Navigating the Labyrinth of "Related Persons" in Canadian Tax Law

In the world of Canadian tax, the term "related persons" carries significant weight. It’s a concept that can seem straightforward on the surface, but the reality is a complex web of rules that can impact everything from how you report income to the deductibility of certain expenses. For small and medium-sized business owners, understanding these rules is crucial to ensure compliance and avoid any unwelcome surprises from the Canada Revenue Agency (CRA).

At Modern Axis CPA, we believe in empowering our clients with the knowledge to make informed financial decisions. This blog post will demystify the concept of "related persons" in a reader-friendly way, using plenty of examples to illustrate these important rules.

Why Does "Related" Matter to the CRA?

The core reason the CRA is interested in transactions between related persons is the principle of "arm's length." An arm's length transaction is one where two independent parties, acting in their own self-interest, negotiate a deal. The price and terms are assumed to be fair market value.

When parties are "related," the CRA presumes they are not dealing at arm's length. This means there's a higher chance that transactions between them might not be at fair market value. For instance, you might sell a piece of equipment to your brother for a nominal amount, or a parent company might provide a service to its subsidiary for free.

These non-arm's length transactions can have significant tax implications. The CRA has specific rules in place to prevent related parties from creating artificial tax advantages. It's important to note that while all related party transactions are considered non-arm's length, not all non-arm's length transactions are between related parties.

Who is Considered a "Related Person"?

The Income Tax Act casts a wide net when defining related persons. Let's break it down into individuals and corporations.

Individuals

For individuals, the rules are based on connections by blood, marriage, common-law partnership, or adoption.

• Blood Relationship: This is a key area where the definition is narrower than you might think. It only includes your direct descendants (children, grandchildren), ancestors (parents, grandparents), and siblings. This means your aunts, uncles, nieces, and nephews are not considered related to you by blood for tax purposes.

  • Example: If you sell a car to your sister, you are considered related. If you sell that same car to your nephew, you are not.

• Marriage or Common-Law Partnership: You are related to your spouse or common-law partner, and to their relatives, as if they were your own.

  • Example: You are considered related to your mother-in-law.

• Adoption: An adopted child is considered the child of the adoptive parent for tax purposes.

It's also worth noting the broad definition of a "child," which includes children of your spouse and even spouses of your children (your son-in-law or daughter-in-law).

Here is a rewritten "Individuals" section with more detailed examples, including how relationships are combined and how separation and divorce affect the "related person" status.

Related Individuals: A Closer Look

For tax purposes, individuals are considered related to one another if they are connected by blood, marriage, common-law partnership, or adoption. Understanding these connections is key, as it determines whether you are dealing at arm's length.

Included Relationships (What Makes You Related)

Here are the primary ways individuals can be considered related:

• Blood Relationship: This category is narrower than many people assume. It only includes individuals in a direct line and siblings.

  • Example: You are related to your parents, your children, your grandparents, your grandchildren, and your brothers and sisters.

• Marriage or Common-Law Partnership: You are related to your spouse or common-law partner.

• Adoption: A legally adopted child is considered the child of the adoptive parent.

• Extended Definition of "Child": The term "child" is broad. It includes not only your biological or adopted children but also your spouse's or common-law partner's children (stepchildren) and the spouses or common-law partners of your children (your son-in-law or daughter-in-law).

How Blood and Marriage/Partnership Connections Combine

The rules extend to your in-laws. You are considered related to individuals who are connected by blood to your spouse or common-law partner.

• Example (Father-in-law): Your father-in-law is your spouse's parent. Since your spouse is connected to their father by a blood relationship, and you are connected to your spouse by marriage, you are considered related to your father-in-law.

• Example (Brother-in-law): Your brother-in-law is your spouse's sibling. He is connected to your spouse by blood, which makes him related to you through your marriage.

• Example (Daughter-in-law): You are related to your son's wife. She is connected to you through her marriage to your son, who is connected to you by blood.

Excluded Relationships (Who is Not Related)

It is just as important to know who is not considered a related person under these specific rules.

• Example (Aunts/Uncles): Your aunts and uncles are not in your direct ancestral line, so they are not considered related to you by blood for tax purposes.

• Example (Nieces/Nephews): Similarly, your nieces and nephews are not your direct descendants and are excluded from the definition.

• Example (Cousins): Cousins are also not considered related persons under these rules.

• Example (In-laws of Siblings): While you are related to your brother, you are not considered related to your brother's father-in-law. There is no direct link combining your blood relationship with your brother to his spouse's blood relatives.

The Impact of Separation and Divorce

The "related person" status can change when a relationship breaks down.

• Married Couples: For legally married individuals, you remain related for tax purposes until you are legally divorced. A period of separation does not end the related-person status. Once a divorce is finalized, you cease to be connected by marriage to your former spouse and, consequently, to their relatives (e.g., your former in-laws).

• Common-Law Partners: The rules are different for common-law partners. You are considered separated after you have been living apart for a period of at least 90 consecutive days due to a breakdown in the relationship. Once this 90-day period is complete, your status as related persons is considered to have ceased as of the date you first started living apart.

Corporations

The rules for corporations are more complex and often revolve around the concept of "control." A person is related to a corporation if:

1. They control the corporation.

2. They are related to the person who controls the corporation.

3. They are part of a "related group" that controls the corporation.

Control, for the purposes of determining if parties are related, generally refers to de jure control, which is the ownership of enough shares to give you more than 50% of the votes.

Two corporations can also be related to each other in several ways, most commonly when:

• They are controlled by the same person or group.

• The person controlling one corporation is related to the person controlling the other.

Example: Alex owns 100% of the shares of Company A. Alex's sister, Sarah, owns 100% of the shares of Company B. Company A and Company B are considered related corporations because the individuals who control them (Alex and Sarah) are related.

"Associated" vs. "Related": What's the Difference?

To add another layer, the Income Tax Act also has the concept of "associated corporations." While there is overlap, "related" and "associated" are not the same thing.

• Related Corporations: This is a broader category used to identify non-arm's length relationships.

• Associated Corporations: This is a more specific set of rules designed to prevent businesses from multiplying their access to certain tax benefits, most notably the small business deduction. Associated corporations are required to share this deduction.

The rules for associated corporations are even more complex and consider both de jure (legal) and de facto (factual) control. This means that even if you don't have majority ownership, if you have significant influence over the corporation's decisions, you could be considered to have de facto control.

Practical Implications for Your Business

Understanding these relationships is crucial for proper tax reporting and planning. Here are some key areas where these rules come into play:

• Corporate Tax Filings: Your T2 corporate tax return includes Schedule 9, which requires a list of all related and associated corporations.

• Tax Planning: The related-party rules are a cornerstone of our Tax Planning & Compliance services. Proper structuring of your business affairs can help you navigate these rules effectively.

The Takeaway

The rules surrounding related persons in Canadian tax law are intricate and can have a significant impact on your business. The examples provided here offer a glimpse into this complexity, but every situation is unique.

At Modern Axis CPA, we specialize in helping small and medium-sized businesses in Victoria and beyond navigate these complexities. From corporate tax filings to strategic tax planning, we're here to provide the clarity and expertise you need.

If you have questions about your own situation or want to ensure you're on the right side of these regulations, don't hesitate to contact us.