege. In the course of an exchange of convertible property, a taxpayer may be entitled to receive a fractional interest in a share. Read more . . .

  

What are Capital Dividends (Tax-Free Dividends): Capital dividends are private corporation dividends that are paid tax-free to their Canadian-resident shareholders, such that no part of the dividend is included in computing the recipient shareholder’s taxable income. Read more . . .

  

Importance of Maintaining a Capital Dividend Account [for Tax-Free Dividends): A private corporation’s Capital Dividend Account is the means by which the corporation pays its resident-Canadian shareholders tax-free capital dividends. The Capital Dividend Account (CDA) does not appear on a balance sheet, although it might appear in the notes of a financial statement, where the accountants are sufficiently apprised as to the inner workings and transactions of the corporation. Read more . . .

 

What is an Eligible Dividend (Enhanced Dividend Gross Up / Tax Credit): An eligible dividend is a taxable dividend that receives an enhanced dividend gross up and an enhanced dividend tax credit and is available on dividends from either a public corporation (not entitled to the small business deduction) or a private corporation with high earnings (net income over the $500,000 small business deduction). Read more . . .

 

What is a Non-Eligible Dividend (Ordinary Dividend): A non-eligible dividend (also known as an ordinary dividend) is a taxable dividend that does not receive the benefit of the enhanced dividend gross-up and the enhanced dividend tax credit that is provided to eligible dividends. Read more . . .

 

What is a Stock Dividend: A stock dividend is a dividend paid by the issuance of shares of the capital stock of the payer corporation. The term "stock dividend" is defined as including any dividend paid by a corporation to the extent that it is paid by the issuance of shares of any class of the capital stock of the payer corporation, . . . Read more . . .

 

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