SECTION 85.1 TAKEOVER ROLLOVER

An alternate form of tax-deferred rollover used in corporate takeovers and reorganizations, particularly in share-for-share exchanges.

Contact our law firm for corporate rollovers at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

Why use Section 85.1  |  How Section 85.1 Operates  |  Tax Advantages of Section 85.1  |  Problems arising with Section 85.1

Why use a Section 85.1 Rollover

A Section 85.1 rollover (share-for-share exchange) provides a vital mechanism for Canadian corporations to execute acquisitions (takeovers and reorganizations) without triggering immediate tax consequences for the target’s shareholders. Under the Income Tax Act, this provision allows a purchasing corporation to acquire shares of a target corporation in exchange for its own treasury shares. The primary benefit is the automatic tax deferral, which ensures that selling shareholders do not realize a capital gain until they eventually dispose of the newly acquired shares. Our law firm specializes in structuring these transactions to ensure that both the purchaser and the vendor meet the specific statutory requirements necessary to qualify for this treatment.

The implementation of a Section 85.1 rollover is particularly advantageous because it does not require the filing of a formal election form with the Canada Revenue Agency (CRA). Unlike the Section 85(1) rollover, which necessitates the joint filing of Form T2057, the Section 85.1 mechanism applies automatically unless the taxpayer chooses to report the gain or loss on their tax return. This reduction in administrative burden makes it an ideal structure for public company takeovers or large-scale reorganizations involving a high volume of shareholders. Our legal team assists in drafting the exchange agreements to ensure that no boot or non-share consideration is provided, which would otherwise disqualify the transaction from full deferral.

From the perspective of the acquiring corporation, Section 85.1 offers a streamlined path to consolidating ownership while preserving cash flow. By using equity as the sole consideration, the purchaser avoids the necessity of securing debt financing or depleting cash reserves to fund the acquisition. Furthermore, the cost base of the acquired shares for the purchaser is generally limited to the lesser of the fair market value and the paid-up capital of those shares immediately before the exchange. We provide comprehensive due diligence to evaluate the tax attributes of the target shares, ensuring that the acquiring entity understands the long-term tax implications of the resulting corporate structure.

For a Section 85.1 rollover to be valid, the parties must remain at arm's length immediately prior to the transaction, and the purchaser must not control the vendor immediately after the exchange. Additionally, the vendor cannot be a person who, together with other non-arm’s length parties, controls the purchaser or owns shares representing more than 50% of the fair market value of the purchaser's equity. These restrictive covenants require precise legal oversight to prevent unintended tax liabilities for the participating shareholders. Our firm provides the necessary tax opinions and structural analysis to confirm that your corporate reorganization adheres to these complex statutory limitations while achieving your commercial objectives.

How does a Section 85.1 Rollover Operate

A Section 85.1 rollover (share-for-share exchange) is a vital tax-deferral mechanism under the Income Tax Act used during corporate acquisitions - takeovers and reorganizations. This provision allows a vendor to exchange shares of a Canadian corporation for shares of a purchasing Canadian corporation without immediately triggering capital gains. For the rollover to apply automatically, the vendor and the purchaser must deal at arm's length immediately before the exchange. Our law firm ensures that the specific statutory requirements are met so that the tax liability is deferred until the newly acquired shares are eventually sold.

The mechanics of the exchange involve the vendor transferring their exchanged shares to the purchaser in consideration for issued shares from the purchaser’s treasury. Under Section 85.1, the vendor is deemed to have disposed of the exchanged shares for proceeds of disposition equal to their adjusted cost base (ACB). Consequently, the cost of the newly issued shares to the vendor is also deemed to be equal to that same ACB. This neutralizes the immediate tax impact for the shareholder, provided they do not receive any boot or non-share consideration, such as cash or promissory notes, as part of the transaction.

From the purchaser’s perspective, the tax treatment of the acquired shares is strictly governed by the Act to prevent artificial stepping up of cost bases. The purchaser is deemed to acquire the shares at a cost equal to the lesser of their fair market value immediately before the exchange and the paid-up capital (PUC) of those shares. It is important to note that unlike a Section 85(1) rollover, Section 85.1 does not require the filing of a joint election form with the CRA. However, the rollover will not apply if the vendor and purchaser choose to report the transaction as a taxable event or if the vendor is a non-resident of Canada.

Our legal team provides comprehensive oversight to ensure that the share-for-share exchange is structured to maintain compliance with both federal and provincial regulations. We conduct thorough due diligence on the PUC and ACB of the shares involved to prevent unintended tax consequences for both the acquiring entity and the selling shareholders. We also draft the necessary share purchase agreements and corporate resolutions required to formalize the exchange while protecting our clients' commercial interests. By utilizing this provision, we assist clients in facilitating corporate consolidations and acquisitions while preserving liquidity and optimizing their long-term tax positions.

 

Contact our law firm for corporate rollovers at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

Tax Advantages of a Section 85.1 Rollover

The Section 85.1 share-for-share rollover provides a specialized mechanism for shareholders to exchange their equity in a target Canadian corporation for shares in an acquiring Canadian corporation without triggering immediate tax consequences. Our firm assists clients in navigating this provision, which is primarily designed for arm’s-length transactions such as corporate takeovers and mergers. Unlike the more general Section 85 rollover, this provision applies automatically when specific statutory conditions are met, eliminating the administrative burden of filing a joint election with the CRA. We ensure that the exchange involves capital property and that the consideration received consists solely of newly issued shares of a single class of the acquiring corporation.

The primary tax advantage of a Section 85.1 rollover is the complete deferral of capital gains that would otherwise be realized upon the disposition of the original shares. Under this provision, the shareholder is deemed to have disposed of their shares for proceeds equal to their ACB, resulting in a tax-neutral event. The tax liability is effectively deferred until the newly acquired shares are eventually sold to a third party. This deferral preserves the shareholder's capital, allowing the full value of the investment to remain productive within the new corporate structure rather than being depleted by immediate taxation.

Procedural simplicity is a significant benefit for our clients, as the Section 85.1 rollover does not require the complex elected amount negotiations or the formal T2057 filings associated with Section 85. While the rollover is the default treatment, the Income Tax Act allows a vendor to "opt out" by simply reporting a gain or loss on their income tax return for the year of the exchange. This flexibility is valuable if a shareholder has capital losses to offset or wishes to utilize their lifetime capital gains exemption. Our legal team provides the necessary oversight to confirm that no boot (such as cash or debt) is received in the exchange, as the receipt of non-share consideration can disqualify the transaction from full rollover treatment.

From the perspective of the acquiring corporation, Section 85.1 establishes specific rules for the cost of the acquired shares and the calculation of PUC. The cost of the shares to the purchaser is generally deemed to be the lesser of their fair market value and their PUC immediately before the exchange. Furthermore, the provision includes adjustments to the PUC of the newly issued shares to prevent the artificial creation of corporate distributions that could be returned to shareholders tax-free. We work with both corporate acquirers and individual vendors to structure these exchanges in full compliance with these technical requirements to ensure the intended tax outcomes are achieved.

Problems arising with Section 85.1 Rollovers

The primary challenge with a Section 85.1 share-for-share exchange involves the strict eligibility requirements regarding the relationship between the vendor and the purchaser. For the rollover to apply automatically, the vendor and the purchaser must deal at arm’s length immediately before the exchange, and the vendor cannot be in a position of control over the purchaser immediately after the transaction. If the CRA determines that the parties were not dealing at arm’s length or that the vendor, together with related persons, controls the purchasing corporation, the rollover will be denied. This results in an immediate realization of capital gains for the vendor, potentially leading to significant and unexpected tax liabilities.

A further complication arises when the consideration provided by the purchaser includes any form of boot or non-share consideration. Section 85.1 is restrictive in that it requires the vendor to receive only shares of a single class of the capital stock of the purchaser in exchange for their shares. If the vendor receives cash, debt, or shares of a different class as part of the exchange, the entire transaction may be disqualified from the automatic rollover provisions. In such instances, the tax-deferred status is lost, and the vendor is deemed to have disposed of their shares at fair market value. This lack of flexibility makes precise structuring of the exchange agreement essential to ensure that no prohibited consideration is inadvertently introduced.

The cost-grinding rules applicable to the purchasing corporation also present a significant disadvantage that must be disclosed to prospective clients. Unlike a Section 85 election, where the purchaser often receives a cost base equal to the elected amount, under Section 85.1, the purchaser’s cost of the acquired shares is generally limited to the lesser of their fair market value and their paid-up capital. This often results in the purchaser inheriting a very low ACB in the shares of the target corporation. Consequently, if the purchaser subsequently sells those shares, they will realize a much larger capital gain than if they had used a different rollover mechanism, effectively shifting a future tax burden onto the acquiring entity.

Finally, the lack of a formal election process under Section 85.1, while seemingly convenient, creates a risk of uncertainty regarding the tax treatment of the transaction. Because the rollover happens automatically by operation of law unless the vendor chooses to report the gain, there is no filed document that confirms the CRA’s acceptance of the tax-deferred status at the time of the deal. If the vendor mistakenly believes the transaction qualifies but fails to meet the technical criteria, they remain exposed to reassessment for several years. Furthermore, foreign shareholders or non-residents may face additional complexities under Section 116 of the Income Tax Act, as Section 85.1 does not automatically exempt them from withholding tax requirements or the need for a certificate of compliance.