A target’s reported profitability can be entirely accurate and still be misleading, if part of it depends on terms only available because the seller was dealing with themselves. Related-party arrangements do not automatically transfer to a new owner on the terms shown in the historical statements, and some do not transfer at all.
Key takeaways
Non-arm’s-length pricing gets its own correction mechanism in the Income Tax Act, which is a useful thing for a buyer to know even outside a tax context. Subsection 69(1) provides that where a taxpayer “has acquired anything from a person with whom the taxpayer was not dealing at arm’s length at an amount in excess of the fair market value” the taxpayer is deemed to have acquired it at fair market value instead — and the mirror rule applies where property is disposed of to a non-arm’s-length person for less than fair market value. Separately, subsection 15(1) requires that where a corporation confers a “benefit… on a shareholder”, the value of that benefit is included in the shareholder’s income. Neither provision was written with a business buyer in mind — they exist to stop tax results from turning on who is dealing with whom — but they are the Act’s own confirmation that related-party pricing is a recognized way for numbers to drift from what an arm’s-length transaction would show. A buyer is doing the same correction for a different purpose: pricing what the business will actually cost and earn once you, not the seller, are the counterparty on every one of these arrangements.
A treadstonelaw.ca answer on this exact question names the mechanism directly: “If a business sells to, buys from, employs, or leases space from a company or person connected to the owner, transactions that wouldn’t happen on the same terms with a stranger can quietly boost the numbers.” deavo.ai’s own guide to reading financial statements before a purchase lists the same pattern among its core red flags: “related-party or non-arm’s-length pricing including rent paid to a property the owner also owns”, alongside “loans to/from related parties or shareholders.” In practice the recurring list is short: below- or above-market rent to an owner-held property company; management or consulting fees paid to a business the owner or a family member controls; intercompany receivables and payables that never settle on commercial terms; and family members on payroll at a rate that does not match the market rate for the work performed.
The recommended fix is not to argue with the seller about whether the arrangement is fair — it is to rebuild the numbers without it. As the same treadstonelaw.ca answer puts it, the buyer’s accountant should “model the numbers without those arrangements in place,” putting the business on “arm’s-length terms instead of as reported.” That means substituting a defensible market rate for the related-party rent, fee or wage, and testing what the reported earnings look like once that substitution is made in both directions — correcting a benefit the seller was extracting, and correcting an expense the seller was absorbing that a new owner will actually have to pay.
The comparison only holds up if it is defensible. deavo.ai’s explainer on SDE versus EBITDA is blunt about where this goes wrong: “aggressive or unsupported add-backs” are “one of the more common points of pushback during due diligence.” An add-back that says “rent adjusted to market” without a comparable lease or an appraisal behind it is an assertion, not a correction, and a lender or a co-investor reviewing the same numbers will treat it that way.
Related-party pricing rarely stays contained to one line. A management fee paid to a related company shows up as an expense that may be allocated unevenly across product or service lines, which is one of the reasons testing gross margin by product or service line needs to happen alongside this exercise rather than after it. And because a related party benefit or a shareholder benefit under section 15(1) has its own tax consequences, an arrangement that looks purely commercial can also be the reason a filed return and the internal books do not match — see reconciling tax filings to the internal accounts.
Buyers instinctively look for related-party pricing that flatters the numbers, but the opposite pattern is just as real and easier to overlook. An owner who charges below-market rent to their own corporation, or who works substantial unpaid overtime the business has never had to price, is understating what the business will genuinely cost to run once a market-rate replacement is in place. Both directions belong in the same exercise, because both change what the earnings base actually represents going forward.
Take a target reporting $180,000 a year in rent paid to a numbered company the owner also controls, for a location where a genuinely comparable arm’s-length lease in the same market runs closer to $140,000 — both figures set here only as illustrative parameters. On paper, normalizing the rent to $140,000 adds $40,000 to adjusted earnings, which is the number a seller’s broker will often present as the add-back. But the honest version of the exercise also asks what happens to the numbered company’s side of the arrangement: if the property is not included in the sale, the buyer still needs somewhere to operate, and the $140,000 arm’s-length figure — not the historical $180,000 — is the real forward cost, whichever way it moves the adjusted earnings relative to what was reported.
Then it should be easy to support with an independent comparison — a genuinely comparable lease in the same market, or a formal appraisal. Treat the absence of that support as the actual problem, not the disagreement itself.
It can. A benefit conferred by a corporation on a shareholder has its own income-inclusion consequence for the shareholder under the Act, and non-arm’s-length pricing generally can be adjusted for tax purposes independently of anything a buyer does. Those are separate questions from valuation, and worth flagging to your own accountant rather than assuming they wash out together.
Most end or get renegotiated on arm’s-length terms, since the related party on the other side of the deal is usually the departing owner. Build the deal on what the arrangement will cost afterward, not on what it cost while the same person sat on both sides of it.
A short call is enough to walk through which related-party items need independent support before you build them into a valuation.
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