Carter: TCC Confirms Family Members Can Deal at Arm’s Length for the Purposes of Section 84.1

In Carter v. The King (2024 TCC 71), the TCC held that a transaction between two family members who were not “related persons” within the meaning of subsection 251(2) occurred at arm’s length for the purposes of section 84.1 . In so concluding, the TCC reaffirmed that in an analysis of whether two or more persons acted in concert, without separate interests, the circumstances leading to the culmination of a transaction and the parties’ manner of dealing with one another are critical.

In the late 1990s, the appellant (Kathryn) and her cousin (Corey) began working at the family business, Brown’s Paving Ltd. (“BPL”), which was then wholly owned by the appellant’s father (Wallace). Corey worked for BPL full-time, while Kathryn worked for BPL in the summers during years she was in school, and full-time when she was not in school.

In 2007, Kathryn and Corey separately approached Wallace to request an ownership stake in BPL. As a result of these conversations, Wallace undertook an estate freeze to lock in his existing equity value while maintaining control over BPL through voting preferred shares. Kathryn, Corey, and Wallace then subscribed for, respectively, 40 percent, 40 percent, and 20 percent of BPL’s common shares.

In 2014, Corey approached Kathryn about buying her shares in BPL. The business was facing mounting competition, and its ability to compete was hampered by the need to siphon off some of its profits to Kathryn. Notwithstanding Corey’s desire to acquire Kathryn’s shares, he had no ability, under BPL’s shareholders’ agreement, to compel her to sell (absent a triggering event, which had not occurred), because the shareholders’ agreement did not contain a “shotgun” clause. Although Kathryn had not previously considered selling her shares, she eventually decided that she should do so because she wanted to start a family and was not enjoying her long commute to and from work.

Kathryn and Corey could not agree on a price for the shares and ultimately had the business valued. After the valuation, the parties agreed on a price of $600,000, but Kathryn imposed two conditions on the sale: the money had to be paid upfront, and she had to be able to use her capital gains deduction.

Wallace was not involved in the negotiations between Kathryn and Corey or in the structuring of the transaction. As Graham J noted, it was not clear why Wallace remained passive, given that, as the controlling shareholder of BPL, he could have directed how the transactions occurred.

Corey needed a loan to finance the purchase and wanted to ensure that interest on that loan would be deductible. After the parties agreed to Kathryn’s conditions (that she would be paid upfront and be able to use her capital gains deduction), Corey and Kathryn used BPL’s lawyer to document the transaction, and they retained an accounting firm, suggested by the lawyer, to provide tax advice.

To fund the purchase, the following transactions occurred:

1. Corey incorporated Corco Holdings Inc. (“Corco”).
2. Corey transferred his shares of BPL to Corco in exchange for shares of Corco. This transaction occurred on a tax-deferred basis pursuant to subsection 85(1).
3. BPL borrowed $600,000 from a bank.
4. Corco purchased all of Kathryn’s BPL shares with a $600,000 promissory note.
5. BPL redeemed the shares that Corco had acquired from Kathryn in exchange for $600,000 cash, resulting in a deemed dividend for Corco, which was deducted under subsection 112(1).
6. Corco used the cash to pay the $600,000 promissory note owing to Kathryn.

Kathryn reported a capital gain and claimed her capital gains deduction. The CRA reassessed her on the grounds that the proceeds of disposition should be recharacterized as a dividend under section 84.1.

Section 84.1 is often a concern for those undertaking transaction structures similar to the one implemented in Carter, in which one family member sells a business to another family member who facilitates the sale by using a new corporation to borrow the funds necessary to acquire the business. For section 84.1 to apply, a number of conditions must be satisfied, of which two were at issue in Carter:

1. The taxpayer and the purchaser corporation must not deal at arm’s length.
2. Immediately after the disposition, the subject corporation (BPL, in this case) and the purchaser corporation (Corco) must be “connected” within the meaning in subsection 186(4).

Arm’s-Length Dealing

The main issue in Carter was whether Kathryn dealt at arm’s length with Corco when she sold her BPL shares. There are two possible ways for an individual and a corporation not to deal at arm’s length: (1) the individual and the corporation are “related” and therefore deemed not to deal at arm’s length under paragraph 251(1)(a); or (2) they are considered to factually not deal at arm’s length under paragraph 251(1)(c).

The Crown and the appellant agreed that Kathryn and Corco were not related. Kathryn and Corey were not connected by blood relationship and so were not related to one another pursuant to paragraph 251(2)(a), meaning that Kathryn and Corco could not be related under paragraph 251(2)(b).

The TCC instead considered whether the taxpayer and Corco factually did not deal at arm’s length. Following Keybrand Foods Inc. v. Canada (2020 FCA 201), two parties will generally not be considered to be dealing at arm’s length if:

1. there is a common mind that dictates the terms of the transaction; or
2. both parties act in concert and without separate interests.

The Crown argued in Carter that the relevant test was whether the two parties acted in concert, without separate interests. Its position was that Corco was a mere facilitator that allowed Kathryn to claim her capital gains deduction and had nothing to gain from the transaction.

The TCC held that Corco was not a mere facilitator for Kathryn. Corco greatly benefited from the acquisition because it increased its beneficial interest in BPL. The share purchase was undertaken in pursuit of Corey and Corco’s own interests. Furthermore, the acquisition was structured to benefit Corco, allowing the company to finance the share purchase and ensuring that the interest paid was deductible by BPL. Kathryn, in contrast, was indifferent as to how the share purchase was financed so long as she was paid upfront.

The concept of the purchaser corporation as a mere facilitator implies that the seller was the driving force behind the transactions. This was clearly not the case in Carter: Corey initiated the share acquisition as a step in his long-term plan to own BPL, while Kathryn had not previously considered selling her shares and could not have been compelled to do so while she remained employed by BPL. Furthermore, if Corco were a mere facilitator, Corey and Kathryn would not have engaged in hard bargaining, and Kathryn would not have put conditions on the sale.

The TCC also rejected the Crown’s argument that the parties were in the same position as if BPL had redeemed Kathryn’s shares with borrowed money. There was no evidence that BPL had any right to redeem or purchase the shares. Rather, the share purchase required Kathryn’s consent.

The court found that Kathryn and Corey had pursued their own interests and, as a result of hard bargaining, had arrived at an arrangement that was satisfactory to both parties. For two parties to act in concert without separate interests, according to the court, “there must be something more than sharing the same tax advisors and having a common interest in getting the deal done.” That “something more” was missing in this case, and therefore Kathryn and Corco dealt at arm’s length.

Meaning of “Connected”

Having concluded that Kathryn and Corco dealt at arm’s length, the TCC did not need to consider the issue of whether Corco and BPL were “connected,” but it briefly addressed this question nonetheless. The court found that Corco and BPL could not have been connected under paragraph 186(4)(b) because Corco did not own more than 10 percent of the voting shares of BPL. Moreover, because there was no evidence that Corco and Wallace did not deal at arm’s length, Corco and BPL could not be connected under paragraph 186(4)(a), read together with subsection 186(2) .

The potential impact of section 84.1 on genuine transfers of ownership between family members has been a topic of much discussion in recent years (including in past issues of this newsletter). Although Carter does not change the analysis for transactions between family members who are related, it does illustrate that two individuals with close ties can nevertheless deal at arm’s length when the tension created by ordinary market forces dictates their behaviour.

*This article was originally published in the Tax for the Owner-Manager, volume 24, issue 3 in 2024. This article was co-authored by Camille Belanger.