The Section 85 Rollover Across the Border: Tax-Deferred in Canada, Taxable in the US Under Section 367

Section 85 of the Canadian Income Tax Act lets a taxpayer transfer property (a business, shares, real estate, goodwill) to a taxable Canadian corporation in exchange for shares at an elected amount between the property's cost and its fair market value, deferring the Canadian gain. It is the standard tool for incorporating a Canadian business or reorganizing a Canadian corporate group. The US has its own nonrecognition rule for contributions to a corporation (section 351), but section 367 turns it off when the transferee is a foreign corporation and the transferor is a US person. A US citizen in Canada who rolls property into a Canadian corporation defers the Canadian gain and recognizes the full gain in the US, with no Canadian tax to credit against it.

Key takeaways

• Section 85: the transferor and a taxable Canadian corporation jointly elect (Form T2057) an amount between the property's tax cost and fair market value as the transferor's proceeds and the corporation's cost; the difference between the elected amount and fair market value is deferred until the corporation sells the property or the transferor sells the shares. Consideration must include shares; boot (cash or debt) up to the elected amount does not trigger gain.
• Section 351: a transfer of property to a corporation solely in exchange for stock is tax-free for US purposes if the transferors control the corporation (80%) immediately after. Section 367(a) overrides it for transfers by a US person to a foreign corporation, treating the corporation as not a corporation for the nonrecognition rule, so the transfer is a taxable sale at fair market value, unless an exception applies (active trade or business assets used abroad, under regulations that were substantially narrowed in 2016).
• The mismatch: a US person doing a section 85 rollover into a Canadian corporation defers the Canadian gain but recognizes the US gain now; Canada has not taxed the gain, so there is no foreign tax credit; when Canada eventually taxes it (on the corporation's sale or the shareholder's sale of shares), the US has already taxed it and the credit runs the wrong way in time.
• Form 926 reports the transfer to a foreign corporation; the penalty for omission is 10% of the value transferred, up to $100,000 (unlimited for intentional disregard).
• Structuring: elect at fair market value in Canada (recognizing the Canadian gain to match the US), use the lifetime capital gains exemption on qualifying shares, transfer only low-gain property, or, for a US person, incorporate as a US-resident owner with a US entity instead.

The Canadian rollover

The transferor (individual, corporation, or partnership) transfers eligible property (capital property, inventory, resource property, eligible capital property; not real property held as inventory by a non-resident) to a taxable Canadian corporation, receives shares (and possibly boot), and elects an amount. The elected amount cannot be less than the boot, cannot be less than the lesser of cost and fair market value, and cannot exceed fair market value. The transferor's proceeds and the corporation's cost are the elected amount. Electing at cost defers the entire gain; electing at fair market value recognizes it (useful to use the lifetime capital gains exemption or losses). The election is filed by the earlier of the two parties' filing deadlines, with late-filing penalties.

Common uses: incorporating a sole proprietorship (transferring the business assets and goodwill to a new corporation); inserting a holding company above an operating company (transferring the operating company's shares); estate freezes; reorganizations.

The US override

Section 351 would make the same transfer tax-free in the US if the corporation were domestic. Section 367(a)(1) provides that for purposes of determining gain on a transfer of property by a US person to a foreign corporation in an exchange described in section 351 (or certain reorganizations), the foreign corporation is not treated as a corporation. The result: the transfer is a taxable exchange, and the US person recognizes gain (not loss) equal to the excess of fair market value over basis, asset by asset.

The historical exception for property transferred for use in the active conduct of a trade or business outside the US was largely eliminated by regulations in 2016 for most intangibles and for goodwill; tangible business assets used in an active foreign business can still qualify, with a gain recognition agreement in some cases. Section 367(d) treats a transfer of intangibles (patents, trademarks, know-how, goodwill under the current regulations) as a sale for a stream of contingent payments, taxed as annual deemed royalties.

Form 926 must be filed with the return for the year of the transfer, reporting the property, its value, and the basis.

The collision

A US citizen in Toronto with a sole proprietorship worth $800,000 (basis near zero) incorporates using a section 85 rollover at cost: Canadian gain deferred entirely. For US purposes, section 367 makes the transfer a sale: $800,000 of gain recognized on the 1040 (part capital gain on goodwill under 367(d)'s deemed royalty treatment, part ordinary on other assets), with no Canadian tax paid in that year to credit. Years later, when the corporation is sold or wound up, Canada taxes the gain; the US taxed it already, and the foreign tax credit for the Canadian tax is available only against US tax on the same income in the same year, which there is none of.

The corporation is also a controlled foreign corporation from formation, with Form 5471 and the GILTI regime.

Structuring alternatives

• Elect at fair market value in Canada. Recognize the Canadian gain in the same year as the US gain; use the lifetime capital gains exemption ($1.25 million) on qualified small business shares if the property is shares; claim the foreign tax credit in the US for the Canadian tax paid. The deferral is lost but the double tax is avoided.
• Transfer low-gain property only. Cash, recently acquired assets, and property with basis close to value produce little US gain.
• Keep the business unincorporated. A US citizen in Canada running a sole proprietorship has no CFC, no Form 5471, no section 367 event, and the U.S. and Canadian tax on the business income reconcile annually through the foreign tax credit.
• Use a US entity. A US citizen who is (or will be) a US resident incorporates in the US under section 351 with no 367 issue; the Canadian side then depends on whether the entity carries on business in Canada.
• Gain recognition agreement. For transfers of shares of a foreign corporation to another foreign corporation, a five-year GRA can defer the US gain; it does not apply to the typical incorporation of a business.

Worked example

A US citizen dentist in Vancouver with a practice worth $1.2 million (equipment basis $100,000, goodwill basis zero) plans to incorporate into a BC professional corporation.

• Section 85 at cost. Canadian gain deferred. US: section 367 recognizes about $1.1 million of gain; goodwill under 367(d) as deemed annual royalties over its useful life, equipment gain currently; US tax of roughly $250,000 over the period with no Canadian credit. The corporation is a CFC.
• Section 85 at fair market value. Canadian gain of $1.1 million recognized; the goodwill gain qualifies for the lifetime capital gains exemption only if it is share gain (it is not; it is a disposition of goodwill to the corporation); Canadian tax roughly $290,000 at half inclusion; US gain recognized the same year; foreign tax credit covers most of the US tax. No double tax, but the deferral section 85 was meant to provide is gone.
• Stay unincorporated. No rollover, no CFC, no 367; the practice income is taxed annually in Canada with a US credit. The Canadian small business deduction is forgone.
• Recommendation. Depends on the value of the small business deduction versus the cost of CFC compliance and the 367 gain; for many US-citizen professionals in Canada, unincorporated wins.

Official sources

"For use by a taxpayer and a Canadian corporation to jointly elect under subsection 85(1)." The form is titled Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation. — Canada Revenue Agency, T2057 Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation, https://www.canada.ca/en/revenue-agency/services/forms-publications/forms/t2057.html

"a U.S. citizen or resident, a domestic corporation, or a domestic estate or trust must complete and file Form 926 to report certain transfers of property to a foreign corporation." — Internal Revenue Service, About Form 926, https://www.irs.gov/forms-pubs/about-form-926

"Certain U.S. citizens and residents who are officers, directors, or shareholders in certain foreign corporations file Form 5471 and schedules to satisfy the reporting requirements of sections 6038 and 6046, and the related regulations." — Internal Revenue Service, About Form 5471, https://www.irs.gov/forms-pubs/about-form-5471

Practitioner note

The section 85 rollover is the first thing a Canadian accountant recommends to an incorporating professional, and for a US citizen it is a taxable sale in the US of everything rolled in. We stop the rollover before the T2057 is filed, run the fair-market-value election and the unincorporated alternative, and usually recommend one of those. The deferral is Canadian; the tax is American.

See also: Planning a move? Start with the Canada-to-US tax checklist and browse every corridor by city, province, and state.

Next step

Fairlight prepares the section 85 and section 367 analysis before incorporation, the T2057 election at the chosen amount, and the Form 926 and Form 5471 filings where a rollover proceeds. See cross-border pricing or book a call.