SECTION 86 SHARE EXCHANGE
Corporate tax planning during the reorganization of the capital structure of the company, disposing of one set of shares for another set of a shares on a tax-free basis, by way of a tax deferral on the received share consideration.
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Importance of Section 86 | How Section 86 Operates | Tax Advantages of Section 86 | Problems arising with Section 86
Rationale for a Section 86 Share Exchange
A Section 86 share exchange serves as a fundamental instrument for corporations seeking to undergo a capital reorganization without triggering immediate tax consequences. Under the Income Tax Act, this provision allows for the exchange of all shares of a particular class for new shares of the corporation, typically involving the conversion of common shares into preferred shares. This process is essential for shareholders who wish to freeze the current value of their equity to facilitate future growth for a new generation of owners or key employees. By implementing this exchange, the existing shareholder locks in the capital gains accrued to date, while the new shares issued carry a fixed redemption value equal to the fair market value of the exchanged shares at the time of the transaction.
From a corporate succession and estate planning perspective, the primary objective is the seamless transition of future corporate appreciation. When a business owner exchanges their participating common shares for fixed-value preferred shares, they effectively cap their personal tax liability upon death or a future sale. The corporation then issues new common shares, often at a nominal price, to the owner’s children or a family trust, ensuring that all subsequent increases in the company's value accrue to those beneficiaries. This structure is a standard requirement for maintaining a manageable tax profile while providing the next generation with a direct stake in the ongoing success of the enterprise. It also provides a mechanism to distribute voting control and dividend entitlements with precision across different classes of stakeholders.
Beyond succession, a Section 86 reorganization is frequently utilized to refine a corporation's capital structure in preparation for external investment or a sale. It allows the company to create specialized share classes with distinct rights, such as specific liquidation preferences or redemption schedules, which are often required by sophisticated investors. Legal counsel ensures that the articles of amendment are meticulously drafted to comply with both corporate statutes and the restrictive criteria of the Income Tax Act to avoid unintended taxable benefits. By aligning the share structure with the long-term strategic goals of the firm, management can better position the entity for complex transactions, including mergers, acquisitions, or the implementation of employee stock option plans.
How does a Section 86 Share Exchange operate
A Section 86 share exchange begins with the formal amendment of the corporation’s articles of incorporation to create a new class of shares, often designated as freeze shares, which possess a fixed redemption value equal to the current fair market value of the corporation. Simultaneously, the existing common shares held by the participating shareholders are exchanged for these new preferred shares. Because this exchange happens by operation of law through the amendment of the articles, the shareholder does not need to enter into a separate purchase and sale agreement for the shares.
To ensure the transaction qualifies for a tax-deferred rollover, the shareholder must receive only shares of the corporation as consideration for the exchanged shares. If any boot or non-share consideration is received, such as cash or a promissory note, it may trigger immediate capital gains to the extent that the value of the boot exceeds the adjusted cost base of the original shares. The operational success of the exchange relies on the precise alignment of the paid-up capital (PUC) of the new shares with the PUC of the old shares. Legal counsel must carefully draft the share provisions to include a price adjustment clause, which protects the tax-deferred status if the tax authorities later determine the fair market value was different than the initial valuation.
The board of directors must formally approve the reorganization by passing a series of resolutions that authorize the share exchange and the filing of Articles of Amendment with the relevant provincial or federal corporate registry. Once the Articles of Amendment are filed and a Certificate of Amendment is issued, the old share certificates are canceled, and new certificates are issued to the shareholders representing their new holdings. It is a critical operational step to update the corporation's central securities register and the register of directors and shareholders to reflect the new capital structure. While Section 86 is an automatic rollover that does not require the filing of a prescribed tax election form like Section 85, a full paper trail of the corporate proceedings is essential for tax compliance.
Following the issuance of the freeze shares, the corporation typically issues new common shares to the next generation or a family trust at a nominal value. This final step completes the shift of future growth in the company's value to the new common shareholders while the original owner’s tax liability is capped at the value of the preferred shares. The law firm ensures that all valuation reports are properly documented and that the share rights, including voting and dividend preferences, are legally enforceable. Ongoing corporate maintenance is required to ensure that any future redemptions of the preferred shares are handled in accordance with the newly established articles and the Income Tax Act requirements
Tax Advantages of a Section 86 Share Exchange
A A Section 86 share exchange provides a primary tax advantage by facilitating a rollover that defers the realization of capital gains during a corporate reorganization. Under the Income Tax Act, this provision allows a shareholder to exchange their existing shares for new shares of the same corporation without triggering an immediate tax liability. The cost base of the old shares is generally transferred to the new shares, effectively pushing the tax consequences into the future. This deferral is essential for business owners who wish to restructure their holdings or implement an estate freeze without depleting current corporate or personal liquidity.
Furthermore, Section 86 is a critical tool for optimizing the use of the Lifetime Capital Gains Exemption (LCGE) and managing future tax exposure. By exchanging common shares for fixed-value preferred shares, a shareholder can freeze the value of their current equity, allowing future growth to accrue to a new class of shares held by family members or a family trust. This strategy can effectively multiply the capital gains exemption across multiple taxpayers, significantly reducing the aggregate tax burden upon an eventual sale of the business. Additionally, the exchange can be structured to convert high-value equity into redeemable shares, providing a controlled mechanism for extracting corporate surplus at more favorable tax rates over time.
The implementation of a Section 86 exchange also assists in the mitigation of double taxation issues that often arise during the transition of a private corporation. By precisely defining the tax attributes of the new shares, such as their PUC and redemption value, legal counsel can ensure that the transition does not inadvertently create deemed dividends or capital gains in excess of the actual economic value. This technical precision ensures that the corporation remains compliant with anti-avoidance rules while maximizing the retention of after-tax capital within the business structure. Consequently, the exchange serves as a foundational step for sophisticated succession planning and the long-term preservation of corporate wealth.
Problems arising with Section 86 Share Exchanges
Section 86 of the Income Tax Act provides a specific mechanism for a capital gains rollover when a shareholder exchanges all of their shares of a particular class for new shares of the same corporation. While this is often viewed as a routine corporate reorganization, a significant overlooked problem involves the strict all shares requirement. Taxpayers frequently fail to account for the fact that every single share of the specified class held by the shareholder must be exchanged in the transaction to qualify for the rollover. Retaining even a fractional share or a single certificate outside of the exchange can disqualify the entire transaction from non-recognition treatment, leading to an immediate and unintended tax liability on the fair market value of the disposed shares.
A primary risk that prospective clients must address is the gift to related persons rule under subsection 86(2), which triggers if the fair market value of the old shares exceeds the fair market value of the new shares received. If it is determined that any portion of this value difference can reasonably be considered a gift to another shareholder, the rollover is partially or fully denied. This often occurs in family-succession scenarios where parents receive preferred shares with a redemption value supposedly equal to the common shares they relinquish. If the Canada Revenue Agency (CRA) successfully argues that the preferred shares were undervalued, the resulting benefit is added to the taxpayer’s proceeds of disposition, creating a capital gain that cannot be deferred.
A frequent observence is overlooking the interplay between Section 86 and the anti-avoidance provisions of Section 84.1. When a shareholder exchanges shares in a non-arm's length transaction, Section 84.1 can override the expected tax-free status if the shareholder receives boot, such as cash or promissory notes, or if the PUC of the new shares exceeds the PUC of the old shares. Failure to perform a precise calculation of the hard tax basis versus the soft tax basis can result in the immediate recharacterization of the exchange proceeds as a deemed dividend. This oversight transforms a planned tax-deferred reorganization into a taxable event with high effective tax rates, often catching the taxpayer without the liquidity necessary to satisfy the resulting tax debt.
Beyond the immediate exchange, problems arise from the failure to manage the tax attributes of the new shares, such as the adjusted cost base and the paid-up capital. Section 86 is a mandatory provision, meaning it applies automatically if the conditions are met, which may not always be beneficial if a taxpayer has capital losses they intended to utilize. Furthermore, the corporate records must be meticulously updated to reflect the exchange, as the CRA frequently audits the minute books and share registries to ensure the legal reality matches the tax filing. If the legal documents do not clearly demonstrate that the old shares were cancelled and the new shares were issued as part of a single reorganization of capital, the entire tax position is compromised.