Over the years, we have received many questions from clients on the prohibited investment rules for registered plans. As this area has proven to be one of common confusion, we asked Ryan Morris, co-chair of the Tax Group at Weir Foulds LLP, to provide some illumination on this area. The following is Ryan’s explanation.
It is well known that registered plans such as RRSPs, RRIFs and TFSAs may only invest in property that is a “qualified investment” for tax purposes. Further, under the Income Tax Act (Canada), such plans must not hold property that is a prohibited investment of the particular plan, even if such investment is a qualified investment. The 2017 federal budget, released on March 22, 2017, proposes to extend the prohibited investment rules to RESPs and RDSPs (collectively, with RRSPs, RRIFs and TFSAs, “Registered Plans”).
The holder or annuitant of a Registered Plan that holds a prohibited investment can be subject to a 50% penalty tax on the value of the investment (which is refundable in certain circumstances) and a 100% penalty tax on any income or capital gain derived from the investment.
Generally, a prohibited investment includes (but is not limited to) an investment in a corporation, trust or partnership in which the controlling individual of the Registered Plan has (i) a “significant interest” or (ii) with which the controlling individual does not deal at arm's length.
What is a significant interest?
Generally, an individual has a “significant interest” in a corporation if the individual owns, directly or indirectly, 10% or more of the issued shares of any class or series of the corporation or a related corporation. An individual has a “significant interest” in a partnership or trust if the individual’s interests in the partnership or trust have a fair market value of 10% or more of the fair market value of all such interests in the partnership or trust, as applicable. It is important to note that the holdings of the individual together with those of persons and partnerships not dealing at arm’s length with the individual must be aggregated for the purposes of determining whether the 10% thresholds above are met.
How do I know if I am arm’s length with the issuer?
Assuming the individual is not related to the issuer, one must determine whether the individual, as a factual matter, does not deal at arm's length with the issuer. In making such determinations, the jurisprudence generally considers whether one party has factual control over the other. However, it is unclear how the tests used by the courts would apply to the prohibited investment rules in certain situations such as when a holder or annuitant of a Registered Plan is an officer or director of a corporate issuer or a controlling shareholder of the manager of an investment fund.
Certain property is specifically excluded from the application of the prohibited investment rules including shares or units of a mutual fund corporation or mutual fund trust that either is subject to National Instrument 81-102 – Mutual Funds or follows a reasonable diversification policy. However, this exclusion applies only for the 24 month period on start-up and wind-up of the fund and is subject to certain anti-avoidance rules.
Compliance with the prohibited investment rules often presents challenges to taxpayers and their advisors. Falling offside the rules can result in material adverse consequences, particularly if correcting measures are not quickly implemented. Taxpayers should consult with a tax advisor on a timely basis if there is a risk that a particular investment or holding is, or could become, a prohibited investment for their Registered Plans.