Transfer of shares and arm's length relationship

Transfers of shares, by sale, gift or otherwise, often occur between persons with family ties, particularly within family businesses. In such transactions, it is important to comply with the provisions of the tax laws (both federal and provincial) in order to avoid undesirable tax consequences.

The Income Tax Act provides that a person who disposes of property to a non-arm's length person for no consideration or for consideration less than the fair market value of the property is deemed to have received consideration equal to the fair market value. One of the impacts of this provision is that if a person sells shares to a non-arm's length person for $100 consideration when in fact the shares have a fair market value of $100,000, the seller will be deemed to have received $100,000 consideration and will be taxed on the resulting capital gain.

However, the purchaser will be deemed to have acquired the property at the actual transaction price, which may in this case result in double taxation when the purchaser disposes of the property in turn. The exception to this rule is where the buyer has acquired the property by gift, for example.

What are the criteria for determining whether two persons are not dealing at arm's length? The Income Tax Act deems related persons not to be dealing with each other at arm's length. For example, individuals who are related by blood, marriage, common-law partnership or adoption are related. An individual and a corporation may also be related persons, especially if the individual controls the corporation. It should be noted that two persons may not be dealing with each other at arm's length without necessarily being related persons: this would be a question of fact. Exceptions exist, however, for transfers between spouses, who may benefit from a "rollover" so that the transfer occurs without tax impact.