In Canadian Mergers and Acquisitions (M&A), a Section 85.1 share-for-share exchange allows a purchaser to acquire a target company by offering their own treasury shares as payment. This automatically defers the capital gains tax for the seller, making it an incredibly powerful and efficient tool for corporate buyouts.
When a business is sold in Canada, the transaction usually takes one of two forms: a cash buyout or a share exchange. If you sell your successful tech startup in Vancouver or your manufacturing firm in Toronto for straight cash, the Canada Revenue Agency (CRA) expects you to pay capital gains tax on that profit immediately. For massive Mergers and Acquisitions (M&A) deals, this immediate tax burden can severely discourage founders from selling their life’s work.
To grease the wheels of the Canadian economy, the federal Income Tax Act provides a brilliant mechanism known as a Section 85.1 rollover. 📍 This rule allows the owners of a target company to trade their shares for the shares of the acquiring company without triggering a tax event. The tax is completely deferred until the seller eventually decides to sell those newly acquired shares for cash down the road. In this guide, we will break down how a Section 85.1 exchange works, its strict legal limitations, and how Canadian tax lawyers execute these deals.
Step-by-Step Process for a Section 85.1 Exchange in Canada
Unlike the complex joint-election process of a standard Section 85(1) rollover, Section 85.1 is designed to be highly automated. However, your corporate lawyers must ensure the transaction structure meets very rigid federal criteria.
Step 1: Verifying Corporate Eligibility
Before any contracts are drafted, your M&A legal team must verify the status of both corporations. 🔍 Under Canadian tax law, the purchaser issuing the new shares must be a taxable Canadian corporation. The target company being acquired must also be a taxable Canadian corporation. If the acquiring company is an American or foreign entity, Section 85.1 generally cannot be used, and a different cross-border tax strategy (like an exchangeable share transaction) is required.
Step 2: Structuring the “Solely for Shares” Consideration
This is the most critical rule of Section 85.1. The seller must trade their shares solely for the treasury shares of the purchasing company. You cannot mix the payment for a specific block of shares. If the purchaser offers you 90% shares and 10% cash (known as “boot”) for your shares, the entire Section 85.1 deferral is destroyed for those shares, and the whole transaction becomes instantly taxable.
Step 3: Drafting the Share Purchase Agreement (SPA)
Once the terms are set, the corporate lawyers will draft the Share Purchase Agreement (SPA). 📝 This massive legal document outlines the exact exchange ratio (e.g., two shares of the purchaser for every one share of the target). It will also include extensive representations and warranties, ensuring the target company has no hidden legal liabilities or unpaid CRA tax debts.
Step 4: Closing and Automatic Tax Reporting
At closing, the share certificates are cancelled and reissued. The beauty of Section 85.1 is that it applies automatically. Neither the purchaser nor the seller needs to file a complex joint election form with the CRA. The seller simply reports the transaction on their annual T1 Personal or T2 Corporate tax return, carrying over the original Adjusted Cost Base (ACB) to the new shares.
How Much Does an M&A Restructuring Cost in Canada?
Executing an M&A deal involving share exchanges requires top-tier legal and financial advisors. You are essentially trading your business for a piece of another business, meaning rigorous due diligence is mandatory. As of May 2026, here are the estimated professional fees for a mid-market Canadian transaction.
| M&A Professional Service | Estimated Cost (CAD) |
|---|---|
| CPA Due Diligence & Valuation | $15,000 – $50,000+ |
| Corporate M&A Lawyer (Drafting SPA) | $25,000 – $100,000+ |
| Tax Lawyer Strategy Review | $10,000 – $30,000 |
| CRA Tax Filing (T2 Corporate) | $3,000 – $8,000 |
- The Value of Deferral: While legal fees easily surpass $50,000, utilizing Section 85.1 can defer millions of dollars in immediate capital gains taxes, leaving the seller with a vastly larger investment portfolio to grow over time.
How Long Does the Process Take?
An M&A transaction using a share-for-share exchange is rarely a quick process. The negotiation of the Letter of Intent (LOI) and the extensive financial due diligence typically takes 3 to 6 months. Once the SPA is signed and the shares are exchanged, the tax deferral is legally effective immediately. The reporting is simply completed during the next standard CRA tax filing season.
Frequently Asked Questions (FAQ)
What is the difference between Section 85(1) and 85.1?
Section 85(1) allows you to accept a mix of shares and “boot” (like cash or promissory notes) up to the cost base of your assets, but requires you to file a complex joint election form. Section 85.1 strictly forbids cash consideration for the exchanged shares, but it happens automatically without needing a joint election.
Can I sell part of my shares for cash and part for shares?
Yes, but it must be structured perfectly. You can sell 500 shares purely for cash (which is taxable), and a separate 500 shares purely for purchaser shares under Section 85.1 (which is tax-deferred). You cannot mix cash and shares as payment for the exact same block of shares.
Does Section 85.1 apply to public companies?
Absolutely. Section 85.1 is heavily used in public company takeovers. When a large public entity listed on the Toronto Stock Exchange (TSX) buys a smaller company, they often offer their publicly traded stock to the target’s shareholders, triggering this automatic deferral.
What happens when I finally sell the new shares?
When you eventually sell the purchaser’s shares for cash, the CRA will calculate your capital gain using the Adjusted Cost Base (ACB) of your original target company shares. You will finally pay the deferred tax at the capital gains inclusion rate applicable in that future year.
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