On October 4, 2011, the federal government introduced formal legislation to enact certain proposals first announced in this year's federal Budgets (the "Budget Legislation"). Of particular note, the Budget Legislation contains a number of legislative changes to the Income Tax Act (Canada) (the "Tax Act") that will broaden the anti-avoidance rules applicable to registered retirement savings plans ("RRSPs"), registered retirement income funds ("RRIFs", and collectively with RRSPs, "Plans") and their respective annuitants (collectively, the "RRSP/RRIF Rules").
The RRSP/RRIF Rules are largely based on the existing anti-avoidance rules that apply to tax-free savings accounts ("TFSAs") and are aimed at deterring the annuitant of a Plan (an "Annuitant") from using the Plan to engage in certain tax-motivated transactions. If enacted, the RRSP/RRIF Rules will generally be effective as of March 23, 2011 (the "Effective Date"), subject to specific transitional rules.
For a general overview of the RRSP/RRIF Rules, see our March 2011 client bulletin: "budget 2011: proposed changes target abuse of RRSPs and RRIFs".
In August, 2011, the Department of Finance (Canada) released a draft version of the RRSP/RRIF Rules for public comment (the "Draft Legislation"), the key provisions of which are summarized in our September 2011 presentation: "Navigating the New RRSP/RRIF Anti-Avoidance Rules".
The RRSP/RRIF Rules are complex and have potentially punitive implications for non-compliant Plans (and their Annuitants). As a consequence, concerns were expressed upon the release of the Draft Legislation about the limited transitional relief provided to Annuitants whose Plans held property on the Effective Date that, by virtue of the RRSP/RRIF Rules, became "prohibited investments". The Budget Legislation introduces a number of modifications to the Draft Legislation, which respond to some (but not all) of these concerns.
penalty tax on "prohibited investments": transitional rules
Generally, under the RRSP/RRIF Rules, a Plan that holds property that is a "prohibited investment" is subject to a penalty tax equal to 50% of the fair market value of such property. Under the Draft Legislation, it was proposed that this tax would not apply to a particular "prohibited investment" acquired by a Plan before the Effective Date. However, such relief would have ceased to be available in cases where the subject investment was thereafter acquired by another Plan of the same Annuitant, raising serious concerns that an Annuitant might inadvertently lose the benefit of the transitional rule as a result of an otherwise innocuous transfer of his or her RRSP or RRIF from one issuer to another.
Under the Budget Legislation, a "prohibited investment" held by a Plan of an Annuitant on the Effective Date will generally continue not to be subject to the 50% "prohibited investment" penalty tax if it is subsequently acquired by another Plan of the same Annuitant. While this change is a welcome one, it highlights the fact that the benefits of the transitional provisions of the RRSP/RRIF Rules can be lost as a result of transactions that, from the perspective of Annuitants, might seem immaterial. Moreover, one can readily imagine other seemingly innocuous transactions that could "taint" the availability of the relief provided under this or other transitional rules. Accordingly, Annuitants will have to pay close attention to the activities of their Plans to ensure that they do not inadvertently lose the benefit of any transitional rules on which they intend to rely.
While the Budget Legislation expands the application of the transitional rules with respect to certain "prohibited investments", it also narrows them with respect to others. In particular, under the Budget Legislation, property that was acquired before the Effective Date, but which first becomes a "prohibited investment" after October 4, 2011, will not be entitled to the protections afforded by the transitional "prohibited investment" rules.
holding and removing prohibited investments from plans
In order to address concerns regarding the difficulties associated with removing certain, illiquid "prohibited investments" from Plans, the Budget Legislation generally permits a Plan and its Annuitant to effect certain transactions, which would otherwise constitute "swap transactions" under the RRSP/RRIF Rules, to remove certain property from the Plan in circumstances where it is reasonable to conclude that the retention of such property by the Plan would result in a tax being payable under the RRSP/RRIF Rules. This relieving rule was contained in the Draft Legislation, but was originally limited to transactions occurring prior to 2013. The Budget Legislation extends the period within which such transactions may be undertaken until the end of 2021.
The Budget Legislation also extends and simplifies the transitional relief that will be offered in respect of the imposition of the 100% penalty tax on income (including capital gains) from "prohibited investments" held by Plans on the Effective Date ("Prohibited Income"). Under the Budget Legislation, Prohibited Income earned or realized prior to 2022 will not generally be subject to the 100% penalty tax, provided that such income is paid directly to the Annuitant of the Plan within 90 days after the end of the taxation year to which it relates and the Annuitant elects in prescribed form prior to July 2012 to have this transitional rule apply. In effect, under this rule, an Annuitant should generally be entitled to avoid the application of the 100% penalty tax in respect of any Prohibited Income to the extent that such Prohibited Income is promptly distributed to, and taxed in the hands of, the Annuitant.
In a related change, the Budget Legislation also permits Plans, in computing their Prohibited Income, to take into account capital losses realized by the Plan in respect of "prohibited investments" (including capital losses that would normally be denied by virtue of the application of certain "stop-loss" or "superficial loss" rules contained in the Tax Act). By contrast, under the Draft Legislation, Annuitants would generally have been subject to the penalty tax on gains in respect of "prohibited investments", without offsetting relief for certain capital losses.
transfers between plans
In response to concerns that the definition of a "swap transaction" in the Draft Legislation was potentially broad enough to include transactions between Plans of the same Annuitant, the revised definition of a "swap transaction" contained in the Budget Legislation expressly excludes transactions between Plans of the same Annuitant, provided the Plans in question have similar tax characteristics (i.e., transactions strictly between two RRSPs or RRIFs, or between two TFSAs).
This is a sensible change and reflects the reality that such transactions are unlikely to provide any incremental tax benefit to the relevant Annuitant. However, the fact that such a change was considered necessary arguably highlights the general concern raised by members of the tax community regarding the RRSP/RRIF Rules, namely that the rules are broad enough that, in the absence of specific exclusions, they may inadvertently be applied to transactions that are neither tax motivated, nor abusive from a tax policy perspective. As a result, Annuitants should carefully monitor the administration of their Plans to guard against such potential pitfalls.
"prohibited investment" exclusion for certain mutual fund investments
In response to concerns that the initial investors in a newly-formed mutual fund trust or mutual fund corporation might naturally hold more than 10% of the units/shares of such fund during the initial start-up period of the fund, the Budget Legislation contains a limited exclusion from the definition of a "prohibited investment" for units or shares of a "mutual fund trust" or "mutual fund corporation" during the first two taxation years of the particular fund, provided that the fund is subject to, and substantially complies with, National Instrument 81-102 Mutual Funds of the Canadian Securities Administrators ("NI 81-102").
Unfortunately, this exclusion is relatively limited in scope. First, it is only available in respect of investments in a fund that "substantially complies" with NI 81-102, raising the concern that technical non-compliance with NI 81-102 on the part of the fund (which may be unrelated to any tax considerations) may taint the ability of investors to rely upon this exclusion. Second, the exclusion is limited to mutual fund trusts and mutual fund corporations subject to NI 81-102, which would not capture a significant number of mutual funds available for purchase by Canadian investors. Third, the exclusion is only available during the first two taxation years of newly-formed, qualifying mutual funds. Accordingly, caution must again be exercised before a Plan seeks to rely on this exclusion.
We expect that the RRSP/RRIF Rules will continue to attract much attention as they are administered by the Canada Revenue Agency over the coming years. Annuitants of Plans should carefully review their circumstances and promptly take any correction action necessary to minimize the impact of the RRSP/RRIF Rules.