Under Canadian tax law, special rules often apply to transfers of money and property between family and friends. The classification of whether a transaction is at “arm’s length” is an essential concept in the federal Income Tax Act (the “Act”). In many instances, a non-arm’s length transaction can give rise to tax consequences that do not correspond to its economic reality. It is essential that Canadian taxpayers who engage in business with friends and family understand what it means to be dealing with a person at arm’s length and when non-arm’s length transfers could adversely impact them. The CRA can issue a section 160 assessment where a transfer has been made from a tax debtor to a non-arm’s length person.
The terms “arm’s length” and “non-arm’s length” are not specifically defined in the Act. Rather, the arm’s length principle is a legal concept used in the Act which refers to situations wherein two parties to a transaction act independently and in their own self-interest. The Act does, however, deem “related persons” not to deal with each other at arm’s length. Generally speaking, individuals are related to each other if they are connected by blood relationship, marriage, common-law partnership or adoption. Corporations can be related to individuals and other corporations in a number of ways, with the common element being some type of relationship to the corporation’s controlling shareholders. Where transactions between related individuals or corporations occur, the parties to the transaction are deemed not to deal with each other at arm’s length.
The absence of a deemed non-arm’s length relationship does not mean that parties are dealing with each other at arm’s length. The Act provides that it is a question of fact whether persons not related to each are dealing with each other at arm’s length at a particular time. The test developed by the courts to determine whether parties deal with each other at arm’s length looks to whether there was a common mind directing the parties, whether the parties had separate and distinct interests in the transaction and whether one of the parties exercised significant influence or control over the other.
In many instances, the existence of a non-arm’s length transaction can incur significant tax consequences for the parties involved. One such instance in which the arm’s length principle can affect the tax outcome of a transaction is where “inadequate consideration” is provided on a transfer of property. Subparagraph 69(1)(b)(i) provides that where a taxpayer disposed of anything to a person with whom the taxpayer was not dealing at arm’s length for no proceeds or for proceeds less than fair market value, the taxpayer is deemed to have received proceeds of disposition equal to the disposed property’s fair market value. This provision can bear harsh ramifications for the transferor if the transferred property has an unrealized gain at the time of the transfer. For example, if one taxpayer sold property with an unrealized gain to a friend at a price less than what the CRA determines to be its fair market value, the transferor could end up owing tax without having received any proceeds with which to pay it!
It’s important that taxpayers who deal with friends and close business associates understand that their transactions could be subject to scrutiny. Please contact one of our tax lawyers for more information or for assistance in responding to an audit by CRA.