SECTION 86 SHARE EXCHANGE - corporate tax planning strategy
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For purposes of effectuating a tax-efficient corporate restructuring, a section 86 share exchange is a legislated tax strategy under the Income Tax Act (Canada) that can facilitate corporate restructuring and succession planning, allowing a shareholder to exchange their existing shares in a corporation for new shares of the same corporation without triggering an immediate tax liability.
The objective goals in structuring business transactions to effectuate a section 86 reorganization / share exchange include:
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In a section 86 share exchange, a shareholder disposes of all of their shares of a particular class ("old shares") in a corporation and, in return, receives property that includes new shares of the same corporation. The key to this provision is that the tax liability on any accrued capital gains is deferred. This means the adjusted cost base (ACB) and paid-up capital (PUC) of the old shares are "rolled over" to the new shares. The tax is not paid until the new shares are eventually sold or redeemed. Key Purposes and Applications The primary purpose of a Section 86 reorganization is to facilitate corporate changes in a tax-efficient manner.
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Estate and Succession Planning (Estate Freeze): This is one of the most frequent uses. A business owner can use section 86 to "freeze" the value of their ownership stake. They exchange their common shares, which would capture all future growth of the company, for fixed-value preferred shares. The new common shares, which now hold all the future growth, can then be issued to the next generation (e.g., children or key employees) at a nominal cost. This locks in the current owner's value and allows for a tax-efficient transfer of future growth to the new owners.
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Corporate Reorganization: A company might restructure its share classes to allow for different rights, such as voting rights, dividend preferences, or liquidation preferences. This can make the company more flexible for strategic goals, like raising capital or bringing in new investors.
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Restructuring Shareholder Rights: It can be used to reorganize the voting rights among shareholders, allowing for changes in who has control of the company.
To effectuate a section 86 share exchange, the critical conditions and requirements include:
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The transaction must occur "in the course of a reorganization of the capital" of the corporation. While the Income Tax Act does not define this phrase, it is generally understood to involve an amendment to the corporation's articles of incorporation.
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The shareholder must dispose of all shares of a particular class they own.
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The property received from the corporation must include other shares of the same corporation. Non-share consideration (known as "boot," such as cash or a promissory note) can also be received, but this may trigger an immediate tax liability on the gain realized on that portion of the consideration.
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The shares being exchanged must be capital property to the shareholder.
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Crucially, Section 86 does not apply if a section 85 rollover is used.
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There is no formal election. Unlike a section 85 rollover, a formal election form is not required to be filed with the Canada Revenue Agency for a section 86 reorganization. The tax deferral is automatic as long as the conditions of the section are met.
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Finally, it is important to remember that a section 86 share exchange is a tax deferral mechanism, not a tax elimination one. The capital gains tax is postponed until the new shares are ultimately disposed of.
Although a section 86 share exchange is a major tax deferral tool, it does not eliminate the tax liability entirely; it simply defers it. The tax is postponed until a later date, such as when the corporation sells the assets or when the individual sells their shares in the corporation. Due to the complexity and strict rules involved, it is highly recommended to seek professional tax law advice is retained when undertaking a section 86 share exchange [more on complexity and mistakes].
Given the complexity and potential for severe tax penalties, it is critical that your section 86 share exchange 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 a multitude of section 86 share exchanges 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.
