Section 85 Reorganizations and Price Adjustment Clauses

When a taxpayer transfers appreciated property to a corporation under the rollover provisions of section 85 of the Act, an election form (T2057) is filed in which the parties set out the fair market value of the property and an elected amount which sets the transfer price. The parties usually elect an amount equal to the taxpayer’s adjusted cost base of the property at the time of the transfer; this amount then becomes the corporation’s adjusted cost base for the property. As consideration for the transfer, the corporation issues shares to the taxpayer having a value equal to the parties’ estimate of the fair market value of the property transferred, less the value of the non-share consideration, if any. In a typical estate freeze, for example, the new shares will be fixed value preference shares having a redemption amount equal to the estimated FMV of the property.

If a person related to the taxpayer acquires common shares as part of the transaction, paragraph 85(1)(e.2) may apply if the FMV of the property transferred exceeds the redemption amount of the preference shares. In that event, the elected amount otherwise agreed to by the parties in the T2057 is increased by the amount of the excess, resulting in the recognition of gain by the taxpayer, but without a corresponding increase in the corporation’s ACB of the property. The parties may protect against this result by entering into an agreement to adjust the redemption amount of the preference shares in the event the CRA disputes the original valuation.

In Information Circular 76-19R3 (dated June 17, 1996), the CRA said that in order to have a price adjustment clause recognized in these circumstances, the parties would have to file an amended section 85 election under subsection 85(7.1) and pay the appropriate late filing penalty. In the CRA’s view as expressed at the time (paragraph 26), the references in the T2057 to an elected amount and fair market value “must be interpreted as fixed and specific dollar figures at the date of transfer, not formulas that can determine or adjust an amount later.”

In a recent technical interpretation (TI 2012-0437001I7 F, posted June 20, 2012), the CRA confirmed that it no longer applies the position set out in paragraph 26 of Information Circular 76-19R3. Provided that the circumstances indicate that the parties actually intended to transfer the property at its FMV, that they made reasonable efforts to determine the FMV at the time, and that they give effect to the terms of the price adjustment clause relating to the redemption amount of the preference shares, the CRA now says that the recognition of the price adjustment agreement does not depend on the filing of an amended section 85 election and payment of the late filing penalty.

While this is not entirely new news (see TIs 2011-0412111C6 and 2007-0243251C6), it is nonetheless welcome. The CRA has recognized that parts of its now substantial body of published technical interpretations and rulings are out of date and do not reflect current assessing practice. A project is underway to deal with this, but it will be some time before the data base is up to date. In the meantime, it may be prudent to confirm with the CRA the status of a published position if the taxpayer intends to rely on it when implementing a transaction.