There are special rules that apply under the Income Act if you dispose of, or acquire property from, a non-arm’s length person.
In general terms, a non-arm’s length person includes a person you are related to (for income tax purposes). So for individuals, this includes your lineal ascendants and descendants such as children, grandchildren, parents and grandparents. It also includes your spouse, siblings, and most inlaws such as siblings-in-law and parents-in-law. Interestingly, it does not include aunts, uncles, nieces and nephews, and cousins. Also, as discussed below, there are special rules that apply to spouses and common-law partners.
In terms of corporations, a non-arm’s length corporation includes a corporation that you control, and a corporation controlled by a person that is nonarm’s length with you. But the corporate non-arm’s length rules are quite complex and can include corporations in a myriad of corporate structures. Professional advice should be obtained.
Disposition for less than fair market value
If you give or dispose of property to a non-arm’s length person for proceeds less than the fair market value of the property, you will be deemed to dispose of the property for fair market value proceeds. Unfortunately, this rule is one-sided, and does not affect the acquiror’s cost of the property.
You sell property to your brother Jack for $15,000. Your cost of the property is $10,000 and the fair market value of the property at the time of sale is $18,000.
You will have proceeds of $18,000, resulting in a capital gain of $8,000, and a taxable capital gain of $4,000 included in your income. However, Jack’s cost of the property will be the $15,000 that he paid for it. So if he turns around and sells it to a third party for $18,000, he will have a capital gain of $3,000 and taxable capital gain of $1,500, resulting in double taxation.
Acquisition at more than fair market value
Conversely, if you acquire a property from a nonarm’s length person for more than its fair market value, your deemed cost of the property will be the fair market value. But again, this a one-sided rule, and the person disposing of the property will have proceeds equal to the actual amount paid for the property.
You acquire property from your brother Jack for $15,000. The fair market value of the property at the time of purchase is $12,000.
Your cost of the property will be $12,000. However, Jack’s proceeds of disposition of the property will be $15,000.
Rollover for transfers to spouse
If you give or dispose of property to your spouse or common-law partner, the above rule does not normally apply. Instead, your proceeds and your spouse’s cost will equal your tax cost of the property, resulting in a tax-free rollover.
However, you and your spouse can elect out of the rollover, in which case the above non-arm’s length rules apply. The election may result in gains or income for you, but a bumped-up cost for your spouse. The election may be beneficial if you have losses that can offset the gains or income resultingfrom the deemed disposition, or if you are able to claim the capital gains exemption on the disposition.
You have a property with a cost of $10,000 and fair market value of $15,000, so the property has an accrued gain of $5,000.
If you give the property to your spouse and do not make the election, you will have proceeds of $10,000 and no capital gain. Your spouse’s cost of the property will be $10,000.
Assume instead that you have capital losses (in the current year or losses from previous years) that can offset the accrued gain. If you make the election, you will have deemed proceeds of $15,000. You will have a $5,000 gain, and $2,500 taxable capital gain included in your income, which will not be taxed because of the offset from your losses. The upside is that your spouse will have a bumped-up cost of the property of $15,000, and thus a lower eventual capital gain on sale of the property.