Section 86 of the Income Tax Act: The Rollover Behind Most Canadian Estate Freezes

Section 86 of the Income Tax Act is a tax-deferred rollover that lets a shareholder exchange all of one class of shares for a new class of shares of the same corporation. It is the statutory basis for most Canadian estate freezes and internal share reclassifications, and unlike a section 85 transfer, no election form is required when the conditions are met.

For Canadian owner-managers, section 86 is one of the most useful tools in the tax planner's kit. It allows a founder to freeze the current value of a private company at today's fair market value (FMV), pass future growth to the next generation or a family trust, and do so without paying tax on the underlying capital gain in the year of the reorganization. This guide walks through how the section 86 rollover works mechanically, contrasts section 86 with section 85, explains the estate-freeze use case step by step, and flags the section 84.1 and section 84(1) anti-avoidance traps that catch the unwary.

What Is Section 86 of the Income Tax Act?

Section 86 of the Income Tax Act permits a tax-deferred exchange of shares of one class of a corporation for shares of another class (and optionally other property, called boot) of the same corporation, provided the exchange occurs in the course of a "reorganization of capital" and the taxpayer disposes of all shares of the particular class held immediately before the exchange.

Three conditions must be satisfied for the section 86 rollover to apply automatically:

1. There must be a reorganization of the capital of the corporation. In Ontario, this typically means articles of amendment filed under section 168 of the Business Corporations Act (OBCA), RSO 1990, c B.16, creating or amending a share class.
2. The taxpayer must dispose of all shares of a particular class held immediately before the reorganization. A partial exchange does not qualify.
3. The taxpayer must receive, in consideration, shares of any class of the same corporation. Boot is permitted but, as discussed below, has tax consequences if it exceeds the adjusted cost base (ACB) of the old shares.

What section 86 does is defer the capital gain that would otherwise arise on disposition of the old shares. What it does not do is change the underlying business, amalgamate two corporations, or remove future tax exposure: it simply shifts the timing.

How a Section 86 Rollover Works: ACB and PUC Mechanics

The mechanics of a section 86 rollover are driven by two tax attributes carried forward to the new shares: adjusted cost base (ACB) and paid-up capital (PUC). Getting either of them wrong is the most common technical error in a corporate reorganization rollover, and the same mechanics apply to every share for share exchange Canada wide under this provision.

ACB of the new shares. Under section 86(1)(c), the ACB of the new shares received on the exchange equals the ACB of the old shares disposed of, less the FMV of any non-share consideration (boot) received. Where the boot exceeds the ACB of the old shares, the excess is a capital gain in the year of the exchange.

PUC of the new shares. Under section 86(2.1), the PUC of the new shares is reduced so that the aggregate PUC of all new shares does not exceed the PUC of the old shares (with adjustments). The corporate-law PUC stated in the articles is not the controlling number for tax purposes: the tax PUC is the figure the Income Tax Act permits the corporation to return to shareholders on a tax-free basis. If the corporation overstates PUC on the new shares, a section 84(1) deemed dividend can arise on issuance, taxable in the hands of the shareholder.

A short example. A founder owns common shares of OpCo with an FMV of $5,000,000, ACB of $100, and PUC of $100. Under a section 86 rollover, the founder exchanges those common shares for new preferred shares with a $5,000,000 redemption value, voting rights, and a non-cumulative dividend right. The ACB of the new preferred shares is $100 (the ACB of the old common shares). The tax PUC of the new preferred shares is also $100, even though the redemption value is $5,000,000. No capital gain is triggered on the exchange. The $4,999,900 of unrealized gain is preserved inside the preferred shares and will surface only when the founder eventually redeems them or sells them to a third party.

The Section 86 Estate Freeze: The Rollover's Headline Use Case

A section 86 estate freeze is the most common Canadian application of the rollover. The objective is to lock in the current value of the business to the founder while letting future growth accrue to children, a family trust, or a Holdco.

The standard internal section 86 freeze looks like this.

1. Starting point. The founder owns 100 percent of the common shares of OpCo, FMV $5,000,000, ACB $100, PUC $100.
2. Articles of amendment. The corporation files articles of amendment under OBCA section 168, creating a new class of preferred shares. The preferreds are drafted with three engineered features: (a) a redemption value equal to the current FMV of OpCo, (b) voting rights (often multiple votes per share) so the founder retains governance, and (c) a discretionary or fixed dividend right.
3. Section 86 exchange. The founder exchanges all common shares for the new preferred shares under section 86. No election form is filed. The freeze preferreds carry ACB and PUC of $100, and a redemption value of $5,000,000.
4. New growth shares. OpCo issues new common shares (the growth shares) at nominal value to a family trust, the next generation directly, or a Holdco. Because the value of OpCo is fully reflected in the redemption value of the preferreds, the new common shares are issued at nominal subscription value: all future appreciation accrues to them.
5. Price adjustment clause. The freeze documents include a price adjustment clause so that, if the Canada Revenue Agency (CRA) successfully challenges the FMV of OpCo on audit, the redemption value of the preferreds adjusts automatically to the correct FMV. Without this clause, a CRA valuation challenge can trigger a section 86(2) deemed gift and an immediate capital gain.

The result: the founder's economic interest in OpCo is now capped at $5,000,000 (the redemption value of the preferreds), and every dollar of growth above $5,000,000 accrues to the family trust or next-generation shareholders. The capital gain on the freeze itself is deferred. Income splitting on dividends paid to the new common shareholders is now subject to the post-2018 tax on split income (TOSI) rules in section 120.4 of the Income Tax Act, which significantly narrowed the planning room but did not eliminate it for excluded amounts.

For a deeper look at how Hadri Law structures internal reorganizations like this, see our corporate reorganizations service page.

Section 85 vs Section 86: Which Rollover Do You Use?

The s 86 vs s 85 rollover question is the most common decision point in a Canadian corporate reorganization. The two provisions look superficially similar but operate on different facts.

Section 85 is a transfer of property to a corporation, typically a new Holdco or a sister corporation. It requires a joint election filed on Form T2057 (or T2058 for partnerships) within prescribed time limits, and the transferor and the corporation jointly elect an "agreed amount" within a statutory range. Section 85 is the workhorse for drop-down reorganizations, transfers into a Holdco, and asset rollovers into a new corporate entity.

Section 86 is an exchange of shares within the same corporation. No election form is required. There is no agreed amount: the rollover is automatic provided the statutory conditions are met. Section 86 is the workhorse for internal reorganizations and single-corporation estate freezes.

The practical decision matrix:

In practice, the two provisions are often layered. A classic Holdco freeze begins with a section 85 drop-down of the OpCo shares into a new Holdco, then a section 86 reclassification inside Holdco to crystallize the freeze. The combination preserves the founder's lifetime capital gains exemption (LCGE) under section 110.6 (where the OpCo shares are qualified small business corporation shares) and locks in the freeze value inside Holdco.

A third option, section 51 of the Income Tax Act, applies where the share exchange occurs under a contractual conversion right (for example, conversion of a convertible debenture into shares). Section 51 is the right tool for those facts and does not require the formal "reorganization of capital" that section 86 requires.

For founder-managed sales out of a freeze structure, our share sale transactions practice advises on the downstream tax planning, including section 84.1 and the LCGE.

Section 84.1 and the Anti-Avoidance Overlap

Section 84.1 of the Income Tax Act is the anti-surplus-stripping rule. It applies where a Canadian-resident individual transfers shares of a Canadian-resident corporation to another corporation with which the individual does not deal at arm's length, and that other corporation is connected with the corporation whose shares are transferred. Where section 84.1 applies, it can grind PUC on the shares received and deem a dividend equal to the non-share consideration received above the greater of the ACB and PUC of the transferred shares.

A section 86 reorganization on its own does not trigger section 84.1, because section 86 is an exchange within the same corporation: there is no transfer to a related corporation. The trap appears when a section 86 freeze is layered with a downstream sale of the freeze preferreds to a related Holdco, or when a freeze is used as part of an intergenerational business transfer to a child's holdco.

The Bill C-208 amendments (Royal Assent June 29, 2021) and the further amendments in Bill C-59 (Royal Assent June 20, 2024, generally applicable to transactions occurring on or after January 1, 2024) changed the intergenerational landscape. Section 84.1(2)(e) now distinguishes between "immediate" and "gradual" intergenerational transfers, each with detailed conditions covering control, ownership transition periods, parental involvement, and family member roles in the business. A poorly structured intergenerational freeze can collapse the section 84.1 exception and re-characterize the entire transaction as a deemed dividend.

The general anti-avoidance rule (GAAR) in section 245 of the Income Tax Act also applies. Section 86 freezes that have no business purpose beyond surplus stripping, or that artificially fragment a single transaction to avoid section 84.1, remain vulnerable to GAAR reassessment.

Corporate Law Mechanics: What the OBCA Requires

A section 86 share for share exchange in Canada is governed by federal tax law, but the corporate-law steps to execute it are provincial. In Ontario, a corporation governed by the OBCA must follow these steps to implement a section 86 reorganization:

• Articles of amendment under OBCA section 168. The articles of amendment create the new class of shares, set out the rights, restrictions, conditions, and privileges of the class, and amend the existing class rights if needed.
• Special resolution of shareholders under OBCA section 170. A special resolution requires approval by at least two-thirds of the votes cast at a properly convened shareholders meeting.
• Class vote rights under OBCA section 170(1). If the amendment affects the rights of an existing class of shares, holders of that class are entitled to vote separately as a class, even if the articles otherwise deny them a vote.
• Dissent rights under OBCA section 185. Shareholders who oppose the amendment may have dissent and appraisal rights, requiring the corporation to pay fair value for their shares.
• Filing with ServiceOntario. The articles of amendment are filed through the Ontario Business Registry.
• Minute book and share register updates. The corporate minute book is updated with the special resolution, the directors resolutions authorizing the issuance of the new class and the cancellation of the old class, and the share register is updated to reflect the exchange.

Skipping any of these steps creates a defective reorganization. The CRA can then take the position that no valid "reorganization of capital" occurred, with the result that the section 86 rollover is denied and a capital gain crystallizes in the year of the purported exchange.

Common Section 86 Pitfalls

Even experienced practitioners hit the same recurring traps on a section 86 estate freeze.

Partial exchange. Section 86 requires the taxpayer to dispose of all shares of the relevant class held immediately before the reorganization. Leaving a single share behind disqualifies the rollover.

Preferred shares below FMV. If the redemption value of the new preferred shares is less than the FMV of the old shares exchanged, section 86(2) treats the shortfall as a gift to the other shareholders (typically the next generation or the family trust) and deems an immediate capital gain in the founder's hands. The price adjustment clause is the standard protection.

Voting and dividend mechanics. Founders often want to freeze economically but keep operational control. If the new preferred shares are not drafted with the right voting and dividend rights, the founder loses control inadvertently the day the new common shares are issued.

PUC error. The most common technical error is overstating the PUC of the new preferred shares to match the redemption value. The corporate-law PUC and the tax PUC are different concepts; overstating tax PUC triggers a section 84(1) deemed dividend at the moment of issuance, fully taxable.

Provincial corporate-law slip. Articles not filed, special resolution defective, or class vote not held: the CRA can argue that no valid reorganization occurred.

Section 84.1 territory. Post-freeze sales of preferred shares to a related Holdco, or unstructured intergenerational transfers, can trigger section 84.1 and a deemed dividend on the seller.

TOSI on dividends. Post-2018, dividends paid on freeze preferreds or growth shares held by adult family members are taxable at the top marginal rate unless an excluded amount test in section 120.4 is satisfied. Income splitting is no longer a default benefit of a freeze.

LCGE timing. A freeze locks in the founder's lifetime capital gains exemption position under section 110.6 (where the OpCo shares are qualified small business corporation shares). Freezing too early can waste the exemption; freezing too late means the family loses the exemption on growth that has already accrued to the founder.

Frequently Asked Questions

What is a section 86 rollover?

A section 86 rollover is the share for share exchange permitted under section 86 of the Income Tax Act. A shareholder exchanges all shares of one class for shares of another class of the same corporation, on a tax-deferred basis, in the course of a reorganization of capital. No election form is required when the statutory conditions are met.

What is the difference between section 85 and section 86?

Section 85 transfers property to a different corporation and requires a joint election on Form T2057 with an agreed amount chosen within a statutory range. Section 86 exchanges shares within the same corporation and requires no election form. Practitioners often layer the two: section 85 drops shares into a new Holdco, section 86 reclassifies inside Holdco.

Is a section 86 exchange taxable?

No, provided the statutory conditions are met. Section 86 defers the capital gain that would otherwise arise on disposition of the old shares. Tax is deferred until the new shares are eventually redeemed or sold. Boot received above the adjusted cost base of the old shares triggers a capital gain in the year of the exchange.

How does section 86 apply to an estate freeze?

In a section 86 estate freeze, the founder exchanges common shares for new preferred shares with a redemption value equal to today's fair market value. New common shares (growth shares) are then issued to children, a family trust, or a Holdco at nominal value. Future growth accrues to the new common shares, and the founder's economic interest is capped at the redemption value of the preferreds.

Does section 86 require Form T2057?

No. Form T2057 is the election form for a section 85 transfer of property to a corporation. Section 86 has no equivalent election form: the rollover is automatic when the three statutory conditions are satisfied (reorganization of capital, disposition of all shares of a particular class, and receipt of shares of the same corporation).

Sources & Official Resources

Federal Statutes Cited

1. Income Tax Act, s. 86 (Exchange of shares by a shareholder in course of reorganization of capital)
2. Income Tax Act, s. 85 (Transfer of property to corporation by shareholders)
3. Income Tax Act, s. 84(1) (Deemed dividend on increase in paid-up capital)
4. Income Tax Act, s. 84.1 (Non-arm's length sale of shares)
5. Income Tax Act, s. 51 (Convertible property)
6. Income Tax Act, s. 110.6 (Lifetime capital gains exemption)
7. Income Tax Act, s. 120.4 (Tax on split income)
8. Income Tax Act, s. 245 (General anti-avoidance rule)

Ontario Statutes Cited 9. Business Corporations Act (Ontario), RSO 1990, c B.16: Full Text

CRA Forms and Guidance 10. CRA Form T2057: Election on Disposition of Property by a Taxpayer to a Taxable Canadian Corporation

Government Portals 11. Ontario Business Registry: Filing Articles of Amendment

Contact Hadri Law

If you are planning an estate freeze, a corporate reorganization, or a transfer of shares to the next generation, the right structure matters. A section 86 rollover looks straightforward on paper, but the interplay with section 85, section 84.1, the TOSI rules, the lifetime capital gains exemption, and Ontario corporate law makes execution unforgiving.

Hadri Law's tax practice is led by Martina Caunedo, Tax Lawyer (Law Society of Ontario, 2024), who brings 12+ years of tax practice and a focus on corporate tax planning, CRA audits, and Tax Court matters. Our corporate practice, led by founder Nassira El Hadri (Law Society of Ontario, 2021) and corporate lawyer Nicholas Dempsey (Law Society of Ontario, 2018, 90+ asset and share sale transactions), handles the articles of amendment, share class design, and OBCA mechanics that an estate freeze requires.

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This article is for general information only and does not constitute legal or tax advice. Reading or relying on it does not create a solicitor-client relationship with Hadri Law Professional Corporation.