Section 85 Rollover: Cross-Border Tax Implications

Section 85 of the Income Tax Act lets a Canadian taxpayer transfer property to a Canadian corporation on a tax-deferred basis. Instead of triggering a capital gain or income inclusion on the transfer, the taxpayer elects a transfer price (the “elected amount”) between the cost of the property and its fair market value, and the corporation takes the property at that elected amount as its cost base. If the elected amount equals the taxpayer’s cost, no gain is triggered. The rollover is the standard mechanism for incorporating a sole proprietorship, transferring a portfolio to a holding company, or reorganizing a family’s corporate structure. It works cleanly when everyone involved is a Canadian resident with no US tax obligations. When a US citizen, green card holder, or cross-border person is involved, Section 85 creates a mismatch that can produce unexpected US tax.

How does Section 85 work?

The mechanics of ITA 85(1) are straightforward in concept. A taxpayer (individual or corporation) transfers “eligible property” to a taxable Canadian corporation. Both parties jointly elect a transfer price (the elected amount) within a permitted range. The lower limit is generally the lesser of the fair market value of the property and the greater of its cost amount and the fair market value of any non-share consideration (boot) received. The upper limit is the fair market value of the property.

If the taxpayer elects at the cost amount and takes back only shares (no boot), no gain is recognized. The corporation’s cost base for the property equals the elected amount, and the taxpayer’s cost base for the shares received also equals the elected amount. The gain is deferred until the shares are sold or the corporation disposes of the property.

Eligible property includes capital property (real estate, investments, goodwill), inventory (at the taxpayer’s election), and eligible capital property. Cash is not eligible property. Accounts receivable can be transferred under ITA 22 (a separate joint election for the sale of receivables) rather than Section 85.

The election form. The taxpayer and the corporation file Form T2057 (or T2058 for partnerships) with the taxpayer’s return for the year of the transfer. Late filing is possible with a penalty.

How does IRC 351 compare?

IRC 351 is the US equivalent. It provides that no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock, and immediately after the exchange, the transferor (or transferors as a group) control the corporation. “Control” means owning at least 80% of the total combined voting power and at least 80% of each class of nonvoting stock.

The differences that matter for cross-border filers:

Feature	ITA 85	IRC 351
Control requirement	None (the transferor does not need to control the corporation)	The transferor or group must own 80% or more immediately after the transfer
Boot received	Permitted; the elected amount is bumped up to the FMV of boot received, which can trigger partial gain	Permitted; gain is recognized to the extent of boot received (IRC 351(b))
Election required	Yes, joint election on Form T2057	No election needed; IRC 351 applies automatically when the conditions are met
Eligible property	Defined list; cash excluded	Broader “property” definition; cash can be transferred (though it raises thin-capitalization and other issues)
Services	Not eligible property	Transfer of property for services does not qualify

The control test is the critical difference. Section 85 lets a minority shareholder roll property into a corporation tax-free. IRC 351 does not, unless the group of transferors collectively reaches 80%. A US citizen who transfers property to their spouse’s Canadian corporation under Section 85 defers the Canadian gain. If they receive only 20% of the shares, the US control test fails, and the IRS treats the transfer as a sale at fair market value.

When do the two systems align?

Section 85 and IRC 351 produce the same result (deferral in both countries) when:

1. The transferor controls the corporation after the transfer (80% or more of voting power and each class of nonvoting stock)
2. The transferor receives only shares (no boot, or boot that does not exceed the gain)
3. The property qualifies as “eligible property” under ITA 85 and as “property” under IRC 351

The typical case is a sole proprietor incorporating their business. The individual transfers all business assets to a new Canadian corporation, receives 100% of the shares, and elects at cost under Section 85. IRC 351 applies automatically because the transferor owns 100% immediately after. Both countries defer the gain.

When do the two systems diverge?

The mismatch arises in several common scenarios:

1. Minority transfer. A US citizen transfers property to a family corporation where they will hold less than 80% of the shares after the transfer. Section 85 still defers the Canadian gain. IRC 351 does not apply because the control test fails. The IRS treats the transfer as a sale at FMV, and the US citizen owes US capital gains tax on the gain, with no corresponding Canadian tax against which to claim an FTC.

2. Boot exceeding gain. If the transferor receives cash or a promissory note (boot) in addition to shares, and the boot exceeds the gain that would otherwise be recognized, Section 85 bumps the elected amount to the FMV of the boot, potentially triggering partial gain in Canada. IRC 351(b) recognizes gain only to the extent of boot received, but does not recognize loss. The two calculations can produce different gain amounts.

3. Depreciable property. Under Section 85, if the elected amount exceeds the UCC (undepreciated capital cost) of depreciable property, the excess is recapture (ordinary income in Canada). Under IRC 351, if the transfer qualifies, the recapture is deferred entirely. If the transfer does not qualify for IRC 351, the US treats the entire gain as ordinary income to the extent of depreciation reclaimed (IRC 1245/1250).

4. Inventory. Section 85 allows inventory to be transferred as eligible property (with certain restrictions). IRC 351 allows inventory transfers, but the character of the gain on a later disposition by the corporation may differ (IRC 351(a) preserves the ordinary income character for inventory contributed).

What about Form 5471?

A US citizen or resident who transfers property to a Canadian corporation under Section 85 may trigger reporting obligations on Form 5471, regardless of whether IRC 351 applies. Specifically:

• If the transfer creates or increases the US person’s ownership in a CFC, Form 5471 must be filed
• Form 5471 Schedule O reports transfers of property to a foreign corporation, including transfers that qualify for IRC 351 deferral
• The penalties for failing to file Form 5471 ($10,000 per year per corporation) apply even when no US tax is owed on the transfer itself

The filing obligation exists independently of the tax result. A Section 85 rollover that is fully deferred under both ITA 85 and IRC 351 still triggers a Form 5471 filing requirement if the corporation is a CFC.

What about Section 85.1 (share exchange)?

ITA 85.1 provides a separate rollover for share-for-share exchanges (exchanging shares of one corporation for shares of another, typically in an acquisition). Unlike Section 85, no election form is needed; the rollover applies automatically when the conditions are met. The cross-border mismatch is the same: the US does not recognize ITA 85.1, and the exchange must independently qualify as a tax-free reorganization under IRC 368 for the US deferral to apply. The IRC 368 requirements (continuity of interest, continuity of business enterprise, business purpose) are different from the ITA 85.1 conditions, so the two can diverge.

What should I do next?

If you are a US citizen or green card holder considering a Section 85 rollover in Canada, or if a Canadian advisor has proposed one as part of an incorporation or reorganization, the US analysis needs to happen before the election is filed. The question is whether the transfer independently qualifies under IRC 351, and if not, what the US tax cost will be.

• Do I file Form 5471 for my Canadian corporation?, the reporting obligation that survives even when the rollover is tax-free
• CFC overview for US citizens with Canadian corporations, the Subpart F and GILTI layer that sits on top of the corporation after the rollover
• What happens to my Canadian corporation when I move to the US?, the mirror question when the move goes the other direction
• Wind up a Canadian corporation before moving, the alternative to keeping the corporation alive after a cross-border move
• CCPC overview, the Canadian corporate tax rates that apply to the corporation after the rollover

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.