On June 12, 2012, the Department of Finance (“Finance”) sent a letter to the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants, in which it agreed to recommend significant relieving changes to the prohibited investment rules in Part XI.01 of the Income Tax Act (Canada) (the “Tax Act”) as they apply to investments made by RRSPs, RRIFs and TFSAs (collectively, “Registered Plans”).

Initially, the prohibited investment and advantage rules in Part XI.01 of the Tax Act applied only to TFSAs. As part of the 2011 Federal Budget, the application of those rules was extended to RRSPs and RRIFs beginning after March 22, 2011. The Joint Committee and several industry organizations representing the investment community raised serious concerns. Finance’s letter responds to several of those concerns and provides some welcome retroactive relief. It is proposed that the amendments be effective after March 22, 2011.

This bulletin summarizes the current prohibited investment rules and portions of the advantage rules, and describes Finance’s recommended amendments to those rules.

Prohibited Investment Rules

A debt or equity investment in a corporation, trust or partnership may be a “prohibited investment” for an RRSP, RRIF or TFSA even though it is a “qualified investment” for the Registered Plan. The planholder of the Registered Plan is subject to onerous penalty taxes.

The Penalty Taxes

When a Registered Plan acquires a prohibited investment or holds an investment that becomes a prohibited investment, the planholder of the Registered Plan is subject to a one-time, potentially refundable penalty tax equal to 50% of the fair market value (“FMV”) of the prohibited investment. Under a grandfathering rule, the 50% penalty tax does not apply in respect of an investment held by an RRSP or RRIF on March 22, 2011 that first became a prohibited investment before October 4, 2011.

The planholder is entitled to a refund of the 50% penalty tax if two conditions are satisfied. First, the Registered Plan must dispose of the prohibited investment before the end of the calendar year following the year in which the tax was imposed (or at any later time that the CRA considers reasonable in the circumstances). Helpfully, a Registered Plan is deemed to dispose of and to reacquire an investment when it ceases to be a prohibited investment.

Second, it cannot be reasonable to consider that the planholder knew, or ought to have known, at the time the investment was acquired by the Registered Plan, that it was or would become a prohibited investment. In addition to the 50% penalty tax, the planholder of a Registered Plan is subject to a penalty tax equal to 100% of the amount of an “advantage”, which is defined to include a benefit that is income (including a capital gain) that is reasonably attributable, directly or indirectly, to a prohibited investment (including any gain resulting from a deemed disposition of the investment as described above). The 100% penalty tax applies without regard to when an investment was acquired or became a prohibited investment. More specifically, there is no grandfathering for investments held on March 22, 2011.

However, there is transitional relief. A planholder may elect on Form RC341, Election on Transitional Prohibited Investment Benefit for RRSPs or RRIFs, before July 2012 so that the 100% tax does not apply to income earned or realized before 2022 on a prohibited investment that was held by the Registered Plan on March 22, 2011 (“transitional prohibited investment benefits”), but only if the transitional prohibited investment benefits are paid to the planholder (not by way of transfer to another Registered Plan of the planholder) within 90 days after the end of each taxation year. Further, a prohibited investment may be transferred from a Registered Plan to the planholder (or a non-arm’s length person) before 2022 without triggering the 100% penalty tax for a further “advantage” in the form of a “swap transaction” (as described below).

The Canada Revenue Agency (“CRA”) has the discretion to waive or cancel all or part of the 50% penalty tax or the 100% penalty tax, taking into account such factors as whether the tax arose as a consequence of reasonable error and whether the transaction(s) that gave rise to the tax also triggered another tax under the Tax Act 1. However, under the current rules, the CRA may not waive the 100% penalty tax unless payments equal to the waived tax are made without delay from the Registered Plan to the planholder.

The Definition of Prohibited Investment

A debt or equity investment in a corporation, trust or partnership (the “Issuer”) will be a prohibited investment for a Registered Plan of a particular planholder in any one of the following three situations, unless the investment is a “prescribed excluded property”.

  1. The planholder has a “significant interest” in the Issuer. Very generally, a planholder is considered to have a “significant interest” in a corporation if the planholder alone or together with non-arm’s length persons owns, directly or indirectly, 10% or more of any class or series of shares of the corporation or of any related corporation. A significant interest in a trust or partnership is measured by reference to the FMV of the trust or partnership as a whole (and not by the number of securities in any one particular class or series);
  2. The planholder does not deal at arm’s length with the Issuer (regardless of the number of securities of the Issuer held); or
  3. The planholder has a “significant interest” in an entity (e.g., a mutual fund manager) that does not deal at arm’s length with the Issuer (e.g., a mutual fund).

An interest in, or a right to acquire, an investment described above will also be a prohibited investment. In addition, debt of the planholder is a prohibited investment.

However, the securities of certain mutual funds will not be a prohibited investment during the start-up phase of the fund. More specifically, “prescribed excluded property” includes shares of a “mutual fund corporation” and units of a “mutual fund trust” (as those terms are defined in the Tax Act) for the first two calendar years of the corporation or trust if the corporation or trust is a mutual fund subject to, and substantially compliant with, the requirements of National Instrument 81-102 (“NI 81-102”).

Finance’s Recommended Amendments

Finance has recommended that the prohibited investment rules be amended, with application after March 22, 2011, as follows.

  • Remove the Condition for Waiving the 100% Penalty Tax – Finance recommended repealing the rule that prevents the CRA from waiving the 100% penalty tax unless payments equal to the waived tax are made without delay from the Registered Plan to the planholder. Instead, the full or partial removal of the amount from the Registered Plan will be one of the factors to be considered by the CRA in granting a waiver. This change will apply to any “advantage” (discussed below), including an advantage related to a prohibited investment. Finance noted that this change was prompted by the CRA’s advice that the existing requirement for the exercise of the discretion to waive or cancel the 100% penalty tax for an advantage could unduly limit the scope for exercising that discretion.
  • Grandfathering for the 100% Penalty Tax – Finance rejected the Joint Committee’s request for complete grandfathering for investments held before March 23, 2011. However, Finance agreed to recommend an indefinite extension of the transitional relief (i.e., beyond 2022). Finance did not extend the time period for making the transitional relief election. Based on discussions with Finance, we understand that it is not opposed to considering the issue.

The Joint Committee’s other recommendations to extend the distribution deadline for transitional prohibited investment benefits from 90 days after the end of each taxation year to April 30 to coincide with tax filing deadlines, and to introduce rules to preserve the grandfathered status of an investment following a corporate reorganization or a permitted share exchange were not addressed in Finance’s letter.

  • Narrow the Definition of a Prohibited Investment – Finance opted not to increase the 10% ownership threshold to a higher percentage (such as the 25% threshold suggested by the Joint Committee) and did not to replace the arm’s length test with a “related persons” test to provide more certainty regarding the application of the rules. However, Finance proposed to narrow the definition of “prohibited investment” in three significant ways.
    • Repeal Category #3 – The category of prohibited investment, identified as #3 above, will be repealed, with the objective of ensuring that the prohibited investment rules do not apply in circumstances where the planholder both lacks a significant interest in the Issuer in question and deals at arm’s length with the Issuer.

This is a significant change intended to address concerns that the existing definition could render an investment that is in the nature of a portfolio investment a prohibited investment. It means that an investment in a mutual fund will not be a prohibited investment for a Registered Plan simply because the planholder holds, for example, 10% or more of a class or series of shares of the fund’s manager. However, it is worth noting that if a planholder holds a controlling interest in a fund manager, the planholder could be considered not to deal at arm’s length with funds managed by that fund manager, and thus an investment in such a fund could be a prohibited investment under category #2 above.

  • Add a New Exclusion – A new exclusion from the definition of prohibited investment will apply where a four-part test is satisfied. While the exclusion is one of general application, we understand that it is intended to narrow the application of the prohibited investment rules as they currently apply to investments in the shares of a multi-class mutual fund corporation. The exclusion will apply to an investment in an entity if all four of the following conditions are satisfied.
    • persons who deal at arm’s length with the planholder hold at least
      • 90% of the entity’s equity value (i.e., the total FMV of all of the issued and outstanding shares of a corporation, all of the income or capital interests in a trust, or all of the interests in a partnership);
      • 90% of the total of the equity value plus the outstanding debt of the entity; and
      • 90% of the total votes associated with the equity of the entity;
    • persons who deal at arm’s length with the planholder own sufficient equity securities of the entity (having terms and conditions that are substantially similar to those of the securities held by the planholder’s Registered Plan) that if held by one individual and considered to be securities of a single class or series would be a significant interest in the entity;2
    • the planholder deals at arm’s length with the entity; and
    • none of the main purposes of the planholder in the acquisition or holding of the investment by the Registered Plan is to obtain an “advantage” (other than income or capital gains on the investment).  

In its letter, Finance stated that the amendment is intended to ensure that the prohibited investment rules do not apply where the value of a planholder’s investment through his/ her Registered Plan is small relative to the capitalization of the entity and is substantially the same as the investment of numerous other arm’s length investors in the same entity.  

  • Expand the Exclusion for Investment Funds – The list of “prescribed excluded property” will be expanded to include:
    • a trust or corporation that is a registered investment under the Tax Act, that meets a basic diversification test and that was not established with a tax avoidance objective (applicable for the first two calendar years of the trust or corporation); and
    • the last two taxation years of those trusts and corporations to which the exclusion would apply if they were start-ups (i.e., to accommodate the wind-up period of an investment fund).

These amendments are intended to address concerns raised about the narrow application of the exclusion only to mutual fund trusts and mutual fund corporations which are subject to, and substantially comply with, NI 81-102, and about the difficulty of avoiding prohibited investment status for the last few investors in an investment fund that was widely-held and is being wound up. However, the amendments do not go so far as to extend the exclusion period for the entire life of a mutual fund that complies with NI 81-102 or to exclude all mutual funds subject to NI 81-102 whether or not they qualify as mutual fund trusts or mutual fund corporations under the Tax Act, as was urged by some stakeholders. Also, no amendment has been recommended to extend the two-year grace period to separate classes or series of a mutual fund corporation.  

  • Add a Deemed Acquisition Rule – A deemed disposition and reacquisition rule will be added for an investment that becomes a prohibited investment, to correspond with the existing rule for an investment that ceases to be a prohibited investment.

As noted in the Joint Committee’s submission and acknowledged by Finance, this change is necessary to ensure that gains accruing during the period when an investment was not a prohibited investments are not subject to the 100% penalty tax.

Advantage Rules

Current 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.

As a result, an “advantage” is defined very broadly to include certain benefits, loans, indebtedness, swap transactions, RRSP strips and, as described above, income attributable to a prohibited investment. Among the benefits that constitute an “advantage” are:

  1. A benefit that is an increase in the total FMV of the property held in connection with the Registered Plan if it is reasonable to consider, having regard to all the circumstances, that the increase is attributable, directly or indirectly, to
  1. a transaction or event (or series or transactions or events) that would not have occurred in an open market in which parties deal with each other at arm’s length and act prudently, knowledgeably and willingly, and had as one of its main purposes to enable a person or a partnership to benefit from the exemption from tax under Part I of any amount in respect of the Registered Plan; or
  2. a “swap transaction”, which is defined as a transfer of property between the Registered Plan and its planholder or a person with whom the planholder does not deal at arm’s length, except for
    1. a payment from the plan in satisfaction of all or part of the planholder’s interest;.
    2. a payment into the plan that is a contribution, a premium or a specified transfer from another plan;
    3. a transfer of a prohibited investment or a non-qualified investment from the plan where the planholder is entitled to a refund of the 50% penalty tax on the transfer; or
    4. a transfer from one Registered Plan of the planholder to another like Registered Plan of the planholder.
  1. A benefit that is income (including a capital gain) that is reasonably attributable, directly or indirectly to
    1. a prohibited investment in respect of the Registered Plan or any other Registered Plan of the planholder;
    2. in the case of a RRIF or RRSP, an amount received by the planholder, or by a person who does not deal at arm’s length with the planholder (if it is reasonable to consider, having regard to all the circumstances, that the amount was paid in relation to, or would not have been paid but for, property held in connection with the Registered Plan) and the amount was paid as, on account or in lieu of, or in satisfaction of, a payment
      1. for services provided by a person who is, or who does not deal at arm’s length with, the planholder, or.
      2. of interest, of a dividend, of rent, of a royalty or of any other return on investment, or of proceeds of disposition, or
      3. a deliberate over-contribution.  

The 100% penalty tax (described above in the context of prohibited investments) applies to any “advantage”, including the FMV of the benefit or the amount of the loan, indebtedness or RRSP strip. The tax is payable by the planholder if an advantage is extended to, or is received or receivable by, the Registered Plan, the planholder or a person who does not deal at arm’s length with the planholder. However, if the advantage is extended by the issuer of the Registered Plan or a person with whom the issuer is not dealing at arm’s length, the issuer is liable to pay the 100% tax.

Finance’s Recommended Amendments

Although Finance refused to make any further significant changes to the advantage rules, it did agree to make certain modifications to the existing rules, for the purposes of clarification and with application after March 22, 2011, as follows:

  • Replace the “Open Market” Test – Finance will replace the requirement in paragraph 1(a) above that the transaction or event (or series) “would not have occurred in an open market” with the requirement that the transaction or event (or series) would not have occurred in a normal commercial or investment context where parties deal at arm’s length and act prudently, knowledgeably and willingly.

This change is intended to respond to uncertainty regarding the scope and meaning of the current wording, and to better target transaction terms that are not commercially reasonable having regard to all the circumstances, e.g., such as where the parties are acting in concert to achieve a tax benefit. It substantially adopts the language suggested by the Joint Committee in its submission to Finance. Finance emphasizes, however, that the clarification does not accommodate estate freeze transactions, as they “involve a type of internal capital restructuring to which the advantage rules were designed to apply in the registered plan context”.

  • Clarify Swap Transaction Exclusion – The wording of the swap transaction exclusion in paragraph 1(b)(iii) above will be clarified to ensure that it identifies both the removal of a prohibited or non-qualified investment from, and the transfer of property (generally cash) into, a Registered Plan on a swap to remove a prohibited or non-qualified investment.

While Finance agreed to this technical change to the swap transaction exclusion, it rejected the Joint Committee’s recommendation that all swaps be permitted unless there is some intent to avoid tax because it could not foresee a practical manner of distinguishing between tax avoidance swaps and other swaps.

Conclusion

While Finance’s recommended amendments to the prohibited investment and advantage rules provide some welcome relieving changes, particularly by narrowing the circumstances in which an investment can be a prohibited investment for an individual’s Registered Plan, they fail to address certain technical issues raised by the Joint Committee, as well as the larger practical issue of how sufficient information can be obtained to determine and continuously monitor ownership thresholds, in order to avoid going offside the rules and incurring harsh penalty taxes. It remains to be seen whether these recommendations represent Finance’s final word on changes to the rules.