If you sell or transfer a property to a non‑arm’s length person for an amount other than its fair market value, there are onerous income tax rules that may apply. The rules are discussed below, and there is an exception for transfers to spouses and common-law partners. But first, what constitutes a non‑arm’s length person?
In terms of individuals, a non-arm’s length person includes any person that is “related” to you under the Act. This will include people related to you by blood, marriage or adoption. The list includes your children, grandchildren, great-grandchildren and so on, your parents, grandparents etc., your siblings, your spouse or common-law partner, and your in-laws. Interestingly, it does not include cousins, aunts, uncles, nieces and nephews, but it does include a brother-in-law and a sister-in-law (including through a common-law partnership).
In terms of individuals and corporations, a non-arm’s length person includes a corporation that you control. It also includes a corporation if you are a member of a “related group” that controls the corporation (e.g. you and your spouse control the corporation). Control of a corporation generally means ownership of shares that entitled you to more than 50% of the votes. A “group” means two or more persons.
In terms of corporations, they will be non‑arm’s length in various circumstances including the following: if one controls the other; if they are controlled by the same person or group of persons; if each of the corporations is controlled by one person and the person who controls one of the corporations is related to the person who controls the other corporation; and if one of the corporations is controlled by one person and that person is related to any member of a related group that controls the other corporation.
The above is a short summary of the non-arm’s length rules. There are other various combinations and situations under which persons can be considered non-arm’s length.
The onerous rules
If you sell a property to a non-arm’s length individual for an amount that is less than its fair market value, you will be deemed to have disposed of the property at fair market value. However, this rule is one-sided, in that the recipient’s cost is whatever they paid you for the property. As illustrated below, this rule can result in double taxation.
You own capital property (e.g. shares, real estate) that cost you $10,000. You sell it to your sister for $20,000 when its fair market value is $50,000.
You will have deemed proceeds of $50,000, and therefore a $40,000 capital gain, half of which will be included in your income as a taxable capital gain. However, your sister’s cost of the property will be $20,000. Thus, if she then sells the property to a (non-related) third party for $50,000, she will have a capital gain of $30,000, which was already part of your $40,000 capital gain.
Conversely, if you buy property from a non-arm’s length person for an amount that is more than its fair market value, you will be deemed to acquire it at a cost equal to its fair market value. But again, this rule is one-sided, in that the seller will have proceeds equal to whatever you paid for the property.
Your sister owns capital property that cost her $10,000. You buy it from her for $50,000 when its fair market value is $20,000.
Your sister’s proceeds will be $50,000, so that she will have a $40,000 capital gain, half of which will be included in her income as a taxable capital gain. However, your cost of the property will be the fair market value of $20,000. Say you sell it at a later time to an unrelated third party for $50,000. You will have a capital gain of $30,000, which was already counted in your sister’s $40,000 capital gain.
Gift of property
If you give property to a person, whether they are arm’s length or non-arm’s length, you will normally be deemed to have received proceeds at the property’s fair market value. But in this case, the recipient’s cost of the property is also deemed to be the fair market value, so the double taxation issue does not arise.
You own capital property that cost you $10,000. You give it to your sister when its fair market value is $50,000.
You will have deemed proceeds of $50,000, and therefore a $40,000 capital gain, half of which will be included in your income as a taxable capital gain. Your sister’s cost of the property will also be $50,000. Thus, if she then sells the property to a (non-related) third party for $50,000, she will have no capital gain and there will be no double taxation.
Transfer to spouse or common-law partner
An exception applies to sales and gifts of property to your spouse or common-law partner. It also applies to a transfer of property to a former spouse or common-law in settlement of rights arising out of your marriage or common-law partnership (e.g. family law obligations).
In these cases, there is an automatic “rollover”, which means you have proceeds of disposition equal to your cost amount of the property and the recipient inherits that same cost of the property. As such, there will be no tax payable on the transfer.
However, you can elect out of the rollover in your tax return for the year of transfer. If you do, the rules discussed above may apply. If there is a loss, it will often be denied as a “superficial loss”, a topic which we will discuss further in a future tax letter.
Finally, note that if you give or sell property or money to a non-arm’s length person for less than market value, in a year when you have a tax debt (income tax or GST/HST) owing to the CRA, and you don’t pay your debt, the CRA can assess the other person for your tax debt, and can seize that property or any other assets the person has to pay your tax bill.