What is an arm's length employee?

By: Updated: April 13, 2022

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When you own a family business, you may have two types of employees: arms-length and non-arm’s length. In this article, we’ll discuss non-arm’s length employees, who are relatives such as your spouse, children and siblings.

 

Why does it matter?

It can have an impact on the eligibility of your non-arm’s length employees to collect Employment Insurance. EI premiums for an employee and employer can total almost $2,300 a year, depending on an employee’s earnings. That’s a lot of money to spend if the employee is not eligible for benefits for being laid off, having employment terminated, or for parental leave.

The Canada Revenue Agency (CRA) implemented the rule to prevent family-owned businesses from creating artificial employment and then “laying off” family members so that they can receive EI benefits.

 

Arm’s length definition

What’s the difference between these two types of employees? When you hire someone who is not related to you, it’s an arm’s length relationship. This means that they are a regular employee and are eligible for Employment Insurance coverage. As an employer, you have to deduct EI premiums from their pay and remit these to the CRA; you must also remit the employer’s share of these premiums.

Non-arm’s length employees can include your spouse, children or siblings. Any employment between related persons is not insurable under the EI regulations. This means that these employees would not be eligible to collect benefits if their employment is terminated.

 

What is a non-arm’s length relationship?

So, this sounds simple: If employees are related to you, they are non-arm’s length.

Well, not so fast. The Canada Revenue Agency has a number of rules to allow these staff to be treated as regular employees. This can change the arm’s length meaning. These include:

  • The CRA is satisfied that they would have entered into a similar employment arrangement if it had been an arm’s length relationship.
  • If their compensation is the same as other employees. In other words, if you are paying your spouse double what other employees are making for the same work, this would be deemed non-arm’s length.
  • What are each employee’s hours and days of work? If all employees have similar schedules, a non-arm’s length employee could be considered eligible for EI.
  • Are the same benefits offered to all employees? If so, this could make a difference to how non-arm’s length employees are viewed.

 

Impact on Employment Insurance

As we have indicated, non-arms length employees are ineligible to collect Employment Insurance. If you own a business and have been deducting EI premiums from paycheques and remitting the employer’s share, there are two steps:

  1. Check with the CRA to determine whether you should be deducting EI premiums. They will be able to provide you with a ruling about the arms-length status of your employees.
  2. What to do if your employees are not eligible for EI and you have been remitting premiums: You may be able to claim a refund for both your business and your staff for up to three years. Here is the refund application form.

 

Does this make a difference for CPP?

Good news! Both arm’s length and non-arm’s employees are eligible for CPP. This means that an employer must deduct CPP premiums from each person’s paycheque and contribute the same amount, remitting the entire sum to the Canada Revenue Agency.

While no one likes to see deductions from their paycheque, employees are accumulating CPP benefits over their working lives. It will pay off when they retire because they will receive a CPP cheque or direct deposit every month.

 

Dealing with the Canada Revenue Agency (CRA)

It’s always a good idea to maintain healthy relations with the CRA. If you are unsure about the arm’s length status of your employees, you can request a ruling. This is a pro-active way of dealing with the issue.

However, you may already be in a situation where the CRA is questioning the status of your employees. The CRA warns that if you don’t fulfill your obligations and comply with payroll regulations, you may face penalties and interest charges. So, it’s a good idea to sort out the situation as quickly as possible.

If the CRA has made a ruling and you don’t agree, there are steps you can take:

  1. Call the tax office. You may be able to sort it out quickly with the CRA over the phone.
  2. If that doesn’t work, you can file a formal appeal. You can do this via your online My Business CRA account. Or you can complete the official appeal form.

When you employ family members, you must be careful to follow all of the CRA rules. Sometimes family members are “non-arm’s length” and are not eligible to receive EI benefits. This means that you should not be deducting EI premiums from their paycheques and remitting the employer’s share of premiums. Check with the CRA to clarify the status of your employees who are family members. If you have been remitting EI premiums and should not have been doing so, you may be eligible for a refund.

 

How to write off 100% of your medical expenses

Are you an incorporated business owner with no employees? Learn how to use a Health Spending Account to pay for your medical expenses through your corporation: 

Download the HSA Guide for Incorporated Individuals

Do you own a corporation with employees? Discover a tax deductible health and dental plan that has no premiums:

Download the HSA Guide for a Business with Staff

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