SECTION 51(1) SHARE CONVERSION - COMPLEXITY & MISTAKES

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While a section 51(1) share conversion is an important tax planning strategy, its complexity gives rise to the prospect of serious mistakes, such that an experienced tax lawyer should be engaged to navigate this highly technical tax law procedure. Areas of complexity that can give rise to mistakes in the execution of a section 51(1) share conversion include:

A. Receiving Non-Share Consideration ("Boot")

  • The Rule: A fundamental condition for a successful Section 51(1) rollover is that the taxpayer receives "no consideration other than the share" for the convertible property.

  • The Mistake: Receiving cash, a promissory note, or any other property in addition to shares. Even a small amount of non-share consideration can disqualify the entire transaction from the Section 51(1) rollover.

  • The Exception: There is a narrow administrative exception for cash received in lieu of a fractional share, provided the amount is nominal (typically not exceeding $200). If this exception applies, the taxpayer can either report the gain or loss on the amount received or reduce the adjusted cost base (ACB) of the new shares by that amount.

B. Discrepancy in Fair Market Value (FMV)

  • The Rule: The FMV of the shares received on the exchange should generally be equal to the FMV of the convertible property given up.

  • The Mistake: Exchanging property with a higher FMV for shares with a lower FMV, especially when there are related persons involved.

  • The Consequence: This can trigger the application of Section 51(2), which can lead to a capital gain and a denial of any capital loss. The taxpayer may be deemed to have conferred a benefit on a related person. For example, a father converting his high-value common shares for low-value preferred shares, allowing future growth to accrue to his child's shares, could result in a deemed capital gain for the father. Conversely, if the FMV of the new shares is greater than the converted property, it may result in a shareholder benefit being conferred on the taxpayer under Section 15.

C. Incorrect ACB Allocation

  • The Rule: The ACB of the original convertible property is carried over to the newly acquired shares. If multiple classes of shares are received, the ACB must be allocated among them on a pro-rata basis, based on their relative FMVs immediately after the exchange.

  • The Mistake: Incorrectly allocating the ACB of the old shares to the new shares.

  • The Consequence: This can lead to an inaccurate calculation of future capital gains or losses when the new shares are eventually disposed of. A misallocation can result in a higher tax liability down the road.

D. Not a Disposition (and why that's a problem)

  • The Rule: A key feature of Section 51(1) is that the exchange is "deemed not to be a disposition" of the convertible property. This is what provides the tax-deferral.

  • The Mistake: Trying to use Section 51(1) when a disposition is required for other tax purposes. For example, if a shareholder is a non-resident of Canada and requires a Section 116 certificate to avoid withholding tax on the disposition of taxable Canadian property, a Section 51 rollover may not be the appropriate provision because it does not involve a disposition.

  • The Solution: In these cases, it may be necessary to use an alternative tax-deferred rollover provision, such as Section 85 or Section 86, which does involve a disposition and allows for an election to be filed.

E. Failure to Consider Alternative Rollovers

  • The Rule: Section 51(1) is an automatic rollover that applies when its conditions are met. However, it is subordinate to other provisions. Section 51(4) specifies that Section 51(1) does not apply where Section 85 or Section 86 applies.

  • The Mistake: Not considering whether Section 85 or Section 86 might be a more suitable or necessary provision for the transaction.

  • The Consequence: This can lead to unexpected tax outcomes. For instance, a transaction that could be structured as an estate freeze may be better suited for a Section 86 "butterfly" rollover, which allows for greater flexibility.

F. Amending Share Rights Instead of Exchanging Shares

  • The Rule: Section 51(1) applies to the exchange of shares.

  • The Mistake: Amending the rights and restrictions of an existing class of shares instead of a formal exchange. While this may not always trigger a disposition, a substantial alteration to the terms of a share can be deemed to be a disposition for tax purposes.

  • The Solution: To avoid this uncertainty, it is often more prudent to effect material changes in share rights through a formal share-for-share exchange to ensure the tax-deferred rollover under Section 51 or 86 applies.

Given the complexity and potential for severe tax penalties, it is critical that your section 51(1) share conversion is correctly structured, with the appropriate legal and supporting paperwork, such that it might effectively respond to any scrutiny. With over two decades of legal experience, which includes designing and implementing many section 51(1) share conversions and other corporate tax planning strategies, we can put that knowledge and experience to use for the advancement of your business.

Our law firm strives to provide strategic tax-driven legal advice and direction to Calgary businesses looking to optimize their business structures and corporate transactions. Contact our law firm at Chris@NeufeldLegal.com or 403-400-4092 to schedule a confidential initial consultation for your business' tax structuring and tax planning initiatives.

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