For tax purposes, the Canadian Revenue Agency requires businesses to complete all transactions at fair market value, but some businesses find themselves making special arrangements with family, friends or others. By not acting at arm’s length, they may wind up with understated revenue, overstated expenses and/or unrecorded tax liabilities. Any error in this area is subject to reassessment, which can be an extremely expensive process.
With that in mind, companies should always keep track of all transactions, in case there is any need for future reassessment. This is also necessary for the purposes of documentation and allocating the small business deduction. More importantly, businesses should develop an understanding of what it means to not act at arm’s length – and what can be done to address any past reporting errors.
Not acting at arm’s length
When you’re not acting at arm’s length, you’re usually doing someone a favour you wouldn’t do for a customer you don’t know. You are only permitted to give friends and family a deal you would give to a third party. That includes giving something to them for free – it is only permitted if you would offer the same product or service to any other customer at no cost.
Why does the CRA have a problem with this?
From the CRA’s perspective, not operating at arm’s length results in lost tax revenue. If we are doing a transaction and I give you something for free, my revenue will be understated because I didn’t charge anything. However, I would have incurred costs that are being claimed as an expense. This could be countered with the argument that I didn’t collect any money either, but because I did it for someone who’s related, the CRA views it as if I personally took the funds from the corporation and gave them to that person to pay for this transaction. This means my business (and potentially personal) income is under-reported, resulting in insufficient business and personal income tax as well as under-reported HST. In this scenario, there are penalties related to all of the above.
A common example
When not working at arm’s length, the most common mistake is failing to attribute a value to a transaction. In some cases, this is because a fee was never charged. Let’s say you allow your friend to use a piece of equipment for their corporation, but you don’t charge them for this. Since no record of the transaction has been recorded, all tax has been overlooked.
Determining fair market value
In most cases, the best way to determine fair market value for a transaction is to consider comparable transactions. If I were to search “fair market value” in my tax research software, it would come up with a million hits. Figuring out what an arm’s length person would be willing to pay is one of the most common – and challenging – determinations a business has to make. At the end of the day, you need to imagine you are pricing this transaction out and shopping it around. What would someone be willing to pay? That is the amount you should be charging.
When you overlook your tax obligations, costly penalties can accumulate. In addition to paying these penalties, the process of becoming compliant typically involves reporting what has been missed and trying to put records into place. It’s also worth looking at the other side of the transaction to determine whether the other party is willing or able to pay. If your oversights go back more than one year and you detect them before the CRA does, you could do a voluntary disclosure, which is an act of good faith that may reduce the penalties you are obligated to pay. In some cases, the solution might also be to give a taxable benefit to a third party, in order to equal out any unfair advantages you gave to family and friends.
Once you become compliant, you should ensure you do the right thing going forward to avoid further complications and penalties. You need to adopt a consistent system that treats everyone like a third party. If a stranger walked through the door, what would you charge them to do what you’re doing? That’s the standard you should apply to everyone.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.