We often see a transaction between related parties that is carried out at a price below the fair market value (“FMV”). However, the proceeds are agreed upon by both parties, making the transaction of commercial substance. Do both related parties benefit from such an arrangement? Not necessarily, at least not from a tax perspective. Let’s look at this in the eyes of the CRA. 

In a technical interpretation released by the CRA 2020-086520, a hypothetical situation was given and the CRA was asked about their position on some key issues. We summarized the situation below:

1. Mr. A and Mr. B are not related to each other, and they are the sole shareholder of Aco and Bco respectively. The two companies are operating active businesses.

2. Mr. A and Mr. B each hold 50% shares of ABco, a company that builds commercial condominiums with the aim of reselling them. 

3. ABco built many condo units. Two of them were each sold to Aco and Bco at the price of $150K, and the rest of them were sold to third parties at $200K each.  

4. Mr. A and Mr. B are aware that the sale price of the two condo units were below FMV, however, the transactions were carried out at the price they would have agreed between them. 

There are a few questions being asked of CRA based on these given facts. The one question we focus on in our discussion is as follows:

Would subsection 56(2) apply to the given situation, so that each of Mr. A and Mr. B would have to add $ 50,000 to his income, namely the excess FMV on the price paid for each of the condo units?

Discussion:

Subsection 56(2) of the Income Tax Act (“ITA”) allows the value of a benefit to be included in a taxpayer's income. And it will apply when the following four (4) conditions are all met:

1. The transfer is made to a person other than the taxpayer;

2. The transfer is carried out following the instructions or with the agreement of the taxpayer;

3. The transfer is made for the benefit of the taxpayer or any person whom the taxpayer wishes to benefit;

4. The transfer would have been included in computing the taxpayer's income if the taxpayer, instead of the other person, had received it.

The facts presented in this given situation are insufficient to determine whether subsection 56(2) would apply. However, in light of this assumption that if Mr. A and Mr. B are responsible for making decisions on behalf of both the seller and the buyer, it could be argued that the sale of the condo units by ABco in favor of Aco and Bco was made with the instructions or with the agreement of each of Mr. A and Mr. B.

Further, if Mr. A and Mr. B would have agreed on a sale price to their respective companies for an amount lower than the FMV, it could be argued that they both wanted to benefit their respective companies.

If ABco had sold the condo units directly to Mr. A and Mr. B and not to their respective companies, subsection 15(1) would have applied to include the $50K shareholder benefit (being the FMV $200K over the price paid $150K) in computing Mr. A’s and Mr. B’s income respectively.

And if the above arguments lead to meeting of all the conditions, then subsection 56(2) could apply to both Mr. A and Mr. B, meaning that each of them would have to include $50K in their income with respect to this transaction. 

In addition to this potential treatment, there may be twoconditions other tax effects arising from this transaction. If the facts indicate a non-arm's length relationship between ABco and each of Aco and Bco, then subsection 69(1) would take effect. ABco would be deemed to have disposed of the condo units at the FMV, and Aco and Bco would each be stuck with the sale price as its adjusted cost base (“ACB”) of the condo unit acquired by virtue of the sales agreement. 

Combining the above tax treatments, we would have: 1. $50K deemed business income being taxed in the hands of ABco (assuming the cost of each condo unit is equal to $150K); 2. $50K being taxed in hands of each of Aco and Bco as capital gain in future disposition; 3. $50K being taxed under each of Mr. A and Mr. B as shareholder benefits. We would call it the triple-taxation effect. 

Conclusion:

Taxpayers should be cautious when negotiating the sale or transfer of property between parties in the context of the same controlling group. Negative and sometimes punitive tax consequences could offset the benefit of the original planning. If you are ever faced with similar situations, please make sure you consult your tax accountant before executing any deal. Our team at Helen Ge CPA is always here to help you avoid tax traps like this. 

References:

-Video Tax News monthly tax update

-CRA IT2020-086520

-ITA subsection 15(1), subsection 56(2), subsection 69(1), paragraph 251(1)(c)