Section 86 estate freeze: common into fixed value prefs, no election

What does section 86 require, and what does each rule do?

Section 86 applies when, in the course of a reorganization of the capital of a corporation, your client disposes of all the shares of a class they own, held as capital property, and receives consideration from the corporation that includes other shares of that corporation laws-lois.justice.gc.ca. Nothing in the section asks for an election, so there's no T2057 to file. If the conditions are met, the rules apply.

In a freeze, your client exchanges their common shares for preferred shares with a fixed redemption value equal to today's FMV of the company, then a family trust or the children subscribe a nominal amount for new common shares. All future growth accrues to the new common shares. Because the freeze stays inside one corporation, it's often called an internal freeze. The section 85 rollover page covers the version that uses a holding company.

How does a $2,000,000 freeze work through the cost, PUC and death rules?

Your client owns all 100 common shares of Opco: ACB $100, PUC $100, FMV $2,000,000. In a reorganization of capital, Opco exchanges them for 2,000,000 Class A preferred shares, redeemable and retractable at $1 each, with no boot. A family trust then subscribes $100 for 100 new common shares.

In the grind formula, A is the PUC increase on all new shares, B is the old shares' PUC minus the boot, and C is the PUC increase on the class in question laws-lois.justice.gc.ca. Either way the preferred shares end up with $100 of PUC, so your client can't pull the frozen value out as a tax free return of capital.

Later redemptions are dividends. When Opco redeems shares, 84(3) deems a dividend equal to the amount paid minus the PUC of those shares laws-lois.justice.gc.ca. Redeem 500,000 Class A shares for $500,000 and the PUC on them is $25 ($100 × 500,000 / 2,000,000), so your client has a $499,975 deemed dividend. Paragraph (j) of the proceeds definition in section 54 removes that dividend from proceeds, leaving $25 of proceeds against $25 of ACB and no gain laws-lois.justice.gc.ca.

At death, 70(5) deems your client to dispose of every capital property at FMV immediately before death laws-lois.justice.gc.ca. Say Opco is worth $5,000,000 by then and nothing was redeemed. The preferred shares are still worth $2,000,000, so the gain is $1,999,900 and the taxable half is $999,950 under section 38 laws-lois.justice.gc.ca. Without the freeze the gain on the common would have been $4,999,900. The $3,000,000 of growth sits in the trust's common shares, with a $100 cost, and the trust's own deemed sale arrives under the 21 year rule. See deemed disposition on death for the terminal return.

When does 86(2) tax value shifted to the children?

Subsection 86(2) applies when the FMV of the old shares exceeds the cost of the boot plus the FMV of the new shares, and it's reasonable to regard part of that excess, the gift portion, as a benefit your client wanted to confer on a related person laws-lois.justice.gc.ca. Proceeds become the lesser of the boot plus the gift portion and the old shares' FMV, any capital loss is deemed nil, and the new shares' cost drops by the gift portion. Unlike the benefit rule in 85(1)(e.2), there's no exception for a wholly owned corporation laws-lois.justice.gc.ca.

Take the same freeze, but the preferred shares carry no retraction right and a dividend the board can skip, and a valuator puts them at $1,500,000. The $500,000 shortfall has moved to the trust's new common shares, which benefits your client's children.

That's a gain now with no cash, and the preferred shares still carry a $0 cost, so their full value is taxed again at redemption or death. The fix is in the share terms: the preferred shares need to be worth what they replace. That usually means a fixed redemption amount equal to the frozen value, a retraction right for the holder, and a dividend entitlement and votes that support the value.

A price adjustment clause is the backstop if the CRA disagrees with the valuation. The CRA recognizes one only when the agreement shows a bona fide intention to transfer at FMV, the FMV was set by a fair and reasonable method, the parties agree to use the CRA or court value, and the excess or shortfall is actually refunded, paid or adjusted canada.ca. When a valid clause is exercised, the folio says the FMV of the consideration is treated as equal to the FMV of the property for 86(2), and it notes the clause can affect the FMV of freeze shares still held at death.

Does corporate attribution under 74.4 apply after the freeze?

It can, because your client has transferred the old shares to a corporation. Subsection 74.4(2) applies for any year in which one of the main purposes of the transfer may reasonably be considered to be to reduce your client's income and benefit a designated person, your client is resident in Canada, the designated person would hold 10% or more of a class of shares under a modified specified shareholder test, and the corporation is not a small business corporation laws-lois.justice.gc.ca.

A designated person is your client's spouse or common law partner, or a person under 18 who doesn't deal at arm's length with your client or is their niece or nephew laws-lois.justice.gc.ca. A small business corporation is a CCPC with all or substantially all of the FMV of its assets used principally in an active business carried on primarily in Canada, or invested in connected small business corporations laws-lois.justice.gc.ca. An operating company usually passes, so the risk grows as passive investments pile up after the freeze.

When it applies, your client is deemed to receive interest at the prescribed rate on the outstanding amount, which is the FMV transferred minus any consideration that isn't shares or debt. That's the rate in Regulation 4301(c) laws-lois.justice.gc.ca, 3% in each quarter of 2026, including October to December canada.ca. Taxable dividends your client receives on the freeze shares reduce the deemed interest dollar for dollar, at their grossed up amount.

The 15% gross up comes from 82(1)(b) laws-lois.justice.gc.ca. Two more reductions matter. Dividends a designated person receives that are taxed as split income also reduce the deemed interest under 74.4(2)(g), so the TOSI rules and 74.4 don't tax the same dividend twice. And 74.4(4) switches the rule off where the designated person's only interest is through a trust whose terms bar them from income or capital while they're a designated person, and nothing has been paid to them or deducted by the trust for them laws-lois.justice.gc.ca. For the full rate history, see CRA prescribed interest rates 2026.

Section 86, section 85 or section 51: which one applies to the exchange?

Section 85 comes first, then section 86, then section 51. Subsection 86(3) turns section 86 off wherever 85(1) or 85(2) applies laws-lois.justice.gc.ca, and 51(4) turns section 51 off wherever 85(1), 85(2) or section 86 applies laws-lois.justice.gc.ca.

Choose section 85 when your client wants a gain on the exchange, for example to use the lifetime capital gains exemption on qualified small business corporation shares, or when the freeze shares come from a new holding company laws-lois.justice.gc.ca. Choose section 86 when the freeze stays in Opco and you want cost carried over with no form. Section 51 covers a conversion of shares or convertible debt of the same corporation for shares only; see section 51 share exchange.