Section 86 of the Canadian Income Tax Act deals with the tax consequences of certain types of corporate reorganizations, specifically, when a shareholder exchanges shares of one corporation for shares of another corporation, or when a corporation transfers its assts to another corporation in exchange for shares of that corporation.
The section provides rules that allow for the deferral of tax on the disposition of the original shares or assets, by allowing the shareholder or corporation to roll-over their tax cost into the new shares or assets received. This means that the tax liability is deferred until a future disposition of the new shares or assets.
Section 86 is intended to facilitate certain types of corporate transactions, such as mergers, acquisitions, and corporate reorganizations, by providing a tax-efficient way for corporations and shareholders to exchange shares and assets without triggering an immediate tax liability.
Section 86 allows for the exchange of shares within a corporation. Corporations are permitted to exchange all of the class of shares for an entirely different class of chares through this section without incurring a tax liability for the corporation or the shareholders.
For section 86 to apply, the exchange must occur in the course of a reorganization of the capital of the corporation. The taxpayer will dispose of all of the shares of any particular class of the capital stock of the corporation that were owned by the taxpayer at the particular time (in this section referred to as the “old shares”) and property is receivable from the corporation that includes other shares of the capital stock of the corporation (in this section referred to as the “new shares”).
Where section 86 is used appropriately, the taxpayer will not have a deemed disposition on the exchange. Essentially one class of shares is exchanged for another and there is no real economic gain to the taxpayer.
The following conditions should be met for this section to apply.
- Shares exchanged must be capital property
- The shareholder must dispose of all of the shares of any particular class owned by the taxpayer
- The taxpayer must receive shares of the corporation (but can also receive non-share consideration)
- Section 86 does not apply if subsection 85(1) or (2) applies.
It is also notable that no election is required under section 86.
The adjusted cost bae (ACB) and paid up capital (PUC) of the shares exchanged would follow new shares. For instance, where 100 Class A common voting shares have an ACB and PUC of $100 with a fair market value of $100,000; and the shares are exchanged for $1,000 Class C preferred non-voting shares with a redemption value of $100 per share, the ACB and PUC of $100 follow the Class C shares.
The rationale would be that there should be no tax benefit in the exchange as there has been no economic transfer.
If you are contemplating a reorganization, consider Shajani LLP for your tax planning and reorganization needs.
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