McGill Law Journal Revue de droit de McGill
TAXING BY DEFAULT
Emily Satterthwaite*
This paper is the first in the Canadian le-
gal literature to address tax elections, which
bestow upon taxpayers the ability to choose
among two or more available tax treatments for
a single taxable event. I argue that policymak-
ers should adopt a rebuttable presumption in
favour of setting default treatments according
to the preferences of a majority of eligible tax-
payers, unless a penalty default structure can
be shown to convey sufficiently valuable infor-
mation to the government. To illustrate how
such a presumption would work in practice, I
apply it to two similar but inconsistently struc-
tured tax elections in the Income Tax Act relat-
ing to transfers of property to a spouse and to a
corporation (subsections 73(1) and 85(1), respec-
tively). I find that the design of subsection 73(1)
is soundits majoritarian default of tax-
deferring rollover treatment avoids unneces-
sary transaction costs and squanders no infor-
mation-forcing role. On the other hand, subsec-
tion 85(1) is counter-majoritarian, and the in-
formation disclosed jointly by taxpayers and
corporations via the 85(1) election can be ob-
tained at lower cost by requiring corporations to
routinely report information about contribu-
tions of property. Mandatory reporting would
also bolster the governments anti-avoidance ef-
forts. Thus, amending subsection 85(1) to re-
verse its default treatment would make an im-
portant corner of the income tax less costly and,
at the same time, more equitable.
Cet article est le premier dans la littra-
ture juridique au Canada daborder la question
des choix fiscaux, qui accordent aux contri-
buables la possibilit de placer un seul fait g-
nrateur de limpt sous plusieurs traitements
fiscaux. Je postule que les dcideurs politiques
devraient faire ladoption dune prsomption r-
futable en faveur dintroduire des traitements
fiscaux par dfaut, selon les prfrences de la
majorit des contribuables admissibles, moins
quune structure penalty default savre
mme de communiquer de linformation suffi-
samment importante au gouvernement. Pour
dmontrer la dmarche pratique dune telle
prsomption, japplique cette dernire deux
types de choix fiscal dans la Loi de limpt sur le
revenu qui sont similaires mais structurs de
faon ingale : le transfert dun bien en immobi-
lisation lpoux et celui une socit (para-
graphes 73(1) et 85(1)). Je trouve que la concep-
tion du paragraphe 73(1) est valable : sa rgle
majoritaire par dfaut, lequel consiste en un
traitement de roulement imposition reporte,
vite dajouter des cots de transaction et
dobliger de linformation. En revanche, le para-
graphe 85(1) est contre-majoritaire, et les in-
formations dclares conjointement par les con-
tribuables et par les socits sous le paragraphe
85(1) peuvent tre obtenues moindre cot si
on oblige les socits de faire des dclarations
habituelles concernant leur apport de biens.
Dailleurs, la dclaration obligatoire renforcerait
les efforts du gouvernement contre lvitement
fiscal. Donc, une modification du paragraphe
85(1) en vue de changer son traitement par d-
faut peut rendre cette procdure en droit fiscal
moins coteuse et plus quitable.
* The author is grateful to Benjamin Alarie, Anita Anand, Colin Campbell, Allison Chris-
tians, Tim Edgar, Alan Macnaughton, Nancy Staudt, Arnold Weinrib, and six anony-
mous referees for invaluable comments and discussions. All errors are my own.
Citation: (2013) 59:2 McGill LJ 337 Rfrence : (2013) 59 : 2 RD McGill 337
Emily Satterthwaite 2013
339
343
348
351
351
353
353
357
358
358
362
365
365
367
372
338 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
Introduction
I.
The Transaction Cost Implications of Default Setting
II.
Setting Defaults to Reveal Information
III.
The Opposite Defaults of the Subsection 73(1) and
85(1) Elections
A. Why Offer a Rollover in the First Place?
B. The Subsection 73(1) Rollover
1. Mechanics
C. The Subsection 85(1) Rollover
1. Mechanics
2. Statutory History
2. Statutory History
IV.
Evaluating Subsections 73(1) and 85(1)
A. Subsection 73(1)
B. Subsection 85(1)
Conclusion
TAXING BY DEFAULT 339
Introduction
Even though most Canadians may not think of taxes as optional, there
are over 230 provisions in Canadas Income Tax Act (the Act)1 that give
taxpayers a choice regarding how to calculate their taxes.2 These tax
elections are so ubiquitous as to sometimes go unnoticed as a matter of
design and have generated little discussion among academics and tax ex-
perts in Canada.3 However, ignoring the design of tax elections is perilous
for a tax system that seeks to be both equitable (to engineer an after-tax
distribution of resources that accords with social norms of fairness) and
efficient (to raise a required amount of revenue at minimum cost).
I demonstrate in this paper that improperly structured tax elections in
the Act can impose substantial transaction costs on taxpayers and the
government, while squandering their intended benefits and dispropor-
tionately burdening those taxpayers least able to navigate the complexity
of the election. From the standpoint of the taxpayer, a tax election offers
flexibility and the potential to decrease her tax liability, but also requires
her to invest resources in understanding the election. She must determine
which available tax treatment is best, as well as learn how to comply with
the election and bear the costs of filing it with the government (either by
herself or through her tax representative).
1 Income Tax Act, RSC 1985, c 1 (5th Supp) [the Act]. Unless otherwise stated, statutory
references in this paper are to the Act.
2 See Ryan Keey et al, eds, Canada Tax Service Elections Guide 2009 (Toronto: McCarthy
Ttrault and Carswell, 2009) at iii. A handful of elections appeared in the 1952 Income
Tax Act, including elections that relate to income averaging, offer investment compa-
nies alternative tax regimes, and allow personal corporations to opt out of the exemp-
tion from tax available under section 61, among others (Income Tax Act, RSC 1952, c
148 [1952 Act]). The index to the Stikemans annotated volume has ten entries under
the heading Elections (H Heward Stikeman, ed The Income Tax Act 19521953 Anno-
tated (Toronto: Richard De Boo, 1953) at 439). But following Canadas landmark tax re-
form legislation in 1972, the number of elective provisions in the Act ballooned. The
elections mentioned in the index to the annotated Income Tax Act of 1972 total more
than forty (H Heward Stikeman, ed, Income Tax Act: Tax Reform Edition 1972 (Toron-
to: Richard De Boo Limited, 1972) at 695; Bill C-259, An Act to amend the Income Tax
Act and to make certain provisions and alterations in the statute law related to or conse-
quential upon the amendments to that Act, 3d Sess, 28th Parl, 1972 (assented to 23 De-
cember 1971), SC 1972, c 63 [Bill C-259]).
3 Heather Field characterizes the Internal Revenue Code as littered with explicit tax
elections. While it is unclear to what extent US tax policy influenced Canadians affinity
for elective tax provisions or vice-versa, the two countries similar trajectories with re-
gard to the increasing prevalence of elective provisions in their income tax laws sug-
gests that scholarship addressing tax elections would be welcomed in both jurisdictions
(Heather M Field, Choosing Tax: Explicit Elections as an Element of Design in the
Federal Income Tax System (2010) 47:1 Harv J on Legis 21 at 2425 (citing to elective
provisions in the 1918 and 1921 Revenue Acts of the United States)).
340 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
From the standpoint of the government, another set of costs and bene-
fits of tax elections is at play. On the cost side, tax elections require the
government to invest resources in administering the election. The gov-
ernment must bear the costs of processing the elections that are filed by
taxpayers, implementing the elective treatment as a basis for calculating
taxes owed, and fielding requests from taxpayers who want to modify or
withdraw tax elections (in cases where such changes to elective choices
are permitted by law).
On the benefit side for the government, however, is the notion that
elections can act as screens. In the tax context, a screen is a choice of-
fered by government that forces (at least some) taxpayers to separate into
two different groups.4 The governments resulting observationinto which
group a taxpayer self-selects when presented with the tax choicemay
prove useful in administering, enforcing, or tailoring the tax law.5 In this
paper, I will refer to such observations about the self-selection of taxpay-
ers as informationdefined narrowly as taxpayer-specific inferences
that can be made by the government upon observing taxpayers elective
choices. In cases where such information is produced by an election, the
informations measurable benefits must be traded off against the costs of
having an election, whether or not it is structured as a penalty default
that is, as a default treatment that is contrary to what a majority of tax-
payers would prefer.
Here, I analyze the trade-offs at the heart of tax elections to tackle the
most basicbut arguably the most importantaspect of designing a tax
election: how to determine the tax treatment that will be available to tax-
payers by default. To distill a clear set of principles for policymakers, I ex-
amine the nature of the transaction costs presented by tax elections as
well as the literature on default rules in the law, with an eye toward de-
signing tax elections in a least-cost manner.6 Specifically, this approach
4 See generally Emily Ann Satterthwaite, Screening in the Law: An Application to the
Election to Itemize Deductions (July 2013) [unpublished working paper, draft on file
with author] (showing that, under certain assumptions and circumstances, the election
in the United States to itemize ones deductible expenses instead of taking the stand-
ard deduction to calculate ones taxable income can work as a screen that separates
taxpayers by the cost of complying with the election).
5 Ibid at 1820 (arguing that information about taxpayers compliance costs is relevant
for a number of tax policy reasons, including enforcement, tagging taxpayers to receive
benefits, and tailoring rate schedules).
6 In this paper, I take a law and economics approach to evaluating tax elections. This has
two key implications. First, I do not weigh in on distributive issues, except to observe
that the structure of an existing election may favour the sophisticated versus the unso-
phisticated, the wealthy versus the non-wealthy, the represented versus the self-
represented taxpayer in court, etc. I treat as fixed societys after-tax allocations of re-
sources and assume that these allocations are what society, or the political process,
TAXING BY DEFAULT 341
seeks to maximize the measurable benefits of a given tax election while
minimizing the elections measurable costs, such as transaction costs gen-
erally or complexity costs more specifically.7 Such an approach, while lim-
ited in that it focuses only on measurable benefits and costs, has the bene-
fit of allowing these to trade off against one another and be calculated on
a net basis, thus ensuring that fewer measurable resources in society will
be devoted to activities related to tax compliance, and instead resources
can be put to more productive uses.
My examination results in a straightforward prescription: policymak-
ers should adopt a presumption that an elections default treatment
should be aligned with the result that most taxpayers would prefer. This
presumption is consistent with the conclusions of tax scholars Heather
Field and Emily Cauble in the American context. However, I argue that
this presumption should not be ironclad: it can be overcome if structuring
the election as a penalty default allows the government to glean infor-
mation that can be used to improve the tax system, provided that such in-
formation cannot be obtained at lower cost by other means.
How might these default-setting principles be put into practice? To il-
lustrate how my prescription can be applied to the status quo, I explore
two provisions of the Act that contain tax elections: subsections 73(1) and
85(1). These allow a taxpayers transfer of appreciated property to a
spouse or to a corporation, respectively, to be treated not as a realization
deems to be right or fair. Second, taking this after-tax distribution of resources as
given, I investigate how Parliament and tax policymakers should structure tax elections
to minimize costs or maximize benefits, or both, for taxpayers and the government. I in-
clude in the definition of costs all opportunity costs to taxpayers and the government,
including any change in behaviour that results from the offering of the election, so long
as such costs (and benefits, on the other side) are measurable. However, I express no
opinion on the issue of whether tax elections should be used as a mechanism to achieve
greater redistribution, and assume that they should not, following previous literature
(see Louis Kaplow & Steven Shavell, Why the Legal System Is Less Efficient Than the
Income Tax in Redistributing Income (1994) 23:2 J Leg Stud 667; Louis Kaplow & Ste-
ven Shavell, Should Legal Rules Favor the Poor? Clarifying the Role of Legal Rules
and the Income Tax in Redistributing Income (2000) 29:2 J Leg Stud 821). Two argu-
ments support this assumption: First, tax election default rules are more akin to dam-
ages and liability rules than to tax rules that directly redistribute income by levying
taxes. Second, concerns about tax elections themselves being more progressive is a red
herring: most tax elections, because they increase complexity for taxpayers trying to
navigate the election, are regressive in the status quo and, others argue, fixing this bad
equity attribute should be policymakers priority. For an argument that most tax elec-
tions are unfair to less sophisticated taxpayers, and for recommendations for structur-
ing them, see Emily Cauble, Tax Elections: How To Live with Them If We Cant Live
Without Them (2013) 53:2 Santa Clara L Rev 421.
7 I define these transaction costs of complying to include opportunity costs incurred by
taxpayers, such as disutility caused by tax complexity, the value of their time, or fore-
gone income or leisure activities due to tax compliance obligations.
342 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
event that triggers tax on any gains in the property but, depending on the
choice of the taxpayer, as a rollover transaction in which tax is deferred
until the transferee disposes of the property.8 Despite their similar con-
texts, these two tax elections have opposite default treatments. Under
subsection 73(1), the taxpayer defaults into rollover treatment. In con-
trast, subsection 85(1) requires that a taxpayer seeking rollover treatment
affirmatively file an election.
Applying the default-setting prescription, I argue that subsections
85(1) and 73(1) should be structured consistentlywith rollover treat-
ment as the default. Evidence suggests that the majority of taxpayers who
interact with both provisions prefer rollover treatment. Moreover, for
those taxpayers who face high costs of compliance or who are unsophisti-
cated about taxes, filing an election may prove too costly or burdensome to
be workable. And there is little evidence that a rollover election could con-
vey information to the government in the screening sense; taxpayers may
have idiosyncratic reasons for wanting to obtain or depart from rollover
treatment, and their choices in this regard would not seem to support in-
ferences that would be useful to the tax authorities. As a result, setting
the default treatment of the subsection 85(1) election as a rollover so that
most taxpayers are not required to incur the costs of executing the elec-
tion is preferable to the status quo alternative on both efficiency and equi-
ty dimensions.
Thus, I recommend amending subsection 85(1) in the direction of con-
sistency with subsection 73(1) so that rollover treatment is the statutory
default.9 I am not the first to suggest this alignment: the original recom-
mendation for subsection 85(1) made by the Carter Commission during
Canadas landmark tax reform was to confer rollover treatment on contri-
butions of property to a corporation by default. For reasons that are not
8 A case could be made for including in this study the other rollover provisions in the Act,
including subsections 13(4) and 44(1), particularly for voluntary exchanges of property.
However, for brevity and focus, I concentrate solely on subsections 73(1) and 85(1). See
Canada Revenue Agency, Interpretation Bulletin IT-259R4, Income Tax Act Exchange
of Property (23 September 2003).
9 The default switch would not change the scope of subsection 85(1) at allit would apply
to all eligible property contributed in exchange for share consideration by a taxpayer to
a taxable Canadian corporation, as under current law. Similarly, my prescription would
also preserve the status quo flexibility offered to taxpayers to choose fair market value
realization or an intermediate elected amount. However, under my proposal in which
the default treatment of the election is rollover, such designations would be accom-
plished via something along the lines of an information reporting requirement. For a
detailed discussion of the flexible elected amount concept in relation to subsection
85(1), see Part I.C.1 and note 42, below. For a discussion of the default switch combined
with an information reporting requirement, see Part IV.B, below.
TAXING BY DEFAULT 343
apparent from the legislative history, the default was switched during the
bill-drafting process. It is not too late to rectify the error.
However, to preserve the contribution-specific disclosure that is cur-
rently provided to the government as part of the subsection 85(1) election
(which does not meet my definition of information but which is nonethe-
less very important for anti-avoidance purposes), I recommend an addi-
tional policy change to accompany a switch in subsection 85(1)s default
treatment: an information reporting requirement for corporations that re-
ceive contributions of property pursuant to subsection 85(1). Rather than
linking the rollover election with the governments need for disclosure
about properties contributed and consideration received in exchange, I
propose to bifurcate the election from the reporting functions of the status
quo by adopting an information reporting requirement that covers all con-
tributions of property to a corporation under subsection 85(1). Both the
rollover election and the governments anti-avoidance arsenal will be
stronger as a result.
This paper proceeds as follows. Part I offers a transaction cost
minimizing argument for setting tax elections default treatments in fa-
vour of the majority of taxpayers preferences. Part II examines the possi-
bility that the reverse approacha non-majoritarian penalty default
could yield valuable information for the government that might outweigh
the costs imposed by the penalty structure. Part III documents the diver-
gence between subsections 73(1) and 85(1) along the dimension of their
default treatments. Part IV uses the default-setting principles distilled in
Parts I and II to evaluate subsections 73(1) and 85(1), and presents an ar-
gument for amending subsection 85(1) to provide for a majoritarian de-
fault treatment in favour of rollover, alongside an information reporting
backstop to address concerns about tax avoidance. The last part con-
cludes.
I. The Transaction Cost Implications of Default Setting
The optimality and structure of tax elections is unexplored territory in
Canada. In the American context, Heather Field is the legal scholar who
has most directly addressed the general topic of elective tax provisions as
a statutory mechanism.10 In addition to Field, other scholars have exam-
10 See e.g. Field, supra note 3. A few other sources have considered the issues of when tax
treatment should be elective and how elections should be structured, but have not tried
to provide guidance on those points. These include a treatise by Michael B Lang and
Colleen A Khoury that was last updated in 1996, which laments the dearth of authori-
ty on elections while seeking to cast some light, albeit indirectly at times, on these
questions (Federal Tax Elections (Ringbound, 1996) at 1.01). Another is a lecture deliv-
ered by H David Rosenbloom, the Director of the International Tax Program at NYU
344 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
ined specific US income tax elections,11 the common law doctrine of elec-
tion,12 and issues relating to compliance with and revocation of elections,13
but this earlier literature does not ponder the mechanism of an election as
an element of design in the tax law, to use the title of one of Fields arti-
cles.14
Most recently, Emily Cauble has suggested that if we cannot get rid of
tax elections that generally disadvantage less sophisticated taxpayers,
then we should structure them to increase their fairnessand she pro-
vides an excellent analysis of how to think about fairness-increasing de-
faults. Here, I build most directly on Caubles translation of default rules
in the contractual setting to default rules in the tax elections setting, but
reach a somewhat different conclusion. Cauble, agreeing with Field, rec-
ommends aligning an elective provisions default treatment with the ex-
pectations of the majority of taxpayers.15 First, a majoritarian default im-
proves equity for those taxpayers who neglect the election or are not so-
phisticated enough to understand how to make the election: they are not
Law School, who spends only a fewalbeit helpfulpages on analyzing the merits of
elections as a tax policy instrument, concluding that, [f]rom multiple points of view,
elective provisions of the Code tend to operate at cross-purposes with the goals of the
income tax (Banes of an Income Tax: Legal Fictions, Elections, Hypothetical Determi-
nations, Related Party Debt (Ross Parsons Lecture delivered at the Supreme Court of
New South Wales, 28 August 2003), (2004) 26:1 Sydney L Rev 17 at 26).
11 See Field, supra note 3 at 23, n 10, citing Lori Farnan, A Mandatory Section 338: Can
It Be Implemented? (1990) 42:4 Fla L Rev 679; Heather M Field, Checking In on
Check-the-Box (2009) 42:2 Loy LA L Rev 451. See also Steven A Dean, Attractive
Complexity: Tax Deregulation, the Check-the-Box Election, and the Future of Tax Sim-
plification (2005) 34:2 Hofstra L Rev 405.
12 See Field, supra note 3 at 24, n 10, citing Steve R Johnson, The Taxpayers Duty of
Consistency (1991) 46:4 Tax L Rev 537 at 57780.
13 See Field, supra note 3 at 24, n 10, citing Lang & Khoury, supra note 10, ch 2; Victoria
A Levin, The Substantial Compliance Doctrine in Tax Law: Equity vs. Efficiency
(1993) 40 UCLA L Rev 1587; John MacArthur Maguire & Philip Zimet, Hobsons
Choice and Similar Practices in Federal Taxation (1935) 48 Harv L Rev 1281 at 1285
93; Edward Yorio, The Revocability of Federal Tax Elections (19751976) 44 Fordham
L Rev 463.
14 Field, supra note 3.
15 Field argues that, [w]hen considering these alternative approaches in the context of
tax elections, default rules that meet taxpayer expectations are generally preferable to
penalty default rules (ibid at 67). See Cauble, supra note 6 at 45979. Cauble analyzes
how various features of the context of a given tax election should affect how default
rules are set, arguing that tailored or untailored default rules may be appropriate de-
pending on whether the election is forward- or backward-looking and whether the in-
terests of jointly electing taxpayers are aligned. She concludes that generally, penalty
default rules ought to be avoided (ibid at 466).
TAXING BY DEFAULT 345
disadvantaged by their failure to act.16 Second, it reduces transaction
costs by minimizing the number of forms that need to be filed by taxpay-
ers and processed by the government.17 But, on the other hand, structur-
ing the election contrary to the expectations of most taxpayers, as a penal-
ty default, may have a different advantage: it may be appropriate where
the government needs particular information from a taxpayer before af-
fording the taxpayer certain favorable treatment,18 such as in the case of
a taxpayer who must provide information about a dependent to receive
the benefit of a dependency exemption. However, it remains unclear
whether or how this tagging function of tax electionsmatching eligible
taxpayers with targeted tax benefits19can or should defeat a presump-
tion in favour of a majoritarian default, or why tags need to be non-
majoritarian in the first place.20 My rubric as developed below seeks to re-
solve these issues. Where Cauble and Field prescribe that, in general, de-
16 Field argues that [b]y meeting expectations, the default rules enhance equity because
taxpayers who might fail to make an election because of their lack of knowledge, sophis-
tication, or ability to afford advice are likely to get their desired treatment anyway and
thus are less likely to be harmed as a result of their lack of knowledge (supra note 3 at
67). See also Cauble, who argues that
taxpayer-favorable default rules are beneficial in several ways. In particular,
they allow taxpayers to avoid the costs of filing elections, they allow the IRS
to avoid the costs of processing elections, and they mitigate the bias against
unsophisticated taxpayers. … [V]arious features that distinguish tax law
from contract law make penalty default rules less valuable in the context of
tax law (supra note 6 at 459).
17 See Field, supra note 3 at 6768:
[U]sing penalty default rules in tax elections would likely raise transaction
costs, given that significant numbers of taxpayers would not want the default
treatment and would thus have to elect out. Thus, transaction costs are gen-
erally reduced by choosing default rules that meet taxpayer expectations be-
cause fewer elections need to be filed, which makes the exercise of the tax
choice simpler for taxpayers and easier to administer for the Service ×..
See also Cauble, supra note 6 at 452.
18 Field, supra note 3 at 69.
19 See e.g. Ritva Immonen et al, Tagging and Taxing: The Optimal Use of Categorical and
Income Information in Designing Tax/Transfer Schemes (1998) 65 Economica 179. See
also N Gregory Mankiw & Matthew Weinzierl, The Optimal Taxation of Height: A
Case Study of Utilitarian Income Redistribution (Working Paper No 14976, National
Bureau of Economic Research, May 2009), online: NBER
chael Keen, Needs and Targeting (1992) 102 The Economic Journal 67 at 6779.
20 Nevertheless, absent a strong justification for the use of a penalty default, the tax law
should generally employ default rules that meet taxpayer expectations because expec-
tation-meeting default rules generally enhance the efficacy of an election while mini-
mizing the burden imposed by the election on taxpayers and the Service (Field, supra
note 3 at 69).
346 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
fault treatments should avoid being structured as penalties, I find that
such a general presumption can be overcome where there is a measurable
information benefit from a penalty default, and this measurable benefit
justifies the costs imposed by the non-majoritarian structure. Further, I
suggest that such measurable information benefits may be more likely to
occur in settings involving corporations, where the unfairness component
of the elective choice may be less pronounced.21
Leveraging the observation that tax elections generally increase com-
plexity, it is clear that their existence is associated with a range of trans-
action costs, both for the government and for taxpayers.22 For the gov-
ernment, implementing a tax election involves promulgating the neces-
sary forms and instructions, making taxpayers aware of the election, pro-
cessing taxpayers election decisions, providing guidance on revocability or
changes in elections, and, among other administrative costs, making sure
the elective treatment is applied consistently across the taxpayers other
tax positions.23 Like other types of transaction costs associated with taxa-
tion, these costs represent losses to society, and tax policymakers seek to
minimize them.24
Similarly, taxpayers bear transaction costs imposed by tax elections.
They can be broken down by sequence type. First, taxpayers must bear
the deliberation costs associated with deciding whether or not to make
an election. These costs may include gathering information about how the
election works, understanding the default treatment, and determining
whether or not the elective treatment will yield a better tax result than
the default. Tax elections are likely to impose deliberation costs on all
taxpayers to whom the election applies. By its nature, an election offers
not just some but all taxpayers in a given situation a choice of tax treat-
ment. The choice is offered by means of mass-distributed tax return forms
and instructions, taxpayer resources, and other government communica-
tions. All of these, of course, increase the governments costs but are de-
signed to make taxpayers aware of the election. Certainly, there will be
taxpayers who are not sensitive to available information about the explicit
election because they do not absorb or pay attention to such communica-
tions. But for the taxpayers who give sufficient attention to tax infor-
21 See Cauble, supra note 6.
22 See Field, supra note 3 at 2930.
23 See ibid ([t]his complexity [of explicit elections] is often mirrored by the administrative
burden placed on the IRS at 29).
24 See Leonard E Burman, The Labyrinth of Capital Gains Tax Policy: A Guide for the
Perplexed (Washington: Brookings Institution Press, 1999) at 3.
TAXING BY DEFAULT 347
mation to become aware that they are confronted with a choice, they are
likely to face positive deliberation costs.25
Second, if the result of the taxpayers deliberation is to proceed with
making the election, there are execution costs associated with actually
completing whatever forms are necessary to effect the election and file it
with the government. The ensuing discussion in Part III of the rigours of
properly filling out and filing the form for the subsection 85(1) rollover
election illustrates that these execution costs can be onerous. Like the
transaction costs borne by the government, deliberation and execution
costs drain taxpayers resources without providing anything of productive
value.
The transaction costs involved in deliberation about and execution of a
tax election also can distort the economic decisions of taxpayers.26 It is
tempting to jump to the conclusion that a given taxpayer will incur the
execution costs of making an election only if the sum of her execution
costs and the deliberation costs is, in the aggregate, less than the tax sav-
ings generated by the elective tax treatment (as compared to the default
treatment). However, this calculation ignores the concept of sunk costs: to
determine whether to proceed with making the election, the taxpayer
must first incur her deliberation costs, and those costs are sunk to gain
the information necessary to know the payoff from the election. Rather
than executing the election only if it is economically efficientthat is, if
her benefit from the elective treatment is greater than the sum of her
costs of electingthe taxpayer will make the choice of executing the elec-
tion on the margin. She will elect if the execution costs are less than the
benefit from the elective treatment as compared to the default treatment.
Thus, the choice to execute the election on the margin may be suboptimal
from an efficiency perspective, and can be seen as a welfare-reducing dis-
tortion of taxpayer behaviour.
In light of these transaction costs imposed by tax elections, it is clear
that the default treatment of a tax election matters. While there may be
some scope for the government to decrease taxpayers deliberation costs,
such as by providing information that will help taxpayers decide quickly
whether they should or should not make the election, minimizing execu-
25 This is in contrast to an analogous so-called implicit election or a workaround transac-
tion that provides the same tax treatment to the taxpayer as does a codified tax election
(see Field, supra note 3). Implicit elections entail other costs, but an advantage is that
their unofficial nature means that not all taxpayers may be aware of the ability to
make the choice, and thus may entail lower aggregate deliberation costs.
26 See Alan J Auerbach & James R Hines Jr, Taxation and Economic Efficiency (Work-
ing Paper No 8181, National Bureau of Economic Research, March 2001) at 1, online:
NBER
348 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
tion costs is an obvious way to make the election less costly. Assuming for
the moment that transaction cost minimization is the governments sole
objective, then the default treatment for the election should be set in a
majoritarian fashionthat is, so that the majority of taxpayers will not
desire to elect out of the default. As a result, only a minority of taxpayers
will need to incur execution costs, and transaction costs will be reduced.
In addition to the straightforward transaction cost story, there is an-
other reason why default-setting matters: well-documented behavioural
patterns that result in defaults being sticky. The literature demon-
strates that agents are often reluctant to opt out of a default despite it be-
ing advantageous for them to do so; people tend to stick with their current
situation, even when faced with a choice.27 This has been dubbed the sta-
tus quo bias, and can amplify the stakes of setting the right default
rules.28
II. Setting Defaults to Reveal Information
This Part considers the possibility that minimizing transaction costs
may not be the sole dimension along which to evaluate how to set the de-
fault treatment of a tax election. There is considerable literature on de-
fault rules in the contexts of contract law, commercial transactions, and
corporate law. Much of it arises in relation to how courts should fill the
gaps where contracts are left incomplete by the parties but need to be in-
terpreted to resolve disputes. Some scholars advocate that courts should
exercise this gap-filling function by interpreting the contract in a majori-
tarian fashionthat is, filling gaps with the terms that the majority of
parties would have wanted had they considered the issue ex ante. Where
the source of contractual incompleteness is the transaction cost of negoti-
ating the full range of possible contingencies in a contract, then majoritar-
ianism has obvious appealthe default rule can be set such that most
parties do not have to expend the costs of contracting around it.
27 See Alex Raskolnikov, Revealing Choices: Using Taxpayer Choice to Target Tax En-
forcement (2009) 109:4 Colum L Rev 689 at 75152, citing Brigitte C Madrian & Den-
nis F Shea, The Power of Suggestion: Inertia in 401(k) Participation and Savings Be-
havior (2001) 116:4 Quarterly Journal of Economics 1149 at 1150. See generally Rich-
ard H Thaler & Cass R Sunstein, Nudge: Improving Decisions About Health, Wealth,
and Happiness (New Haven: Yale University Press, 2008).
28 Sunstein and Thaler sum up the striking evidence on default choices:
[I]f, for a given choice, there is a default option[,] … then we can expect a
large number of people to end up with that option, whether or not it is good
for them. And as we have also stressed, these behavioral tendencies toward
doing nothing will be reinforced if the default option comes with some implic-
it or explicit suggestion that it represents the normal or even the recom-
mended course of action (ibid at 83).
TAXING BY DEFAULT 349
But other commentators have criticized this approach, arguing that
majoritarianism oversimplifies the calculation. Ian Ayres and Robert
Gertner show that choices in the law can operate to induce individuals to
self-select along different dimensions or characteristics.29 In particular,
there are
[t]wo related mechanisms for inducing actors to reveal private in-
formation [that] are well understood. One solution is to impose a pu-
nitive default and allow individuals to elect out of it in a way that
produces information about them. Another approach is to force ac-
tors to choose from a menu of options structured in such a way that
an actors choice discloses salient information about his preferences.
In either case, agents are compelled to choose a course of action and
their choices produce information sought by the principal. Agents
choices are revealing.30
However, the idea that punitive defaults can induce actors to self-
select has only fairly recently gained traction in the tax context.31 Recent
work by Benjamin Alarie argues that the government routinely acts as a
second-degree price discriminator 32 by harnessing self-selection among
taxpayers in the context of anti-avoidance enforcement efforts.33 And Alex
Raskolnikov has proposed a dual enforcement system in which taxpay-
ers are forced to choose between two regimes, with the objective of allow-
ing the government to better target tax enforcement to taxpayers diverse
motivations for paying or not paying taxes.34
29 Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules (1989)
99:1 Yale LJ 87.
30 Raskolnikov, supra note 27 at 710.
31 See ibid at 71015. Raskolnikov applies the penalty default notion to tax enforcement:
offering a choice of enforcement schedules in lieu of the current one-size-fits-all ap-
proach … is likely to produce welfare improvements by inducing taxpayers to reveal
their types before they know their precise tax situations in a given year and before they
decide what specific reporting positions to take (ibid at 713).
32 Second-degree price discrimination occurs where a producer with market power lacks
information about the preferences of individual consumers but has information about
the distribution of preferences across consumers in the population (Benjamin Alarie,
Price Discrimination in Income Taxation (2011) at 1920 [unpublished working paper,
archived online at
33 Alarie argues that
the income tax can leave open self-selection among taxpayers into various
types of tax avoidance. The tax avoidance contemplated by a second-degree
price discriminating government at this point could be explicitly approved
(i.e., tax expenditures) or it could merely be condoned temporarily and tacit-
ly. In either event, the idea would be to allow taxpayers to further refine
their tax liabilities according to their own responsiveness to taxation (ibid at
22).
34 Raskolnikov, supra note 27 at 693.
350 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
In other work, I argue that elections can act as screens to separate
taxpayers according to their costs of complying with the election.35 Here,
Raskolnikovs dual enforcement system concept is relevant because it il-
lustrates how explicit elective provisions in the tax law can cause taxpay-
ers to separate themselves along characteristics that are unobservable but
valuable for effective tax administration. Indeed, most of the inefficiencies
inherent in the tax system would disappear if the government possessed
perfect information about taxpayers characteristics and preferences: first-
best lump sum taxation would be possible, enforcement techniques could
be finely tailored, outreach could be targeted to increase salience, and
other tax miracles could be performed. Raskolnikov proposes maintaining
our current deterrence regime with high statutory fines and well-
publicized punishments alongside a newly developed compliance regime
with lower statutory fines, an emphasis on taxpayer service, and stand-
ards of review that increase the probability of conviction.36 Under his pro-
posal, taxpayers would choose one of two options from a menu of regimes,
such that gamers predominantly would find it advantageous to choose
deterrence and non-gamers compliance. To the extent that taxpayers
choices allow the government to separate gamers from the rest of the tax-
payer population, tax enforcement efforts could be more efficiently target-
ed to take into account taxpayers diverse motivations, achieving higher
compliance at lower social cost. Raskolnikovs proposal relies on a menu of
choices being presented to taxpayers, but its principle can be extended to
the use of a non-majoritarian default that acts as a penalty for most
taxpayers. The penalty would force them to reveal their enforcement pref-
erences by electing out of the default regime.37
These two sets of rationales for setting elective tax provisions default
treatments point in opposite directionsa majoritarian default can mini-
mize transaction costs but a non-majoritarian default can reveal valuable
taxpayer information to the government. Each rationale can reduce the
costs involved in having an income tax. In order to determine which con-
sideration dominates, policymakers will need to ask questions such as:
How onerous are the transaction costs imposed on taxpayers by the need
to execute the election? And what, if any, role would be played by the in-
formation revealed by a non-majoritarian penalty default?
35 See Satterthwaite, supra note 4.
36 Raskolnikov, supra note 27 at 71339.
37 See the detailed discussion in Raskolnikov about setting the default treatment for those
taxpayers who fail to affirmatively select from the menu of two enforcement options
(ibid at 75052). Raskolnikov argues that the correct default treatment is not obvious,
except for non-filers who should be defaulted into the deterrence regime, because the
default would apply only to those taxpayers who have revealed themselves as unwilling
or unable to make the affirmative menu choice.
TAXING BY DEFAULT 351
While it is hard to avoid the fuzzy conclusion that the facts and cir-
cumstances of the particular election will determine policymakers balanc-
ing between the two rationales, it bears noting that the two intersect in
an important way. Where the government seeks to gain information
through its choice of a penalty default, the execution costs associated with
the election may blunt any information-forcing function that the election
might possess, in the following way: Taxpayers make the choice to elect
out of the default treatment on the margin. Therefore, if the tax benefits
from electing out are swamped by the execution costs of the election (e.g.,
a complicated form or onerous rules for filing), taxpayers will choose ra-
tionally to simply stick with the default. The sticky default behavioural
bias will exacerbate this problem. In the case of a penalty default with
high execution costs, only a small subset of taxpayers who would other-
wise choose to elect out of the penalty will find it worthwhile to do so. As a
result, where execution costs are high, the presumption in favour of a ma-
joritarian default becomes stronger as the burden on the government of
showing how the penalty default will reveal information about the specific
electing-out cohort of taxpayers becomes heavier.
III. The Opposite Defaults of the Subsection 73(1) and 85(1) Elections
In exploring why there is a divergence in the default treatments pre-
scribed under the subsection 73(1) and 85(1) elections, it makes sense to
first take a brief tour of the mechanics and legislative histories of each
subsection. The following Part shows that, notwithstanding the technical
differences in the applications of rollover treatment between the two sub-
sections, their underlying policy motivations are the same and thus are
unlikely to explain the divergence in default treatments.
A. Why Offer a Rollover in the First Place?
Subsections 85(1) and 73(1) are associated with the most significant
tax reform in Canadas history.38 The Royal Commission on Taxation, or
the Carter Commission (after its chair, Kenneth Carter), was appointed in
1962 and cast particularly intense scrutiny upon the base on which the
income tax was assessed. Under the 1952 Act and its predecessors, capital
gainsincreases in the value of capital property as distinguished from the
38 The reform effort undertaken by the Carter Commission utilized evidence taken and
testimony heard from over 700 people as well as 300 briefs submitted by interested in-
dividuals or representatives of … organizations. In 1967, it produced a six-volume re-
port containing nearly 2,700 pages that recommended sweeping changes to the struc-
ture of the Canadian income tax system (see Recommendations of The Royal Commis-
sion on Taxation (Don Mills, ON: CCH Canadian Limited, 1967) at iii [Recommenda-
tions]).
352 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
income streams generated by such propertywere not considered part of
taxable income at all.39 The Carter Commission recommended including
capital gains in the income tax base due to considerations of fairness, effi-
ciency, and progressivity.40 The subsequent adoption of legislation embod-
ying this policy shift is the Commissions most important legacy.
Despite the compelling justifications for broadening the income tax
base to include capital gains, the new policy raised thorny questions about
the timing of taxable events. The Carter Commission accepted the need
for a tax system that was rooted in the realization principlethe rule
that tax should only be imposed upon a specified triggering event. Typi-
cally, a realization event would generate liquidity with which to pay the
resulting tax liability, such as a sale of a capital asset for cash. However,
to minimize the opportunities for taxpayers to avoid realization events
and as a second-best approximation of an ideal accrual-based income tax,
the Commission recommended that the term disposition should be used
in the broadest sense.41 Indeed, the statute as adopted and as it stands
today reflects this breadth, covering almost every transfer so long as the
transaction results in a change of beneficial ownership of the property
(but even this is not required for some dispositions relating to trusts).42
39 1952 Act, supra note 2. See also EJ Benson, Proposals for Tax Reform (Ottawa: Queens
Printer, 1969) at ch 3 [White Paper].
40 Recommendations, supra note 38.
41 Report of the Royal Commission on Taxation, vol 3 (Ottawa: Queens Printer, 1966) at
368 [Carter Commission Report vol 3].
42 See subsection 248(1). The core definition of disposition is (a) any transaction or
event entitling a taxpayer to proceeds of disposition of the property, but also includes
the much broader category of
(b) any transaction or event by which,
(i) where the property is a share, bond, debenture, note, certificate, mort-
gage, hypothecary claim, agreement of sale or similar property, or inter-
est, or for civil law a right, in it, the property is in whole or in part re-
deemed, acquired or cancelled,
(ii) where the property is a debt or any other right to receive an amount,
the debt or other right is settled or cancelled,
(iii) where the property is a share, the share is converted because of an
amalgamation or merger,
(iv) where the property is an option to acquire or dispose of property, the
option expires, and
(v) a trust, that can reasonably be considered to act as agent for all the
beneficiaries under the trust with respect to all dealings with all of the
trusts property (unless the trust is described in any of paragraphs (a) to
(e.1) of the definition trust in subsection 108(1)), ceases to act as agent
for a beneficiary under the trust with respect to any dealing with any of
the trusts property.
TAXING BY DEFAULT 353
Events that are not transfers may nevertheless constitute dispositions for
purposes of the Act; neither does the taxpayer need to actually receive the
proceeds of the disposition for a disposition to have occurred. For instance,
when a debt or share is redeemed, cancelled, or converted, or an option
expires, a disposition has occurred and taxwhether or not an individual
has the cash to pay itmay be due.43
As a result of the new tax policy relating to capital gains, taxpayers
faced incentives to avoid tax-triggering transfers of capital property.
Commentators have called this the lock-in effect.44 Particularly in cases
where the person or entity holding legal title to the property changes but
the beneficial ownership remains within a single economic unit (such as
corporate stakeholders or members of a household), policymakers were
concerned that taxing capital gains on disposition might distort taxpayers
asset allocation behaviour and, in turn, damage Canadas economic com-
petitiveness. Tax-deferred rollover treatment for property transferred to a
spouse or contributed to a corporation can be seen as a departure from the
strict application of the realization principle designed to address concerns
about the lock-in effect, as shown in the subsection-specific discussions
that follow.45
B. The Subsection 73(1) Rollover
1. Mechanics
If subsection 73(1) did not exist, a transfer of appreciated property
from one spouse to another generally would result in a tax liability for the
transferor, and the transferee spouse would take the property with a cost
43 Ibid.
44 See Rick Krever & Neil Brooks, A Capital Gains Tax for New Zealand (Wellington: Vic-
toria University Press, 1990). Krever and Brooks argue that
capital gains create special problems for a tax system that arbitrarily at-
tempts to measure ability to pay and impose a tax liability annually. Juris-
dictions that tax capital gains have invariably attempted to avoid the per-
ceived problems that would be created by taxing accrued gains annually by
taxing capital gains annually only when they are realised. However, this in
turn gives rise to a lock-in problem (ibid at 1.2).
See also Burman, supra note 24 at 3.
45 See Vern Krishna, The Fundamentals of Canadian Income Tax, 9th ed (Toronto: Car-
swell, 2006) ([t]he rationale for permitting a taxpayer to rollover assets is that it is un-
desirable, and perhaps unfair, to impose a tax on transactions that do not involve a
fundamental economic change in ownership, even though there may be a change in
form or legal structure at 1112).
354 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
base equal to fair market value.46 Subsection 69(1) articulates the general
rule for non-arms-length transfers of property, such as those between
spouses: they are treated as taking place at fair market value, regardless
of the actual consideration given in exchange for the property.47 This
deeming rule is designed to prevent manipulation of asset transfer prices
between parties who are not dealing with each other on an economic
arms length basis.48 Subsection 69(1) further prescribes that any result-
ing capital gain, or any allowable capital loss not limited by the stop-loss
rules,49 is recognized by the transferor.50
To avoid this result, subsection 73(1) provides a deeming rule that
carves out qualified transfers of property between spouses from the reach
of subsection 69(1). It deems a qualified transfer as occurring, generally,
at proceeds equal to … the adjusted cost base to the [transferor] individu-
46 Note that different rules apply if the property is gifted. See subsection 69(1)(b) (rules for
transferred cost base may be disturbed by payment of consideration less than fair mar-
ket value for the gift). See Michael FT Addison & Gil J Korn, Interspousal Transfers:
The Things They Dont Tell You at the Diamond Shop (2002) 50:2 Can Tax J 728 at
73031. Addison and Korn generally focus on implications of transferring property to a
trust of which a spouse is a contingent income or capital beneficiary, but note that ab-
sent any relieving provisions in the Act, transfers of property that result in a disposition
by a taxpayer are taxable, and the tax cost of a disposition may therefore be a deterrent
to a property transfer to a spouse (ibid at 731).
47 Generally, subsection 69(1) deems all non-arms-length transfers of property as having
taken place at the fair market value of the property at the time of transfer. This section
exists to prevent tax attributes, such as losses, from being artificially created and used
to offset tax liability.
48 Krishna, supra note 45 at 1113.
49 See subparagraphs 40(2)(g)(i) and (ii) (in particular, a taxpayers loss from the disposi-
tion of a property, to the extent that it is a superficial loss, a loss from some types of
debt, or losses from other types of specified property, is deemed to be nil). A superficial
loss under section 54 occurs when property is transferred by an individual to a person
who is affiliated with the transferor for purposes of the Act, where the transferred
property (or property substitute) is owned by the transferor or an affiliated person thir-
ty days before or after the disposition. See also KA Siobhan Monaghan et al, Taxation of
Corporate Reorganizations (Toronto: Carswell, 2010) at 4849.
50 See paragraph 69(1)(b):
[W]here a taxpayer has disposed of anything
(i) to a person with whom the taxpayer was not dealing at arms length for
no proceeds or for proceeds less than the fair market value thereof at the
time the taxpayer so disposed of it,
(ii) to any person by way of gift inter vivos, or
(iii) to a trust because of a disposition of a property that does not result in
a change in the beneficial ownership of the property;
the taxpayer shall be deemed to have received proceeds of disposition there-
fore equal to that fair market value.
TAXING BY DEFAULT 355
al of the particular property immediately before [the time of the trans-
fer].51 By treating the proceeds of disposition as equal to the transferors
adjusted cost base, the transferor realizes no taxable capital gains as a re-
sult of the transfer.52 The transferee inherits the adjusted cost base from
the transferor, and tax is deferred until the property is disposed by the
transferee in another transaction.53 In addition, sections 74.1 and 74.2
generally operate in concert with subsection 73(1) to attribute any income
or losses from the transferred property (or substitute property) back to the
transferor, rather than attributing them to the transferee spouse. These
attribution rules also apply to any taxable capital gains or allowable capi-
tal losses generated by the transferred property.54
Rollover treatment for qualifying spousal transfers of property, there-
fore, is the statutory default: subsection 73(1) mandates rollover treat-
ment unless the individual elects in the individuals return of income un-
der this Part for the taxation year in which the property was transferred
51 Subsection 73(1) and paragraph 73(1)(a). Note that where the capital property is depre-
ciable property of a prescribed class, subparagraph 73(1)(a)(i) provides for the appor-
tionment of the undepreciated capital cost to approximate rollover treatment, thus re-
quiring that the spouse, common-law partner, or trust be liable for the recaptured de-
preciation on a subsequent disposition of the property. See David G Duff et al, Canadi-
an Income Tax Law, 3d ed (Markham: LexisNexis, 2009) at 110608.
52 See generally Addison & Korn, supra note 46.
53 Paragraph 73(1)(b) ([the particular property is deemed] to have been acquired at that
time by the transferee for an amount equal to those proceeds).
54 These attribution rules have independent, and broader, application to spousal transfers
of property other than those covered by subsection 73(1). For instance, if an individual
transfers property to a trust, the income of which is to be distributed for the benefit of
the individuals spouse and a third party, the transfer would not meet the definition of a
qualifying transfer under subsection 73(1.01), because only some combination of the
individual and her spouse or common-law partner can receive or otherwise obtain use of
the income or capital of the trust. Nonetheless, unless fair market value consideration
was received pursuant to section 74.5, the transfer would trigger the attribution rule of
section 74.1. Thus, while it is possible that a spousal property transfer would fail to
qualify for rollover treatment at the same time that the propertys income, losses, or
gains would nonetheless be ensnared by the attribution rules of section 74.1, generally
the two provisions operate together. This lack of symmetry results, in part, from the
more general operation of the attribution rules of sections 74.1 to 74.5 as anti-avoidance
mechanisms to curtail income splitting among spouses subject to different marginal
tax rates (see subsections 74.1(1) and 74.1(2)). Note further that section 74.1 (and 74.2,
which has similar language) apply only to attribute income, losses, and gains that re-
late to the period in the year throughout which the individual [transferor] is resident
in Canada and [the transferee] is the individuals spouse or common-law partner. See
also Hilary E Laidlaw & Sandra Mah, Trust After Marriage: Using a Trust to Satisfy
Support Obligations (2010) 58:1 Can Tax J 145 at 148 (discussing the implications of
the more restricted rules for transferring property to a trust in the context of separating
spousesbecause the rollover applies only to a trust created for a current spouse or
common-law partner, the transfer must occur before the couple divorces).
356 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
that the provisions of this subsection not apply.55 In the event that the
transferor spouse makes the election, the transfer is treated as a disposi-
tion of property at fair market value pursuant to the deeming rule of sub-
section 69(1). Furthermore, subsection 74.5(1) provides that, where the
transferor files an election under subsection 73(1) and the fair market
value of the transferred property did not exceed the consideration given in
exchange for it at the time of transfer, the attribution rules of sections
74.1 and 74.2 are suspended.56 Thus, rollover treatment accompanied by
the spousal attribution rules is the clear default, and electing out of the
default treatment deems the transfer to have taken place at fair market
value consideration for the transferred property, even if the consideration
was less than fair market value. If the taxpayer does not elect out of the
default, the income, gain, and loss attribution rules will continue to ap-
ply.57
According to Interpretation Bulletin IT-325R2, the mechanics of mak-
ing the election are trivial: There is no official form for the election not to
have the subsection 73(1) rollover apply. This election is normally made
by the transferor simply reporting the full tax consequences of the dispo-
sition on his or her Income Tax Return for the year of the transfer.58
55 Subsection 73(1).
56 Paragraph 74.5(1)(c) states that
subsections 74.1(1) and (2) and section 74.2 do not apply to any income, gain
or loss derived in a particular taxation year from transferred property or
from property substituted therefor if
(c) where the property was transferred to or for the benefit of the transfer-
ors spouse or common-law partner, the transferor elected in the transfer-
ors return of income under this Part for the taxation year in which the
property was transferred not to have the provisions of subsection 73(1) ap-
ply.
Paragraph 74.5(1)(a) adds that sections 74.1(1) and (2) and 74.2 will not apply if at the
time of the transfer the fair market value of the transferred property did not exceed the
fair market value of the property received by the transferor as consideration for the
transferred property. See also Canada Revenue Agency, Interpretation Bulletin IT-
511R, Interspousal and Certain Other Transfers and Loans of Property (21 February
1994), s 21(c) (the attribution rules are suspended if the transferor elects not to have
the provisions of subsection 73(1) apply (i.e., any gain or loss is realized at the time of
transfer)).
57 Note that, in addition to the requirements under paragraphs 74.5(1)(a) and (c), where
consideration received for the transferred property by the transferor includes indebted-
ness, other fair market value requirements (for interest payments) need to be met in
order to suspend the attribution rules (see subsection 74.5(1)(b)).
58 Canada Revenue Agency, Interpretation Bulletin IT-325R2, Property Transfers After
Separation, Divorce and Annulment (7 January 1994) (also noting that if the trans-
feror and the recipient remain spouses, a capital loss realized on such a disposition of
However, additional rules, such as whether the election can be revoked
via an adjustment to the transferors income tax return, are not readily
available.
TAXING BY DEFAULT 357
2. Statutory History
As Justice Bowman stated in Lipson v. Canada, [s]ubsection 73(1)
has as its purpose the facilitation of inter-spousal transfers of property
without immediate tax consequences.59 And Neil Brooks has character-
ized the purpose of the rollover provision as reflecting the economic reality
of shared property within a family: Within marital units it is often diffi-
cult to determine the beneficial ownership of property. … Providing a roll-
over for interspousal transfers eliminates what would be a serious tracing
problem.60 Both interpretations are consistent with the larger rationale
of avoiding capital property lock-in, particularly because the individual
and not the familyremains the unit of taxation in Canada, despite the
Carter Commissions recommendation to the contrary.61
property may be disallowed as a superficial loss pursuant to paragraph 54(i) and sub-
paragraph 40(2)(g)(i) at para 6).
59 2006 TCC 148 at para 21, [2006] 60 DTC 2687.
60 The Irrelevance of Conjugal Relationships in John G Head & Richard Krever, eds,
Tax Units and the Tax Rate Scale (Victoria: Australian Tax Research Foundation, 1996)
35 at 76.
61 The Carter Commission advocated adopting the family as the unit of taxation in Cana-
da, rather than the individual (Carter Commission Report vol 3, supra note 41 at 125).
For example,
[t]he most serious consequence of the failure to accept the family as a taxa-
ble unit arises when wealth is transferred from one spouse to another.
Although in most families wealth accumulated by a couple is the result of
their joint efforts and decisions, the passing of property from one spouse to
another is a taxable event. Exemptions provide some relief, but we believe
that the taxation of these intra-family transfers is wrong in principle (Rec-
ommendations, supra note 38 at 13).
Another argument made by the Commission in favour of the use of the family as the tax
unit is that it would have allowed [t]he rules against income splitting … [to] be with-
drawn because splitting would have no significance (ibid at 13). The 1952 Act con-
tained spousal income attribution provisions very similar to those of section 74.1, except
that gains or losses from dispositions of property were not yet contemplated as being
taxable (supra note 2, s 21(1)). For better or worse, the Commissions position on the
family tax unit did not carry the day, and the 1972 tax reform bill continued the tradi-
tion of the individual as the unit of taxation in Canada. Perhaps because parts of the
Commissions argument concerning the shortcomings of the individual tax unit were
sufficiently compelling, the 1972 legislation included the subsection 73(1) deeming rule
to allow rollover treatment for spousal property transfers. However, Parliament did not
adopt analogous anti-abuse provisions to those advocated by the Commission that
358 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
The subsection 73(1) rollover provision was included as part of the
1972 tax reform bill, but it did not contain an election. Instead, rollover
treatment for spousal transfers of property was mandatory. Only begin-
ning in 1979 was the transferor spouse offered an election to avoid the
application of subsection 73(1)s rollover treatment.
It is not clear from the legislative or judicial history why the election
was added, although one may speculate that it may have been to avoid
complications where property was being transferred in the context of mar-
ital breakdown. For instance, when spouses are in the process of separat-
ing, a transfer of property absent the election would saddle the transferee
spouse with future taxes on any built-in gain associated with the proper-
ty, as well as the income from the property once the section 74.1 and 74.2
attribution rules ceased to apply. Unless the couple was savvy enough to
negotiate an intermediate transfer at arms length to a third party to ob-
tain a cost base of fair market value, default rollover treatment could
cause complications in splitting up property or, at worst, cause an unwit-
ting transferee spouse to face an unexpected tax liability after the dissolu-
tion of the marriage became final. Alternatively, the adoption of the elec-
tion may have had, at the time, an expressive equity rationale. Allowing
spouses to choose to treat a transfer within the couple as a real transac-
tion that occurred at arms length may have conveyed respect for the idea
that spouses could be treated as economic equals, reflecting changing atti-
tudes toward gender and family.
C. The Subsection 85(1) Rollover
1. Mechanics
Like subsection 73(1), subsection 85(1) operates as an exception to the
subsection 69(1) deeming rules and applies to contributions of property to
a corporation under certain conditions.62 If these conditions are met, the
would have denied rollover treatment for property transfers in marriages that were
childless or lasting less than five years.
62 First, the corporation to which the taxpayer is transferring property must be a taxable
Canadian corporation as defined in section 89(1). There are three main requirements
for being a taxable Canadian corporation under subsection 89(1): the corporation must
be resident in Canada; either be incorporated in Canada or have been a resident of
Canada continuously since 18 June 1971; and not be exempt from tax under Part I of
the Act. Second, the property transferred must constitute eligible property as defined
in section 85(1.1), although commentators note that most property will constitute eli-
gible property for purposes of section 85(1), with the exception of certain rights, real
property inventory and, subject to certain limited exceptions, real property owned by a
non-resident (Monaghan et al, supra note 49 at 92). Third, the consideration received
TAXING BY DEFAULT 359
taxpayer and the transferee corporation may file a joint election63 specify-
ing an elected amount that is deemed to constitute, generally, three
things: the taxpayers proceeds of disposition,64 the taxpayers cost of the
consideration received from the corporation,65 and the corporations cost in
the transferred property.66
Paragraphs 85(1)(b), (c), (c.1), (d), and (e.1) contain the basic deeming
rules67 that operate to constrain the value that the taxpayer and the cor-
poration may jointly elect within a certain rangethat is, they designate
upper and lower bounds on the elected amount.68 This structural feature
by the taxpayer must include shares of the capital stock of the transferee corporation
(see subsection 85(1)).
63 Ibid.
64 See paragraph 85(1)(a).
65 See paragraphs 85(1)(f), (g), and (h) (apportioning a taxpayers cost among boot, pre-
ferred shares, and common shares, respectively).
66 See paragraph 85(1)(a).
67 Beyond the basic deeming rules, note that there are specific deeming rules for certain
kinds of property, including inventory and non-depreciable capital property, inventory
used in a farming business following the cash method of accounting, eligible capital
property (which can trigger issues relating to the earned goodwill of a business), depre-
ciable property of a prescribed class, and luxury passenger vehicles, among others (see
paragraphs 85(1)(c.1), (c.2), (d), (d.1), (e), (e.1), and (e.4)).
68 For the upper bound on the subsection 85(1) elected amount, the amount cannot be
greater than the fair market value of the transferred property (see paragraph 85(1)(c)).
For the basic lower bound, paragraph 85(1)(b) provides that if the elected amount is less
than the fair market value of the non-share consideration transferred to the taxpayer in
exchange for the property the taxpayer contributed to the corporation (such non-share
consideration, including most liabilities of the taxpayer that are assumed by the corpo-
ration, is commonly called boot), the elected amount will be deemed to be the fair
market value of the boot. This paragraph 85(1)(b) basic lower bound is designed to pre-
vent the taxpayer from deferring tax when continuity of interest in the underlying in-
vestment is lacking or entirely absent. In addition, there are further lower limits on the
lower bound: paragraph 85(c.1) applies specifically to inventory property, capital prop-
erty other than depreciable property of a prescribed class, and other specific types of
property, stating that where the elected value is less than the lesser of (i) the fair mar-
ket value of the property at the time of the disposition and (ii) the cost amount to the
taxpayer of the property at the time of the disposition, the elected amount will be
deemed to be the lesser of (i) and (ii). Paragraphs 85(1)(d) and (e) have roughly analo-
gous rules for eligible capital property in respect of a business of the taxpayer and for
depreciable property of a prescribed class, respectively. Where these further lower
bound provisions conflict with the basic lower bound provision in paragraph 85(1)(b)
(that is, where the deemed amount under paragraphs (c.1), (d), or (e) would not be equal
to the deemed amount in paragraph (b)), the elected amount is deemed to be the greater
of the deemed amounts (see paragraph 85(1)(e.3)). Finally, where the lower and upper
bound provisions conflict with one anotherthat is, where the lower bound deemed
amount under (b) (subject to the further lower limits in (c.1), (d), and (e)) is less than the
fair market value of the boot, the upper bound prevails: the elected amount is set at the
fair market value of the transferred property, and the excess value received by the tax-
360 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
distinguishes it from subsection 73(1): for spousal transfers, the election
provides a binary optioneither rollover treatment or disposition at fair
market value. By contrast, subsection 85(1) can be seen as offering a
menu of elective treatments because taxpayers can jointly elect any
amount between the applicable upper and lower bounds.
The admittedly complicated upper and lower bound rules on the elect-
ed amount have two key implications: First, a taxpayer who transfers
property that has an accrued loss to a corporation must realize that loss
upon transfer.69 The discernible policy rationale behind this outcome is to
prevent corporations from importing losses from their contributing share-
holders; this outcome represents an important difference as compared to
straight nonrecognition treatment. Second, in the event that the upper
and lower bound provisions conflict and the taxpayer receives a subsec-
tion 15(1) benefit that is included in taxable income, the amount of the
benefit will increase the taxpayers cost in the consideration received from
the corporation pursuant to subsection 52(1).70
Unlike filing an election under subsection 73(1), which can be done on
the transferors annual tax return, the rules for making a valid election or
a valid series of elections under section 85(1) are far more complicated.
Form T2057 is required to make the subsection 85(1) election;71 on this
form a box dubiously labeled informative notes reminds taxpayers that
[t]he rules for section 85 elections are complex. … If this form is incom-
plete, the Canada Revenue Agency may consider the election invalid, and
subsequent submissions may be subject to a late-filing penalty.72 Com-
payer may trigger tax as a section 15(1) benefit. See paragraph 85(1)(b) (subject to par-
agraph (c) …) and subsection 85(1)(c); subsection 15(1); Monaghan et al, supra note 49
([n]o benefit should arise, however, in respect of common shares issued by a wholly
owned corporation, on the basis that the fair market value of all the common shares
owned by the taxpayer immediately after the transfer cannot exceed the fair market
value of the property transferred to the corporation at 111 ×.).
69 See the numerical example in ibid at 101.
70 [A]n amount [so included] shall be added in computing the cost at any time to a tax-
payer of a property if … (b) the amount was … otherwise added to the cost, or included
in computing the adjusted cost base, to the taxpayer of the property (subsection 52(1)).
71 There are analogous rules, under subsection 85(2), that apply to the contribution of
property by a partnership to a corporation in exchange for shares. Under those circum-
stances, the joint election is made using Form T2058 (Canada Revenue Agency, Form
T2058, Election on Disposition of Property by a Partnership to a Taxable Canadian
Corporation, online: CRA
paper, I assume that a partnership is not the transferor of the property.
72 Canada Revenue Agency, Form T2057, Election on Disposition of Property by a Tax-
payer to a Taxable Canadian Corporation at 2, online: CRA
[Form T2057]. This form is analogous to Form T2058 (supra note 71 at 2), which applies
in the event that the transferor is a partnership.
TAXING BY DEFAULT 361
mentators emphasize that the election is not for the faint of heart,73 and
that the slightest deviation from the technical rules of the section can in-
validate the rollover and trigger a deemed disposition at fair market val-
ue.74
Two particular aspects of the subsection 85(1) election increase its
complexity. First, the election must be made jointly by the transferor tax-
payer and the transferee corporation.75 Under subsection 85(6), the elec-
tion must be made 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 re-
turn of income pursuant to section 150 for the taxation year in which the
transaction to which the election relates occurred.76 Given the potential
difficulties involved in making sure that the parties communicate about
their tax return due dates and finalize the rollover form in advance of its
due date, it is not surprising that there are remedial provisions for late fil-
ings: a subsection 85(1) election can be filed up to three years after the
original deadline under subsection 85(6).77 However, there is a penalty.78
73 See Darcy D Moch & Stanley R Ebel, Basics of Corporate Reorganizations: Sections 51,
85, 85.1 and 86 in 2002 Prairie Provinces Tax Conference (Toronto: Canadian Tax
Foundation, 2002) 10:1, online: Canadian Tax Foundation
portant to appreciate that [the non-automatic feature of section 85(1)] … can create an
administrative inconvenience for the transferee corporation in terms of reviewing, pre-
paring, and/or filing elections, particularly in the case of large public takeovers where
the provisions of section 85 are relied upon at 10:23).
74 Krishna, supra note 45 at 1114.
75 The term jointly elected itself raises questions in the context of subsection 85(1). Joint
elections are defined elsewhere in the Act with reference to particular sections, but
there is no definition in the Act that is applicable to section 85. It is easy to imagine how
difficulties in orchestrating such agreement and execution could arise, particularly in
the case where the corporation must coordinate with many transferors to ensure that
all elections are properly filed and reflect the corporations best interests. However, in
situations with large numbers of exchanging transferors, typically the transaction may
be structured such that other sections of the Act, such as section 85.1, will apply.
76 Subsection 85(6). This requirement is clarified in the instructions accompanying Form
T2057 (supra note 72 at 1), which state that the requisite number of copies of the form
must be filed on or before the earliest date on which any one of the parties to the elec-
tion is required to file an income tax return for the tax year in which the transaction oc-
curred, taking into consideration any election [to change the due date for a tax return].
77 See subsection 85(7).
78 The penalty is, generally, the lesser of $100 and 0.25 per cent per month late of the ex-
cess of the fair market value of the property at the time of disposition over the amount
of the election or amended election. The penalty appears to be capped at $8000 so, for
bungled elections on large transfers, petitioning the Minister is almost certainly advis-
able (subsection 85(8)). Note that, if the parties can convince the Minister of National
Revenue that accepting an amended election or an initial election after the three years
have expired is just and equitable, further time may be allowed (subsection 85(7.1))
362 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
Second, the election must be made on an asset-by-asset basis.79 Be-
cause the cost basis of the contributed property must be properly allocated
among the shares and any boot received in exchange, and the tax conse-
quences can differ in material respects depending on the order in which
different properties are contributed,80 the election requires a specific and
adequate description of each property transferred, including the fair
market value, adjusted cost basis, agreed amount, and information about
the consideration received in exchange for the property.81 These details
are required for each property, with variations depending on the type of
property contributed.82 The taxpayer must retain all supporting schedules
and records necessary to substantiate her position.
2. Statutory History
Why does subsection 85(1) exist? The Carter Commission offered a
spirited defense of allowing rollover treatment for contributions of proper-
ty to a corporation as a way of combating the lock-in effect:
We recognize that it is often necessary to change the form of owner-
ship of a business or property, or to rearrange or reorganize the af-
fairs of corporations for business reasons. If every such change or re-
organization were to result in a disposition for tax purposes by the
shareholders, or the corporation, or both, this could have an inhibit-
ing effect and could tend to produce undesirable rigidity in corporate
structures. Because we regard a corporation as an intermediary, and
individuals as the persons who ultimately bear the taxes, we consid-
er that certain corporate reorganizations and transfers which
change the form of ownership, but do not effect a change in the ulti-
mate beneficial ownership of a business or property, should not re-
sult in a tax liability.83
The Commission was surely aware that subchapter C of the Internal
Revenue Code of the United States confers nonrecognition treatment on
79 See Krishna, supra note 45 at 1123 (the ability to list several properties on the same
form does not imply that there is a single election being made). But see Canada Reve-
nue Agency, Information Circular 76-19R3, Transfer of Property to a Corporation Un-
der Section 85 (17 June 1996) [IC 76-19R3] (showing that in some situations more
simple reporting may be available, in providing that the taxpayer can indicate on the
form only the total fair market value of the properties, the fair market value of the con-
sideration received, and the agreed amount for the whole class at para 3).
80 See Canada Revenue Agency, Information Bulletin IT-291R3, Transfer of Property to a
Corporation Under Subsection 85(1) (12 January 2004) at para 15. See also the discus-
sion in Monaghan et al, supra note 49.
81 IC 76-19R3, supra note 79 at para 3. See Form T2057, supra note 72 at 3.
82 See ibid at 3 (calling attention to the slightly different requirements for listing capital
property, depreciable property, resource property, eligible capital property, etc.).
83 Carter Commission Report vol 3, supra note 41 at 371.
TAXING BY DEFAULT 363
contributions of property to a corporation where the contributor owns a
requisite majority of the corporations shares after the contribution.84 Alt-
hough the Commission did not indicate whether its recommendations
were inspired by its neighbours approach, its resulting prescription took a
similar tack85 and proposed that contributions of property to a corporation
should, in general, not trigger tax.86
Furthermore, the Commission added a twist not present in the corre-
sponding American provision: it suggested that taxpayers who wanted
partial gains to be recognized upon contributing property to a corporation,
and their cost bases in the property and the shares adjusted accordingly,
should be able to choose recognition treatment. In particular, it proposed
that the law allow taxpayers to elect out of the default of rollover tax
treatment.87 In recommending that a taxpayer be allowed to opt out of
rollover treatment, the Commission can be seen as affirmatively encour-
aging taxpayers to make contributions of property to corporations
regardless of their particular tax situations, which could make rollover or
realization treatment more or less advantageous.
Consistent with the recommendations of the Carter Commission, the
bill that was introduced in the House of Commons duly included an elec-
tive rollover provision for contributions of property to a corporation.88
However, a curious thing happened between the time that the Carter
84 The Internal Revenue Code simply assigns a default treatment to contributions of prop-
erty, without the opportunity to elect out of nonrecognition treatment: No gain or loss
shall be recognized if property is transferred to a corporation by one or more persons
solely in exchange for stock in such corporation and immediately after the exchange
such person or persons are in control (as defined in section 368(c)) of the corporation
(IRC 351(a) (2012)).
85 Note, however, that the language of subsection 85(1) provides for something other than
straight nonrecognition.
86 See Recommendations, supra note 38; Krishna, supra note 45 at 111213. Note that,
pursuant to the deeming rules above, losses must be recognized by the transferor upon
contribution.
87 The Carter Commission recommended that
the parties should also have the right to elect that the disposition would take
place at a price which was specified as being the fair market value of the as-
sets transferred. [But] [i]f this election was made, and if the price specified
for all the property transferred and for each asset or class of assets should be
shown not to be the fair market value, the administration would be entitled
to require that this price be adjusted to the fair market value (Carter Com-
mission Report vol 3, supra note 41 at 371).
88 Bill C-259, supra note 2. See also SE Edwards et al, eds, Explanation of Canadian Tax
Reform (Don Mills, Ont: CCH Canadian Limited, 1972) at 3 [CCH Explanation] (the
CCH authors provide a helpful summary of the process by which the tax reform legisla-
tion wound its way through Parliament).
364 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
Commission report was released and commented upon by the Minister of
Finance in a White Paper: the direction of the election for rollover treat-
ment upon contribution of property to a corporation was reversed. Rather
than drafting the legislation such that rollover treatment was the default,
the legislation allowed the opportunity for tax deferral only if the taxpay-
er and the corporation have jointly so elected in prescribed form and with-
in prescribed time.89 As summarized by the practitioners who published
the CCH Explanation of the legislation, a joint election must be filed in
order to take advantage of the roll-over provisions. If no election were
filed, the rules in subsection 69(1) regarding inadequate consideration
would presumably apply.90
No available sources indicate why the default tax treatment was re-
versed in the legislation.91 Although numerous speeches were made by
Members of Parliament and others,92 a review of the floor debates in the
House of Commons yielded no mention of the use of elective provisions in
89 See Bill C-259, supra note 2, s 85(1).
90 CCH Explanation, supra note 88 at 165.
91 Throughout the autumn of 1971, Bill C-259 was the subject of extensive debates in the
legislature. Bill C-259 had its second and third readings on 12 October and 10 Decem-
ber, respectively, and was approved by the Senate on 21 December. The statute re-
ceived royal assent on 23 December 1971, and the new law became effective for most
purposes on 1 January 1972 (see CCH Explanation, supra note 88 at 3). A 1981 York
University LLM dissertation had this to say about the existence of the election:
The enormous flexibility granted to parties who elect to have their transac-
tion fall within the ambit of section 85 seems incompatible with the general
philosophy underlying the non-recognition provisions enacted in the I.T.A.
…
It is difficult to imagine why … the choice of tax consequences resulting from
the transaction are left to the discretion of the parties once they decide to in-
voque the rollover provision, while other rollovers do not provide for such a
choice (Andr Lareau, A Decade Later: An Analysis of the Section 85 Rollover
and its Underlying Policy Considerations, (Master of Laws Thesis, Osgoode
Hall Law School, 1981) at 7577 [unpublished, archived at the National Li-
brary of Canada]).
The dissertation compared section 85 to other rollover provisions, including subsections
44(2), 70(9), 40(4), and 70(b)). It focused on the 1974 elimination of the eighty per cent
continuity of interest requirement for subsection 85(1) and did not shed light on the
perplexing default reversal in the structure of the election (ibid).
92 There was much discussion on the complexities and poor draftsmanship of the pro-
posed amendments: for example, Member of Parliament David MacDonald from Eg-
mont charged that [w]hat the government has done with respect to the taxation pro-
posals is to produce an exaltation of ad hocery while giving unwarranted prominence to
what surely must be described as the supertechnocrat (House of Commons Debates,
28th Parl, 3rd Sess, Vol 8 (14 September 1971) at 7806 (David MacDonald)). Despite
this focus on complexity, I did not find any testimony or speeches mentioning the use of
elections as tax mechanisms during debates on Bill C-259.
TAXING BY DEFAULT 365
general, of the rollover treatment of property upon contribution to a cor-
poration in particular, or of why the election default was reversed.93
Which default ruleif eitheris superior? And is it the same for sub-
section 73(1) as for subsection 85(1)? The following Part addresses these
questions in light of the prescription developed in Parts I and II.
IV. Evaluating Subsections 73(1) and 85(1)
Here, we can see the prescriptive rubric for evaluating tax elections
default provisions in action: an elections default treatment generally
should align with the result that most taxpayers would prefer. However,
this presumption can be overcome if structuring the election with a non-
majoritarian penalty default would allow the government to glean valua-
ble and otherwise unobservable information about taxpayers that could be
used to increase the efficiency of the tax system.
For each of the rollover provisions, I first evaluate whether the status
quo election is structured as a majoritarian default and how this structure
influences the execution costs at stake. Second, I ask whether it is plausi-
ble that structuring the default treatment as a penalty in order to cause
some taxpayers to elect out might reveal valuable information to the gov-
ernment.
A. Subsection 73(1)
The default structure of subsection 73(1) appears to be majoritarian.
Perhaps because it did not start off as a rollover provision that included
an explicit election, its current structure seems to accommodate most tax-
payers preferences to defer tax on any accrued gains in capital property
transferred to a spouse. While it would be helpful to have survey evidence
or other data about taxpayer preferences for rollover treatment in the
context of spousal property transfers, it seems fair to assume that most
taxpayers would prefer to defer any gains on appreciation in the trans-
ferred property, even if this causes the future income from the property to
be attributed to them. This conclusion results from the following risk-
benefit analysis: the taxable capital gains on the property at the time of
transfer are certain, while the future income stream is speculative.
93 Fast forwarding to 2012, subsection 85(1) looks and operates, generally speaking, much
like it did in 1972. The only notable change, which does not have direct bearing on the
analysis of the structure and function of the elective portion of the provision, occurred in
1974, when the requirement that the transferor own 80 per cent of the transferee corpo-
ration after the transfer was jettisoned.
366 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
Of course, particular taxpayers may have idiosyncratic circumstances
that would make electing out of rollover treatment and adjusting the cost
basis to fair market value attractive. First, they may have allowable capi-
tal losses that could offset realized gains. Second, if the transferor spouse
was in a significantly higher bracket than the transferee spouse and the
capital asset was expected to generate significant income streams in the
future, the impact of circumventing the section 74 attribution rules might
be worth the tax liability on an immediate realization of gains. Third, in a
similar disparate-bracket situation, electing out of rollover treatment can
facilitate income splitting in the following way. When (as now) the pre-
scribed rate for spousal loans is low, the higher-earning spouse can make
a loan to the lower-earning spouse at the prescribed rate of interest.94 At
the same time, the higher-earning spouse can transfer income-earning
property (assets such as stocks, bonds, etc.) to the lower-income spouse at
fair market value and circumvent attribution by making the proper elec-
tion. The lower-income spouse can deduct the interest expense since the
loan was incurred to earn income.95 When the dust settles, the higher-
income spouse has interest income (plus the capital gain or loss, if any, on
the property that was transferred), but this income is likely to be more
than offset by foregoing the income on the property that was transferred
to the lower-earning spouse. Finally, as discussed above, where spouses
are separating before the final dissolution of their marriage, electing out
of the default treatment may simplify the division of property by waiving
the attribution rules and accelerating tax on any gains.96
Notwithstanding this majoritarian default structure, it bears noting
that the subsection 73(1) election has a fairly low impact on execution
costs. The fact that there is simply a box to check on the individual tax re-
turn, without further reporting requirements, implies that executing the
election is not difficult. While deliberation costs may not be negligibleall
taxpayers who transfer property to a spouse are confronted with the
choice about whether to treat the transfer as rollover or notthe execu-
tion costs that would be minimized by a majoritarian election appear to be
already low.
94 See subparagraph 80.4(1)(a). See also Canada Revenue Agency, Interpretation Bulletin
IT-533, Interest Deductibility and Related Issues (31 October 2003).
95 See subparagraph 20(1)(c)(i).
96 Note that, because marital dissolution is likely to be among the most common reasons
for electing out of rollover treatment in the context of subsection 73(1), the government
might be able to reduce deliberation costs associated with the election by more specifi-
cally targeting information on making the election, such as in a publication containing
guidance for separating spouses on their tax decisions.
TAXING BY DEFAULT 367
The low execution costs of the 73(1) election reduce the stakes of de-
fault-setting. Where execution costs are low, imposing them on a majority
of taxpayersvia a penalty default structurewould have a smaller im-
pact than if execution costs were higher. If forcing taxpayers to elect out of
fair market value realization treatment and into rollover treatment would
reveal valuable information to the government, one would expect that the
costs of checking a box would not deter taxpayers from making the elec-
tion and conveying the valuable information.
Does a plausible story exist of how a penalty default structure in
which taxpayers were required to elect into rollover treatment would re-
veal information to the government? Anything in this regard is specula-
tive, and penalizing taxpayer inattentiveness certainly seems to be a
strategy for generating revenue at low political cost.97 But it is harder to
identify an account of how structuring the subsection 73(1) election as a
penalty default might reveal taxpayer information that the government
could leverage to increase the efficiency of the tax system. Moreover, insti-
tuting a penalty default in this case would run the risk of fostering the
undesirable outcome of capital lock-in. To the extent that the penalty de-
fault proved sticky or, for whatever reason, a taxpayer who would benefit
from rollover treatment failed to elect in, the clear policy objective of mak-
ing rollover treatment available in the first place would be defeated.
Therefore, applying the default-setting rubric developed above yields a
clear conclusion: subsection 73(1) is properly structured as a majoritarian
default, and there is insufficient justification for reimagining it in a penal-
ty-default structure.
B. Subsection 85(1)
Applying the default-setting rubric to subsection 85(1) yields a more
rousing conclusion. Starting with the 1972 Act, the elections default
treatment in favour of fair market value realization appears to have been
set not in accordance with the preferences of the majority of taxpayers but
rather as a penalty. True, the election as it is structured delivers a variety
of useful disclosures to the governmentabout the cost basis of contribut-
ed property, its effect on paid-up capital, and other dimensions that allow
the government to police tax avoidance. But this information can be elicit-
ed in a lower-cost and more effective manner than by structuring the elec-
97 The example of the Form T1 check-box to receive a credit for GST taxes paid is an obvi-
ous example of a penalty defaulttaxpayers who are inattentive and miss this will lose
out on the benefits of the credit, and the government will raise revenue (Canada Reve-
nue Agency, Form T1 General, Income Tax and Benefit Return (2012) at 1, online:
CRA
the uncredited commodity tax distorts taxpayers behaviour as consumers.
368 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
tion as a penalty for the majority of taxpayers. As a result, I suggest that
Parliament should amend subsection 85(1) to adopt rollover treatment as
the default, consistent with the original recommendations of the Carter
Commission, and should pair this amendment with a new mandatory re-
porting requirement for corporations receiving property pursuant to sub-
section 85(1).98 I discuss each policy reform in turn.
That the current default structure of the subsection 85(1) election is
non-majoritarian should not provoke controversy. Practitioners confirm
that most taxpayers contributing property to a corporation under 85(1)
elect straight rollover treatment rather than an intermediate elected
amount or the realization default (transfer at fair market value). Such
anecdotes should be verified by systematically surveying tax filings or
taxpayers themselves, but assuming that the distribution of taxpayer
preferences in favor of rollover is sufficiently lopsided, the status quo can
be seen a penalty default that imposes execution costs on a majority of
taxpayers.
Moreover, the hefty execution costs of electing out of subsection 85(1)s
default treatment raise the stakes of getting the default right. Making an
election requires coordination between the transferee and the corporation;
a special form must be filed before the prescribed deadline; each contrib-
uted property requires a separate election; and so on. To the extent that a
majority of taxpayers elect out of the default treatment, there is scope for
reducing transaction costs. Still, under the default-setting rubric, the pre-
sumption in favor of a majoritarian default can be overcome if structuring
the default as a penalty yields sufficiently valuable information to justify
the penaltys associated increase in costs. Is this the case for subsection
85(1)? I contend that it is not, because the reasons that taxpayers may de-
cide not to seek rollover treatment in the context of subsection 85(1) are so
varied. For instance, rollover treatment may be unfavourable where the
transferor has accrued capital losses carried over from previous periods.
Because allowable capital losses can only absorb taxable capital gains, it
98 Recall that the Commission suggested implementing an election not to allow taxpayers
to elect into rollover treatment, but rather to allow taxpayers to elect out of rollover
treatment. It appears that the Commission sought to advance its policy goal of facilitat-
ing the efficient movement of capital by increasing options for taxpayers whose idiosyn-
cratic situations might not fit with the default treatment. Returning to the language of
the Carter Commission report, forming a corporation without adverse tax consequences
seems to be so sacrosanct that its report refers to the right to elect disposition at fair
market value in the event that rollover is disadvantageous. In proposing this combina-
tion of default treatment and election, the Carter Commission appears to seek to subsi-
dize the preferred policy outcome by offering something for everyonethereby reducing
the price of corporate formation for those who would be penalized by the default. See
Recommendations, supra note 38.
TAXING BY DEFAULT 369
makes sense to use them as soon as possible.99 Second, for taxpayers dis-
posing of qualified small business corporation shares by contributing
them to another corporation pursuant to subsection 85(1), the capital
gains exemption confers tax-free treatment on a threshold amount of
gains without needing to make an election.100 Third, parties may want to
avoid having two propertiesboth the asset held by the corporation and
any shares received in exchangewith low cost bases.101 The rollover
staves off tax that would be owed by the transferor upon contribution of
the property, but it is a deferral of, not an exemption from, future tax lia-
bility. Because the rollover deprives both the transferor (in the considera-
tion received for the property) and the transferee (in the property trans-
ferred) of a step up in cost basis to fair market value, a rollover generates
two properties with low cost bases in place of just one. When either party
disposes of her property, tax will be dueboth the transferor will pay tax
on the gains in the shares and the corporation will pay tax on the gains in
the property. Of course, the severity of this disincentive will vary with the
expected amount of time that the transferor and the transferee intend to
hold their respective properties. If the expected holding period is long, de-
ferral may be more attractive.102 The literature mentions various other
situations in which rollover treatment would not be preferable, but all
seem unlikely to apply to the circumstances facing the vast majority of
taxpayers.103
99 See paragraph 3(b)(ii) (capital losses are generally deductible only against capital
gains). See also Duff et al, supra note 51 at 957.
100 See paragraph 110.6(2.1)(a). See also Howard J Kellough & Peter E McQuillan, Taxa-
tion of Private Corporations and Their Shareholders, 3d ed (Toronto: Canadian Tax
Foundation, 1999) at 5:31.
101 See discussion in Krishna, supra note 45 at 115960.
102 Krishna notes that the tradeoff is the discounted present value of the tax deferred on
the rollover versus the disadvantage of double taxation (ibid at 1160). More precisely,
if the sum of the tax liabilities to the transferor and the transferee, discounted to pre-
sent value by the respective expected holding periods, exceeds the tax liability that will
be payable by the transferor absent rollover treatment, then the tax-minimizing solu-
tion is for the parties to file the subsection 85(1) election. However, this highlights the
coordination costs pointed out in Part II.D.3, above: while total taxes would be mini-
mized by following this rule, the savings to each of the transferor and the corporation
could easily be asymmetric depending on the expected holding periods, effective tax
rates, and other factors. In such asymmetric situations where the taxpayer does not
control the corporation, this could lead to higher coordination costs, price adjustments
to compensate the transferor for tax immediately due, or a bargaining impasse.
103 See Kellough & McQuillan, supra note 100 at 8:44 (other reasons not to elect rollover
treatment under subsection 85(1) include foreign affiliate considerations as well as the
desire to preserve the subsection 39(4) election in respect of the disposition of qualifying
Canadian securities); Maureen Tabuchi, Share Capital Reorganizations for Private
Corporations (2003) 51:3 Can Tax J 1340.
370 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
Because there are so many idiosyncratic reasons that taxpayers might
decide to elect out of rollover treatment (even if it is a minority of taxpay-
ers that choose to do so), the potential for the election to act as a useful
screen is dampened. The government cannot make clear inferences on the
basis of a particular taxpayers or corporations decision to elect or not
elect rollover versus fair market value versus intermediate elected
amounts in the context of subsection 85(1). As a result, it is very unlikely
that the election can produce information sufficient to rebut the presump-
tion in favour of a majoritarian default. In any event, an information-
forcing function of a non-majoritarian election would have to be identified
by the government and debated internally, during which (presumably) the
benefits of the information yielded by the election would be weighed
against the transaction costs imposed by a penalty default. Given the lack
of clues or a sufficiently compelling story, I conclude that the presumption
in favour of a majoritarian default should stand.
There is also an equity dimension that must be considered alongside
the efficiency rubric that I offer. Because the transaction costs of electing
out of the default treatmenthowever it is setare substantial, some
taxpayers will be deterred from making the election. The deterred tax-
payers are likely, on balance, to be less sophisticated or have access to
fewer resources relative to taxpayers making the election. While this may
be less true for subsection 85(1) as compared to subsection 73(1) because
contributions of property to a corporation are likely to be made by more
sophisticated taxpayers or those represented by counsel or accountants,
the execution costs will undoubtedly affect taxpayers on the margin.
Where the default treatment is majoritarian in that it meets the prefer-
ences of most taxpayers (including, in particular, those at the bottom of
the resource spectrum), the effect of the provision will be more equitable
than if it was structured with a penalty default.
Merely switching the subsection 85(1) default to rollover treatment is
not a silver bullet. In order to preserve the current statutes flexibility as
well as its policy of preventing importation of losses, rollover treatment
would apply by default only when the taxpayers cost exceeded the fair
market value of the property. Otherwise, the transferee corporation could
receive property that, if disposed after transfer, would yield a capital loss.
And, to continue to offer taxpayers the full range of elected amounts, the
elective treatment under an amended statute would need to allow for the
same range as under current law. Finally, where property was contribut-
ed in exchange for both share and non-share consideration, taxpayers
would still need to allocate the cost among the shares and any boot re-
ceived in exchange. Thus, switching the default treatment to rollover is
not a panacea for the complexity inherent in subsection 85(1). But avoid-
ing a situation where a majority of taxpayers find themselves scrambling
to file an extremely complicated election before a deadline in order to
TAXING BY DEFAULT 371
avoid penalties would be a substantial step in the direction of increased
efficiency and equity.
Separate from the case for a majoritarian default treatment for sub-
section 85(1), however, is the concern that changing the status quo default
treatment would have unintended consequences in other areas of tax ad-
ministration, particularly anti-avoidance enforcement. The current penal-
ty default structure of the subsection 85(1) election also requires substan-
tial disclosure from taxpayers. Form T2057 requires electing taxpayers to
provide many details about the property contributed (its fair market val-
ue, adjusted cost base, and other details) and the share consideration re-
ceived in exchange for the contributed property (a description of shares,
their paid-up capital, and the fair market value of total consideration re-
ceived).104 This disclosure is used by the government to make a number of
determinations that are central to its efforts to combat tax avoidance,105
including: whether the paid-up capital of the share consideration issued in
exchange for the property might result in a deemed dividend,106 whether
the indirect gift rule is applicable,107 whether a paid-up capital grind is
required for the shares issued as consideration,108 and other determina-
tions central to properly assessing taxes due. Because this disclosure
about contributions of property covered by subsection 85(1) is so im-
portant in allowing the government to combat surplus-stripping and other
tax avoidance strategies, I propose the adoption of a mandatory reporting
requirement for all disclosure currently provided on Form T2057.109 Best
of all, such reporting would not depend on an election being filed, and
thus would not deprive the government of disclosure simply on the basis
of an idiosyncratic elective choice. To the extent that the anti-avoidance
gains justify the costs that such a requirement would impose on reporting
corporations and their shareholders, it should be adopted as a comple-
ment to switching the default treatment of the subsection 85(1) election.
104 Supra note 72 at 3.
105 See IT-291R3, supra note 80 (the current version of Information Circular 88-2, General
Anti-Avoidance Rule, and Supplement 1 thereto also discuss a number of examples that
illustrate the use of subsection 85(1) and comments on the application of subsection
254(2) [the general anti-avoidance provision in the Act] thereto at para 34).
106 See subsection 84(1) (defining a deemed dividend in relation to paid-up capital).
107 See subsection 85(1)(e.2).
108 See Canada Revenue Agency, Interpretation Bulletin IT-463R2, Paid-Up Capital (8
September 1995).
109 See Leandra Lederman, Reducing Information Gaps to Reduce the Tax Gap: When Is
Information Reporting Warranted? (2010) 78:4 Fordham L Rev 1733 (Lederman dis-
cusses in detail the factors that should influence policymakers in their decisions about
when to adopt information reporting, and finds that corporate-level reporting is often
most efficacious).
372 (2013) 59:2 MCGILL LAW JOURNAL REVUE DE DROIT DE MCGILL
Conclusion
This paper accomplishes two things. First, it builds a principled rubric
to assist policymakers in thinking about how to set the default treatment
for tax elections. The rubric balances the transaction costs of executing
tax elections against the possibility that taxpayers elective choices can
yield valuable private information to the government. I show that, in gen-
eral, a tax elections default treatment should align with the result that
most taxpayers would prefer. However, this presumption can be overcome
if structuring the election as a non-majoritarian penalty default would al-
low the government to glean valuable information about taxpayers that
could be used to improve the tax system, provided that such information
is not available elsewhere at lower cost.
Second, this paper analyzes an inconsistency in the structure of two
key tax elections in the Act relating to contributions of property to a
spouse and to a corporation, respectively. Whereas subsection 73(1)s de-
fault treatment is rollover, subsection 85(1)s default treatment is fair
market value realization, despite the recommendation of the Carter
Commission to the contrary. When the default-setting rubric is applied to
the subsection 73(1) and 85(1) rollover provisions, the results are clear.
Subsection 73(1)s default is likely aligned with majoritarian preferences,
and in any event the execution costs of making the election are low and
there does not appear to be an information-forcing purpose in adopting a
non-majoritarian penalty default. Thus, I recommend no change in the
structure of subsection 73(1). On the other hand, subsection 85(1) was
structured, without explanation, contrary to the recommendations of the
Carter Commission, thus saddling taxpayers with a default that most will
be forced to elect out of. The costs of executing the election are not trivial.
Moreover, there is not a persuasive story according to which a penalty de-
fault would cause certain taxpayers to reveal information about them-
selves to the government. Therefore, I recommend a simple change to the
status quo subsection 85(1) election: rollover treatment should be the de-
fault treatment, consistent with the subsection 73(1) structure as well as
the initial recommendations of the Carter Commission.
Such a change to the default of subsection 85(1) would not be earth-
shattering in its impact on the tax system, but it would undoubtedly de-
crease pressure on taxpayers to elect out of a penalty default and thereby
reduce aggregate execution costs. Moreover, it would have desirable equi-
ty effectsin the event that a taxpayer was not represented by counsel or
was unsophisticated about the tax consequences of making the election,
her inaction would have less severe consequences. If such a default-switch
were accompanied by a mandatory reporting requirement for corporations
receiving contributions of property pursuant to subsection 85(1), the pos-
sible negative consequences to anti-avoidance enforcement of changing
the subsection 85(1) election could be mitigated. Reimagining the default
structure of subsection 85(1) would be a small but meaningful step in the
right direction for Canadas income tax system.
TAXING BY DEFAULT 373
