A freeze that needed no election at all

The situation

A British Columbia industrial supply distributor had been reorganised in 2014, when the founder's shares were redesignated as Class A common shares. The 2014 articles gave the holder of a Class A share the right to convert it, at any time, into fixed-value Class E redeemable preferred shares. Nobody had ever used it.

In 2026 the founder, then 58, wanted to bring his two operating managers into the equity without giving up all of his own upside. The plan was to freeze roughly seventy per cent of his position and retain the rest as growth shares alongside the managers' new common shares.

The problem

The first proposal was a section 86 freeze, on the model of every other freeze the firm had done. It does not work on these facts. Subsection 86(1) applies only where the taxpayer has disposed of capital property that was “all the shares of any particular class of the capital stock of the corporation that were owned by the taxpayer at the particular time”, in the course of a reorganisation of capital. A partial freeze of 700 out of 1,000 shares of one class is not that. Section 86 can be made to fit only by first splitting the holding into two classes, which is itself a reorganisation and its own set of documents.

The second proposal was a subsection 85(1) rollover. That works, but carries a deadline the founder does not set: subsection 85(6) requires the election “on or before the day that is the earliest of the days on or before which any taxpayer making the election is required to file a return of income pursuant to section 150” for the year of the transaction. The corporation had a 30 June year end; the earliest of the two due dates was its, not the founder's.

The third route was in the articles. Nobody had read them.

The numbers

Subsection 51(1) applies where a share of the capital stock of a corporation is acquired by a taxpayer from the corporation in exchange for a capital property of the taxpayer that is another share of the corporation, or a bond, debenture or note of the corporation “the terms of which confer on the holder the right to make the exchange”. Where it applies, “the exchange is deemed not to be a disposition of the convertible property”. There is no gain, because there is no disposition.

The founder converted 700 Class A shares into 2,310,000 Class E preferred shares redeemable at $1 each — $2,310,000, being seventy per cent of the $3,300,000 fair market value confirmed by an independent valuator. He retained 300 Class A shares carrying $990,000 of value and all future growth on that slice.

Paragraph 51(1)(d) sets the cost of the new shares by the formula A × B/C, where A is the adjusted cost base of the convertible property immediately before the exchange. The 700 converted Class A shares carried $58,800 of the founder's $84,000 base, and the only shares acquired on the exchange were Class E, so B/C is one. The Class E shares carry $58,800 of adjusted cost base in total; the retained 300 Class A shares keep $25,200.

Nothing was filed. No prescribed form, no penalty exposure, no deadline in anyone's diary.

The rule that decided it

The three provisions are not alternatives a taxpayer chooses between. The Act ranks them, and the ranking is in the text. Subsection 51(4) provides that “Subsections 51(1) and 51(2) do not apply to any exchange to which subsection 85(1) or 85(2) or section 86 applies”. Subsection 86(3) provides that subsections 86(1) and 86(2) “do not apply in any case where subsection 85(1) or 85(2) applies”. Section 85 sits at the top, section 86 next, section 51 last. Which one governs is settled by what the documents actually do, not by which memo was written.

The condition that nearly destroyed the plan is the narrowest one in subsection 51(1). The provision applies only where “no consideration other than the share is received by the taxpayer for the convertible property”. The draft directors' resolution had the company reimburse the founder $18,000 of legal fees “on the conversion”. On its face that is consideration received for the convertible property in addition to the shares. One line in a resolution would have taken the exchange outside section 51 entirely and left it as an ordinary disposition. The reimbursement was moved to a separate resolution passed on a different date for services unconnected to the exchange.

Subsection 51(2) then mirrors subsection 86(2): where the fair market value of the convertible property exceeds that of the shares received and the excess benefits a related person, the same gift-portion arithmetic applies. Section 51 removes the filing risk, not the valuation discipline — see preferred shares fixed below what the business was worth.

The outcome

The conversion was effected under the existing Class A share conditions, supported by an independent valuation of the whole company at $3,300,000 and a directors' resolution recording the conversion ratio. The managers subscribed for common shares for nominal consideration. The founder retained 30% of the common equity and $2,310,000 of fixed redeemable value, with no tax payable and nothing to file.

The 2014 drafting was worth more than the 2026 planning. Nobody then was thinking about a management buy-in twelve years later; they wrote a conversion right into a share class because it cost nothing. See exit provisions written at the start.

What it would have cost otherwise

Route by route: a section 86 freeze would have required a prior reorganisation to split the Class A shares into two classes, adding a set of resolutions and an articles amendment before the freeze itself could begin. A section 85 rollover would have reached the same tax result but with a joint election on a prescribed form due on a date controlled by the corporation's year end rather than the founder's.

Doing nothing formal and simply transferring 700 shares to a family trust would have been the expensive answer: a non-arm's-length disposition is priced at fair market value under section 69, producing a gain of roughly $2,251,200 on shares for which no cash changed hands. That is the baseline all three rollover routes are measured against.

The tell

The tell was that nobody had opened the articles. Two rounds of planning proceeded on the assumption that the shares were ordinary common shares, because that is what the cap table called them. A share class named “Class A common” can carry conversion rights, redemption rights, retraction rights and voting restrictions that the cap table does not show.

The second tell is a drafting habit rather than a fact: any resolution that pairs a share exchange with a payment of any kind, however small and however unrelated it looks, is worth reading twice against the words “no consideration other than the share”.

Takeaways

• • Section 51 applies automatically where the shares are convertible by their own terms. No election, no prescribed form, no deadline — the exchange is simply deemed not to be a disposition.
• • Its narrow condition is that no consideration other than the share is received. A fee reimbursement, a small cash payment or a note issued in the same resolution takes the exchange outside the provision.
• • Section 86 requires the disposition of all the shares of a particular class in the course of a reorganisation of capital, so it cannot do a partial freeze without a prior class split.
• • Section 85 works in almost every case but carries a joint election due on the earliest filing date of any electing party — which is often the corporation's, not the individual's.
• • The ordering is statutory: 85 displaces 86, and 86 displaces 51. Read the share conditions before choosing a route; the cheapest one may already be drafted.

Sources

• • Income Tax Act, s. 51 — s.51(1) (marginal note Convertible property), including the no-other-consideration condition and the cost formula in 51(1)(d); s.51(2) (gift portion); s.51(4) (ordering).
• • Income Tax Act, s. 86 — s.86(1) (all the shares of a particular class); s.86(3) (section 85 takes priority).
• • Income Tax Act, s. 85 — s.85(1); s.85(6) (marginal note Time for election); s.85(7) (late-filed election and penalty).
• • Income Tax Act, s. 69 — the fair-market-value pricing that applies if no rollover provision does.
• • Treadstone Law — section 85 rollovers and an Ontario corporation and Treadstone Law — corporate reorganisations. Both are Ontario-focused and address sections 85 and 86; neither covers the section 51 route, which is why this file states the condition from the Act itself.