The June, 2011 Canadian Federal Budget (the Budget) proposes to introduce certain rules under the Income Tax Act (Canada) relating to registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) (collectively, Registered Plans) that previously applied only to tax-free savings accounts (TFSAs), being (a) the “advantage” rules, (b) certain “non-qualified investment” rules, and (c) the “prohibited investment” rules. The “advantage” rules generally target structures and transactions that may disproportionately shift income or assets into or out of a Registered Plan, or that are otherwise viewed as exploiting or abusing the tax attributes of a Registered Plan. The Budget proposes to replace the income inclusion and deduction mechanism and the 1% monthly tax with respect to Registered Plans that hold “non-qualified investments” with a special tax (refundable in some cases) equal to 50% of the fair market value of the “non-qualified investment”. This bulletin focuses on the “prohibited investment” rules.
As a result of the Budget proposals, shares of corporations that are “qualified investments” for Registered Plans could be “prohibited investments” for Registered Plans of some shareholders and subject to onerous penalty taxes. Similar rules apply with respect to interests in trusts and partnerships, as well as to investments in debts of corporations, trusts and partnerships.
Generally, a shareholder will hold a “prohibited investment” if he or she holds shares of a corporation (the Subject Corporation) in his or her Registered Plan and:
- holds (together with related persons and other non-arm’ s length persons) 10% or more of any class or series of shares of the Subject Corpora tion (the 10% Threshold);
- does not deal at arm’s length with the Subject Corporation (regardless of the number of shares held);
- holds certain interests (generally similar to the 10% Threshold) in another entity (i.e. another corporation, partnership or trust) that does not deal at arm’s length with the Subject Corporation; or
- could hold a “prohibited investment” upon the exercise of certain options or similar rights.
If a Registered Plan holds a “prohibited investment”, the consequences are significant:
- The shareholder will generally be subject to a one-time tax equal to 50% of the fair market value of the investment held by the Registered Plan. A grandfathering rule provides relief if the shares were qualified investments prior to March 22, 2011 and they are disposed of before the end of 2012.
- In addition, to the extent that income (including dividends and capital gains) is derived from the shares after March 22, 2011, a special tax equal to 100% of that income will generally be levied upon the shareholder (without grandfathering).
In some cases the CRA has the discretion to waive or cancel some or all of these taxes, but it is not yet known how the CRA will exercise its discretion. Anybody who may potentially be caught by the new rules should contact their tax advisors.
The appropriate solution will generally depend upon a shareholder’s particular circumstances. For example, suppose that (a) Mr. X owns 16% of the shares of the Subject Corporation (8% within his RRSP and 8% outside of his RRSP), (b) Mr. X deals at arm’s length with the Subject Corporation, (c) the shares held by Mr. X have increased in value since he acquired them in 2002, and (d) Mr. X holds his shares as capital property. Mr. X would hold a “prohibited investment” because his holdings exceed the 10% Threshold. Mr. X may want to consider the following options:
- Mr. X could withdraw the shares that he holds within his RRSP. This would generally be treated as a withdrawal from his RRSP in an amount equal to the fair market value of the shares withdrawn, in which case Mr. X would have to include this amount in his taxable income for the year in which the withdrawal was made.
- Mr. X could sell just over 6% of the shares that he holds outside of his RRSP to an arm’s length buyer. This would bring him under the 10% Threshold but would generally result in a capital gain to Mr. X, in which case Mr. X would have to include one-half of the capital gain in his taxable income for the year in which the shares were sold.
- Mr. X could sell just over 6% of the shares that he holds in his RRSP to an arm’s length buyer and reinvest the proceeds from the sale within his RRSP. This would bring Mr. X under the 10% Threshold and would not give rise to a taxable disposition.
- Mr. X. could swap the shares that he holds in his RRSP for cash or other property equal to the fair market value of those shares. Mr. X would then hold the entire 16% of his shares outside of his RRSP, and his RRSP would hold cash or other property with a fair market value equal to the value of the shares that were withdrawn. Provided that the fair market values of the shares removed from the RRSP and the cash or other property contributed to the RRSP are equal, this should not result in a taxable event. However, any such transaction should be carefully structured and should be supported by a valuation of any property transferred.
Several institutions are refusing to process “swaps” and similar transactions pending clarification of the tax rules.
Please note that detailed legislative provisions have not yet been released to implement the above-noted amendments, so the rules discussed above are still subject to change and our comments are qualified entirely on that basis.