IMPORTANT NOTE REGARDING THIS ARTICLE:
Following the publication date of this article, the Minister of Finance announced amendments to the August 16, 2011 draft legislation pertaining to "prohibited investments" held in a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF). You may reference the update to this article here.
It is an unfortunate fact of life that the transgressions of a few individuals often lead to onerous penalties or compliance costs for the innocent majority.
The 2011 Federal Budget presented certain measures that would appear to relate to such situations. In particular, the Budget will extend certain anti-avoidance rules - that currently apply only to Tax Free Savings Accounts (TFSAs) - to Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs), with potentially costly results to many owners of private businesses, and to investors in publicly traded companies and funds.
Currently, there are rules governing which types of investments can be purchased through RRSPs and RRIFs. Publicly traded investments are generally acceptable. However, RRSP/RRIF funds may also be invested in shares of a private qualifying small business corporation, provided the RRSP/RRIF annuitant (i.e. the person to whom the funds in the plan will be paid) owns less than 10% of the shares of any class of the corporation or of a corporation related thereto. In making this determination, shares owned by related persons and by the annuitant's RRSP/RRIF are included.
Alternatively, even if an arm's length annuitant owns 10% or more of a company's shares, the shares can still be considered a qualified investment if the cost of the shares is less than $25,000.
All of these tests are one-time tests that must be met at the time the shares are acquired. Thus, any subsequent changes to the key factors (i.e. percentage shareholdings, arm's length relationships, etc.) do not affect the shares' status as a qualified investment.
However, the proposed Budget measures extend the "prohibited investment" rules (that formerly applied only to TFSAs) to RRSPs and RRIFs. A prohibited investment includes:
- debt of the RRSP/RRIF annuitant;
- an investment in shares or debt of entities in which the RRSP/RRIF annuitant, plus his/her RRSP/RRIF and non-arm's length parties, own at least 10% of the outstanding shares of any class of the company or a related company; and
- a corporation that does not deal at arm's length with the annuitant or with a corporation, partnership or trust in which the annuitant has an interest of 10% or more.
As a result of the extension of these prohibited investment rules to RRSPs and RRIFs, investments that previously were qualified investments may now be prohibited where they exceed the 10% threshold. The previous $25,000 de minimus exemption will no longer apply. Consequently, the only acceptable holding of small business corporation shares is where the RRSP/RRIF and related parties own less than 10% of the shares of any class of the company, and the annuitant always deals at arm's length with it. In addition, in the public market context, an investor could be caught by these prohibited investment rules if he/she and any related parties own 10% or more of any company, fund or partnership.
The penalty for holding a prohibited investment is equal to 50% of the value of the investment for the calendar year in which the RRSP/RRIF acquires the prohibited investment, or in which property held by the RRSP/ RRIF becomes a prohibited investment. The tax is refundable if the RRSP/RRIF disposes of the investment by the end of the year following the year in which the tax arose. However, no refund is available if the annuitant knew, or ought to have known, that the property was or would become a prohibited investment. As originally announced in June, the new rules would have applied to prohibited investments in an RRSP or RRIF at March 22, 2011, with potentially tremendous costs to annuitants where the value of their initial investment had increased significantly. Fortunately, the draft legislation released on August 16, 2011 changed the application of the prohibited investment penalty to investments acquired after March 22, 2011.
In addition to the 50% penalty, the TFSA rules that tax any advantages (at a rate of 100%) are also being extended to RRSPs and RRIFs. An "advantage" is any transaction that is designed to exploit the advantages of the RRSP/RRIF, and will include income and capital gains from prohibited investments. In particular, capital gains arising from a "swap" transaction (i.e. where the RRSP/ RRIF annuitant pays cash to acquire investments owned by the RRSP/RRIF) will be considered an advantage, except where the swap is undertaken in order to remove a prohibited investment from the plan after 2012.
As a transitional measure, the August 16, 2011 draft legislation reduced the 100% tax on income and capital gains realized on prohibited investments owned at March 22, 2011, to 42.9% if:
- the annuitant of the plan files an election by June 30, 2012; and
- the income is earned or capital gains are realized before 2017, and are paid out of the plan within 90 days after the end of the particular year.
This provision will require trustees of registered plans to assume the administrative burdens of tracking this information, following up with the annuitant to determine whether an election has been filed, and ensuring that the income is paid out annually. It will be interesting to see if the provision survives.
Finally, the Canada Revenue Agency can waive or cancel any of these penalties at its discretion.
Contact your Collins Barrow advisor for more information on these new penalties, or to help determine how they may impact your RRSP/RRIF strategies.
Judy Moore, CA, is a Tax Partner in the Toronto office of Collins Barrow.
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