Anonymised, illustrative composite. A buyer paid a $310,000 premium for a stepped-up equipment base. Half of what it paid for was real. The other half is expressly taken back by the subsection that governs rollovers of depreciable property.
At a glance
An Alberta metal fabricator was being sold on a share basis. The buyer's model leaned heavily on the press line: nine machines in a single prescribed class, most of them fifteen years old on the books and considerably better than that on the floor. The vendor's equipment condition report supported a fair market value of $840,000 against an undepreciated capital cost of $286,000.
Because the buyer wanted the depreciation and the vendor wanted the lifetime capital gains exemption that only a share sale delivers, the parties used a hybrid: the vendor incorporated a new company, rolled the equipment into it under subsection 85(1) at an elected amount equal to fair market value, and then sold the shares of the new company. See the section 85 rollover explained for the mechanics of the election itself.
The buyer's tax memorandum described the result in one sentence: the rollover gives the new corporation “a fresh capital cost of $840,000”. That sentence is the error. The elected amount does set the new corporation's undepreciated capital cost. It does not set its capital cost.
Subsection 85(5) is headed Rules on transfers of depreciable property, and it applies wherever subsection 85(1) or 85(2) has applied to a disposition of depreciable property and “the capital cost to the transferor of the property exceeds the transferor’s proceeds of disposition of the property”. The vendor's original capital cost was $1,480,000. The elected amount was $840,000. So the subsection applies, and it applies automatically — there is nothing to elect out of.
The consequences are two lines. First, “the capital cost to the transferee of the property is deemed to be the amount that was its capital cost to the transferor”. Second, “the excess is deemed to have been deducted by the transferee under paragraph 20(1)(a) in respect of the property in computing income for taxation years that ended before that time”.
The elected amount itself was permissible. Paragraph 85(1)(c) caps it: “where the amount that the taxpayer and the corporation have agreed on in their election in respect of the property is greater than the fair market value, at the time of the disposition, of the property so disposed of”, the amount is deemed to be that fair market value. Paragraph 85(1)(e) sets the floor at the least of the undepreciated capital cost, the cost, and the fair market value — here $286,000. An election at $840,000 sits inside both.
Vendor side: proceeds of $840,000 against a pool of $286,000 produced recapture of $554,000, included in income under subsection 13(1). The vendor knew this and priced it in.
Buyer side: the new corporation's capital cost is deemed to be $1,480,000, and the $640,000 excess is deemed to have been deducted by it as capital cost allowance in years ending before the transfer. Its opening undepreciated capital cost is therefore $840,000 — exactly the elected amount. The pool the buyer paid for is real.
What is not real is the recapture ceiling. On the buyer's own modelled exit — a sale of the press line for $1,250,000 in year five — recapture runs up to the deemed capital cost of $1,480,000, so the whole excess over the pool at that date is fully taxable income. Had the capital cost genuinely been $840,000, recapture would have stopped at $840,000 and the remaining $410,000 would have been a capital gain, of which half is taxable under paragraph 38(a). The difference is $205,000 of income the model had removed and the Act had not.
The unit question is what a rollover can and cannot move. A section 85 election moves an amount — the proceeds to the transferor and the cost to the transferee. It does not move an asset into a new tax history. Subsection 85(5) exists to say so for depreciable property: the transferee inherits the transferor's capital cost and the transferor's accumulated depreciation as though it had claimed the depreciation itself.
This is not the same rule as paragraph 13(7)(e), which is the provision most often confused with it. Paragraph 13(7)(e) applies where a taxpayer “acquired (otherwise than as a consequence of the death of the transferor) a depreciable property (other than a timber resource property) of a prescribed class from a person or partnership with whom the taxpayer did not deal at arm’s length” and the cost to the acquirer exceeds the transferor's cost. It caps a stepped-up purchase price on a non-arm's-length sale. Subsection 85(5) does the opposite job, in the opposite direction, on a rollover where the elected amount is below the transferor's capital cost. Different trigger, different arithmetic, and citing one for the other produces the wrong number.
The premium was recut. The buyer's adviser rebuilt the model in two halves: the present value of capital cost allowance on the extra $554,000 of pool, which survives subsection 85(5) intact; and the tax saved on the modelled exit by a lower recapture ceiling, which does not survive it at all. The second half was worth about two-thirds of the $310,000 premium as originally computed. The premium came down to $118,000 and the deal closed on that basis.
The vendor's $554,000 of recapture was unaffected — that is a real cost the vendor bears to move the pool, and it is the reason a hybrid structure is negotiated rather than assumed. See pricing the difference between a share and an asset deal for how that trade is normally priced.
Had the premium been paid as drafted, the buyer would have paid $310,000 for a benefit worth roughly $118,000, and it would not have discovered the gap until it sold the line five years later — at which point the excess would have arrived as fully taxable recapture rather than as a half-taxed capital gain.
There is no structure that fixes this. A rollover cannot manufacture depreciation, and a genuine arm's-length asset purchase — which would have given a true $840,000 capital cost — costs the vendor the exemption on the share sale. The choice is real; what is not available is both.
The tell was in the memorandum's own words. “A fresh capital cost” is a phrase with no statutory basis on a rollover of depreciable property, and the subsection that governs the point is titled after exactly that subject matter. Two lines of subsection 85(5) contradict the sentence.
The second tell was structural: fifteen-year-old machinery on the books at 19% of cost is precisely the fact pattern subsection 85(5) is written for.
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