Banka: Transferring assets to a new entity
The next logical step in the sequence of events from sole proprietorship to incorporation is the transfer all of the assets.
So if you were to start using those assets in the new corporation, what value would you set them up at? Being used assets, there is a need to determine what the fair market of those assets would be on the date of the transfer.
You would be required to dispose of them in the proprietorship at that value.
So a disposal of a capital asset could give rise to a capital gain or loss and possibly the recapture of capital cost allowance.
There is a section in the income tax act that deals specifically with this issue called Section 85.
Accountants call this a section 85 rollover. Normally, when there is a transfer or sale of assets between two unrelated parties, the transfer happens at fair market value.
Section 69 of the Income Tax Act requires that when this transfer occurs between related persons such as a shareholder of a corporation and the corporation, it also be carried out at fair market value.
Section 85 allows a difference between the proceeds of disposition and fair market value on the assets being transferred so that tax on the transfer is deferred.
There are a number of conditions that need to be complied with in order for this tax deferred transfer to take place.
The transferor can be an individual, trust, partnership or a corporation and the transferee must be a corporation. The assets must be assets that are considered eligible for transfer.
These assets can be classified as a capital property, real property, goodwill and inventory.
Subsection 85(1) contains many sections and paragraphs pertaining to the different types of assets and can be quite confusing when trying to determine what the upper and lower limits are on the item being transferred, especially when there are two of the same kinds of items being transferred such as two buildings.
The shareholder and corporation can agree on an amount per item transferred subject to limits as specified in subsection 85(1) of the Income Tax Act.
These limits make it impossible to artificially inflate or deflate the value of an item being transferred.
Accounts receivable is a special case and can be transferred using Section 22 or Section 85.
The CRA has published Interpretation Bulletin IT291R3 which clarifies subsection 85(1) of the act.
The Canada Revenue Agency regularly audits and investigates these kinds of transfers so it is suggested that a legal document be created to substantiate the values agreed upon in the transfer.
This document also needs to include a price adjustment clause in case the values being transferred are challenged.
The CRA’s policy with respect to the price adjustment clause are outlined in IT-169 which contains two conditions that must be present.
The first is that the agreement reflects a bona fide intention to transfer the property and to arrive at the value by a fair and reasonable method and the excess or shortfall in the price is refunded or paid or a legal liability.
The section 85 transfer is filed on form T2057.
This form is required to be filed before the first taxpayer of the agreement is required to file their tax return.
So if you are a Canadian Controlled Private Corporation with a year end of Nov. 30, after the first year of operation, your tax return will need to be filed by Feb. 28 of the following year while the sole proprietorship has until June 15 to file its tax return. In this case, the return would need to be filed by June 15.
The shareholder needs to receive some sort of consideration for the assets they transferred into the corporation.
Usually this is in the form of at least one share of the corporation and either cash or a promissory note. The consideration received needs to be fair market value as well. The T2057 requires that an amount of consideration received be placed opposite the value of the asset being transferred so that it is easy to determine what was received by the transferor per asset to make sure that the asset was transferred at fair market value.
If preferred shares are received as consideration, care must be taken to make sure that the shares are retractable, entitled to dividends and have priority over the other shares in the event of a dissolution.
Along with the transfer of assets on section 85, the debts related to those assets can also be transferred as in the case of a transfer of land and buildings and the associated mortgage to those land and buildings.
In addition, the transfer may trigger the requirement to pay property purchase tax or GST/HST. Form GST44 can be used to exempt the transfer from the GST/HST tax, however, there is no form that exempts the property purchase tax.