Scenarios using Section 86 Reorganization - Share Exchange
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A Section 86 reorganization - share exchange, often referred to as a "share-for-share exchange," is an extremely useful tax-deferral mechanism that is written into the Income Tax Act (Canada). It allows a shareholder to dispose of all their shares of a particular class (the "old shares") to the corporation and receive in return consideration that includes newly issued shares of the same corporation (the "new shares"). The most significant benefit of this transaction is that it is a tax-deferred rollover, meaning the immediate capital gain that would normally arise from disposing of appreciated shares is postponed. The adjusted cost base (ACB) of the old shares is effectively transferred to the new shares, deferring the tax liability until the new shares are ultimately sold or redeemed. This strategic deferral makes Section 86 indispensable for corporate structuring and long-term wealth management, allowing business owners to implement significant changes without immediate, costly tax consequences.
The most common and impactful use of a Section 86 share exchange is in estate and succession planning, specifically through a mechanism known as an estate freeze. A business owner, holding common shares that have significantly appreciated in value, can exchange these growth shares for fixed-value preferred shares. The value of the original owner's equity is thereby "frozen" at its current fair market value, protecting it from future capital gains tax upon the owner's death or retirement. The future appreciation and growth of the corporation can then accrue to newly issued common shares, which are typically subscribed for by the next generation, a family trust, or key employees. This technique efficiently shifts future tax burdens and capital gains liability to the successor owners, ensuring a smooth intergenerational transfer of wealth and business continuity.
Beyond estate planning, Section 86 is frequently employed to facilitate internal corporate restructuring aimed at achieving greater operational or financial flexibility. Corporations often need to amend their capital structure to accommodate new strategic goals, such as introducing new investors, creating different incentives for management, or separating economic interest from voting control. For instance, a corporation may restructure to issue different classes of shares with varying rights regarding dividends, voting power, or liquidation preferences. Using Section 86, an existing shareholder can exchange their current shares for a new class (perhaps converting voting common shares into non-voting common shares) to simplify governance or to prepare for a public offering, all while maintaining the tax-deferred status of the transaction.
A related beneficial application arises when a shareholder needs to crystallize the lifetime capital gains exemption on their shares of a Qualified Small Business Corporation. Although the Section 86 exchange itself is a rollover and does not typically trigger a gain, it can be executed to realize a controlled amount of capital gain to utilize any remaining portion of the shareholder's lifetime capital gains exemption. By receiving a small amount of "boot" (non-share consideration like cash or a promissory note) in the exchange, the shareholder can trigger a capital gain precisely equal to the amount needed to fully utilize their available exemption. This strategic crystallization protects a portion of the current accrued gain from future taxation, offering a permanent tax saving, provided the transaction is properly structured within the constraints of the Income Tax Act (Canada).
As such, the power of the Section 86 share exchange lies in its ability to facilitate complex, fundamental changes to a corporation's capital structure without requiring the immediate payment of capital gains tax. The tax situations that benefit most are those where significant accrued capital gains exist and the shareholder needs to manage future tax liability, orchestrate a transfer of business value to successor owners, or reorganize share rights for strategic, financial, or governance purposes. This provision grants business owners crucial control over the timing and utilization of their tax liabilities, serving as an essential tool for sophisticated Canadian tax planning.
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.