Questions? Call 416-367-4222
Canadian Income Tax Tests for Factual Non-Arm's Length

Published: June 17, 2021

Introduction – Factual Non-Arm’s Length under the Income Tax Act

The concept of non-arm’s length is important in Canadian Tax Law. There are several significant tax implications under the Income Tax Act that can result when two parties to a transaction deals at non-arm’s length. For example, section 69 of the Income Tax Act applies to a transfer of capital property under fair market value between two non-arm’s length parties. Section 69 deems the receiver of the property to have acquired the property at fair market value, thus often triggering unexpected capital gain tax for that taxpayer.

Section 251 of the Income Tax Act offers three categories where the Income Tax Act deems two parties to be dealing at non-arm’s length. These categories are:

  1. “related persons” as defined in subsection 251(2);
  2. A taxpayer and his or her personal trust ; and
  3. Factual non-arm’s length

This article will cover the topic of the factual non-arm’s length rule under paragraph 251(1)(c). The Income Tax Act does not specifically define factual non-arm’s length. Therefore, we must look to the relevant tax case law to determine the criteria for factual non-arm’s length.

The Test for Factual Non-Arm’s Length

The Supreme Court of Canada first examined the concept of factual non-arm’s length in Canada v. McLarty and formulated the test as the following:

  •       was there a common mind which directs the bargaining for both parties to a transaction;
  •       were the parties to a transaction acting in concert without separate interests; and
  •       was there “de facto” control

We will briefly discuss each component of this three-part test below.

Common Directing Mind – the Merritt Estate test

The test for the existence of a common mind directing the bargaining was laid down in M.N.R. v. Merritt et al., [1969]. The Merritt test was recently affirmed in a Tax Court of Canada decision Damis Properties Inc. v. The Queen, [2021].

The Merritt test was formulated in Damis as:

. . . where the “mind” by which the bargaining is directed on behalf of one party to a contract is the same “mind” that directs the bargaining on behalf of the other party, it cannot be said that the parties are dealing at arm’s length.

Common directing mind test is formulated to look at whether two corporations or a person and a corporation are dealing at non-arm’s length.

For example, in a transaction between two corporations, when one person exercises a very high level of power and influence over both corporations as a matter of fact, then that person is likely the common directly mind of both corporations regardless of that person’s legal rights under corporate law.

Acting In Concert – Poulin and Sushi Sales Ltd.

The acting in concert component of the factual non-arm’s length test was recently discussed by the Tax Court of Canada in Poulin v. The Queen. [2016]. The Court in Poulin stated the acting in concert test as:

in order to determine whether or not parties are acting in concert, without a separate interest, one must examine whether they are acting for their own benefit, or for that of someone else:

The Court went on to state that the existence of a negotiation process, or even the existence of conflicts between the parties during the transaction does not rule out the parties to have acted in concert.

However, the acting in concert is often mistakenly stated as a common purpose or common interest test, as opposed to lacking any separate interest. This is a serious misreading of the acting in concert test.

Such misreading would unreasonably widen the factual non-arm’s length test to cover business dealings with a mutually beneficial interest shared by both parties. The Tax Court of Canada addressed this error in Sushi Sales Ltd. v the Queen [2003]:

To say that every time two independent business persons in pursuit of [their] own business interests work together to achieve a mutual beneficial commercial objective means that they are “acting in concert” and are, therefore, not at arm’s length would mean that no business relationships would ever be at arm’s length.

The difference between a mutually beneficial common interest and acting in concert without separate interest can be highly nuanced. Canadian taxpayers with doubts whether the acting in concert test applies to them should consult an experienced Canadian Tax Lawyer for further tax guidance and expert tax advice.

De Facto Control – Keybrand Foods Inc.

The Federal Court of Appeals in Keybrand Foods Inc. v Canada addressed the de facto control component of the test. The Court stated:

In my view, there is no practical difference between the concepts of de facto control and directing mind, in relation to the determination of whether two persons are dealing with each other at arm’s length. If a person is the directing mind for a particular transaction, that person would also have de facto control of the terms and implementation of that transaction and vice versa.

The Court then noted that financial dependence between two parties made it more likely than not that their relationship was a non-arm’s length one.

Pro Tax Tips – Failure to Report Non-Arm’s Length Transaction Correctly Can Attract Serious Consequences

Besides section 69 consequences for non-arm’s length transfer of capital property, non-arm’s length transaction can also attract serious consequences such as withholding tax on interest payment made to a foreign lender under subsection 212(1) of the Income Tax Act. Additionally, section 84.1 of the Income Tax Act denies a taxpayer’s otherwise tax-free return of paid-up capital when the taxpayer and the purchaser corporation do not deal at arm’s length.

The factual non-arm’s length rule under paragraph 251(1)(c) can operate to deem a transaction to be non-arm’s length even when the relationship between the parties does not fall under the definition for related persons under the Income Tax Act or the definition for personal trust. Consult with an experienced Canadian tax lawyer if you have any issues with disputing a CRA tax assessment against you based on CRA’s determination that a particular transaction was non-arm’s length.


"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."


The mere presence of separate legal counsel or independent legal advice for a formal negotiation process are not sufficient to render a transaction non-arm’s length.

The mere presence of financial dependence does not render two parties to be dealing at non-arm’s length. However, a high level of financial dependence could serve as strong evidence that one party has de facto control over another, thus making their relationship non-arm’s length.

Get your CRA tax issue solved

Address: Rotfleisch & Samulovitch P.C.
2822 Danforth Avenue Toronto, Ontario M4C 1M1