In Budget 2012, the Government proposed to expand the "prohibited investment" and "advantage" tax regimes that were first unveiled in 2009 as the anti-avoidance control for Tax-free Savings Accounts ("TFSAs"). Having previously extended the penalty taxes in respect of "prohibited investments" and "advantages" to RRSPs and RRIFs (collectively with TFSAs, "Registered Plans"), the Government announced in Budget 2012 the further expansion of these concepts to RCAs.
In simplified terms, an RCA is defined in the Income Tax Act (Canada) (the "Tax Act"), subject to specific exceptions, as a plan or arrangement under which contributions1 are made by a current or former employer of a taxpayer (or a person with whom the employer does not deal at arm's length) to a custodian in connection with benefits to be received by any person on, after, or in contemplation of any substantial change in the services rendered by the taxpayer, the taxpayer's retirement or the loss of the taxpayer's office or employment.
The taxation of RCAs is subject to a special set of rules. Contributions made to, and income earned in, an RCA is normally subject to a 50% refundable tax. Employers are typically eligible to claim a deduction in respect of contributions made to an RCA. Finally, amounts paid from an RCA are generally subject to income tax withheld at source and, where the custodian has filed the required return, may trigger the repayment of the 50% refundable tax.
Additional information with respect to what constitutes an RCA, and the general tax treatment of RCAs, can be found at http://www.cra-rc.gc.ca/tx/bsnss/tpcs/pyrll/clcltng/spcl/rrngmnt-eng.html.
Since RCAs are already subject to a 50% refundable tax on all contributions and investment income, one might ask why new anti-avoidance measures relating to RCAs are required. Over the past several years, the Canada Revenue Agency (the "CRA") has undertaken a special audit project that has specifically targeted RCAs for review. In the context of such reviews, specific questions have been posed as to the constitution of the relevant RCA and any specific debtor/creditor relationships involving the RCA. The Government states that it has been concerned that RCAs have been involved in a "number of arrangements" that abuse the RCA refundable tax rules. Of particular concern to the CRA are structures that involve large contributions to an RCA, which are invested in a way that permits the contributions to ultimately be returned to the contributors. Under such circumstances, the investments held by the RCA become worthless, but the refundable tax (50% of the original contributions) is recovered under the RCA rules dealing with impaired assets. Budget 2012 also refers to insurance products paid for through an RCA that result in benefits being realized outside the RCA such that they are not taxable as RCA distributions. While the CRA has challenged such arrangements on the basis of the existing anti-avoidance provisions in the Tax Act, the Government asserts that more direct legislative action is required.
Details of the proposed legislative framework for the expansion of the "prohibited investment" and "advantage" tax regimes to RCAs have not been expressly provided by the Government. Rather, Budget 2012 and the accompanying Notice of Ways and Means Motion specify that the new RCA regime will be modelled on the existing rules applicable to Registered Plans, building on the existing concepts of "advantage", "prohibited investment", "significant interest" and "swap transaction" found in those rules.
Budget 2012 specifically proposes that the new "prohibited investment" restrictions will apply in respect of RCAs that have a "specified beneficiary". A "specified beneficiary" of an RCA will be an individual who has an interest or right in respect of an RCA and who has a "significant interest" in an employer in respect of the RCA. In other Tax Act provisions, a person is considered to have a "significant interest" in a corporation if they own, directly or indirectly, at any time in the relevant year, 10% or more of the issued shares of any class of the capital stock of the corporation or of any other corporation that is "related" to the corporation.2 Similarly, an individual will have a "significant interest" in a trust or partnership if he/she, either alone or together with persons or partnerships with whom they do not deal at "arm's length", holds interests that have a fair market value of 10% or more of the fair market value of the interests of all members of the partnership or beneficiaries under the trust, respectively.
Under the proposed RCA regime, a 50% penalty tax will be levied on the value of "prohibited investments" acquired or held by an RCA with a "specified beneficiary". Similarly, the proposed rules will impose a 100% penalty tax on the value of "advantages" obtained by a "specified beneficiary" or a person who does not deal at arm's length with the specified beneficiary. In addition, under the proposed RCA regime, the RCA rules dealing with impaired assets (which allow an RCA to recover the 50% refundable tax) will not be available in respect of contributions made on or after Budget Day (i.e., March 29, 2012) where the decline in value of the assets is reasonably attributable to a "prohibited investment" or an "advantage" (unless the Minister of National Revenue is satisfied that it is just and equitable to refund such tax).
Under the existing rules applicable to Registered Plans, a "prohibited investment" includes (i) the debt of a annuitant/holder (a "Plan Holder") (other than certain insured mortgages), (ii) investments in entities (A) in which the Plan Holder has a "significant interest", (B) which do not deal at arm's legth with entities in which the Plan Holder has a "significant interest", or (C) with which the Plan Holder does not deal at arm's length, and (iii) certain "prescribed property" (including shares of a "specified small business corporation" that cease to qualify as such). Based on this existing language, the new RCA rules may have adverse implications for "specified beneficiaries" who hold (either on their own, or together with non-arm's length persons) significant interests in corporations, trusts or partnerships, where their RCA also holds investments in those entities.
Likewise, under the existing rules applicable to Registered Plans, the definition of an "advantage" is quite broad and includes benefits obtained from a variety of transactions intended to exploit the tax attributes of a Registered Plan (including, but not limited to, income and capital gains from "prohibited investments"). Custodians and beneficiaries of RCAs will need to carefully examine the formal text of the new proposals, when released, to ensure that unexpected consequences are not triggered by the enactment of the new proposals.
The new penalty taxes will generally apply to investments acquired after March 29, 2012 and to investments that become "prohibited investments" after that date. The tax on "advantages" will apply to "advantages" extended, received or receivable on, or after, March 29, 2012, other than certain specified advantages that relate to property acquired, or transactions occurring, before that date, provided certain transitional conditions are satisfied.
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The expansion of comparable anti-avoidance rules to RRSPs and RRIFs in Budget 2011 caused significant concern among investment fund managers and promoters, especially in the start-up phase of funds. Employers and executives contemplating new RCAs, and those with existing RCAs, must carefully consider the impact of the proposed changes to the RCA rules and the specific language of the eventual amendments to the Tax Act.