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At Arm's Length - More Than Just Family


The Income Tax Act (Canada) (“ITA”) contains a number of provisions that may apply to a transaction between parties that are not at arm’s length. The purpose of these provisions is to prevent transactions from occurring that may result in one or more parties receiving a tax benefit as a result of their relationship with the other party that may not reflect the ordinary commercial terms of the transaction. In general, where a transaction between two non-arm’s length parties does not occur at fair value, the disposing party to the transaction is deemed to have disposed of the property for its fair value, regardless if the consideration given up by the acquiring party is above or below the actual fair value.

The definition of “arm’s length” is not defined in the ITA although subsection 251(1) of the ITA sets out some general guidelines to consider when determining if two parties are at arm’s length. Understandably, related parties are deemed not be dealing at arm’s length. However, it is a question of fact if unrelated parties may be at arm’s length. The ITA is silent as to the de facto arm’s length relationship. Therefore, we must rely on this determination by the courts. The leading case on de facto arm’s length determination is the Supreme Court decision in the McLarty case where the court confirmed the methodology used by the Federal Court in the Peter Cundill case outlining the following three main criteria to consider when determining if there is a de facto arm’s length relationship:

  1. The existence of a common mind, which directs or dictates the terms of the bargaining of both parties to a transaction;
  2. Parties to a transaction acting in concert without separate interests; and
  3. De facto control.

There are a number of adverse tax consequences that could result if parties enter into a transaction and it is subsequently determined that they are not at arm’s length, such as the conversion of a capital gain to a deemed dividend or the possibility of double tax as a result of one sided adjustments to the deemed acquisition cost to the purchaser.

Following are a few additional considerations that have been utilized by the courts when determining if parties may be at arm’s length:

  • If the mind acting for one of the parties is the same mind directing the second party then they may not be at arm’s length?
  • Is the same person dictating the terms of the bargain for both parties?
  • Was there bargaining between the terms of the exchange between the parties?
  • Does one party have a bargaining position of greater strength than the other?
  • Is there an agent that may be directing the mind of both parties?
  • Are there restrictions to the authority of the agent?
  • Did the parties seek legal and tax advise from the same parties?
  • Do the terms of the arrangement reflect ordinary commercial dealings of the parties?
  • Does one party have the power to impose its will over the other?
  • Does one party have the ability to influence in a very direct way the shareholders who would have the ability to elect the board of directors?

Therefore, in order to reasonably asses the intended results of various tax motivated transactions, it is important that one looks beyond the blood relationships of the individuals involved in the transactions to assess whether there may in fact be a non-arm’s length transaction that may occur.