Important changes to the taxation of registered retirement savings plans and registered retirement income funds (collectively referred to as an "RRSP", although the changes apply equally to both types of plans) were enacted late last year that significantly reduce the types of investments that can be held in an RRSP without being subject to onerous taxes. These changes will require investors to be much more diligent in considering any new investments in their RRSP. Moreover, since the changes apply to any investments held in an RRSP on or after March 22, 2012, the changes mean that investors must review their existing RRSP investments and determine whether they are caught by the new rules. If the new rules apply, investors will have to determine whether they are eligible for special transitional relief, in which case if they want to continue to hold the investments in their RRSP they will need to make annual payments out of their RRSP and file a tax election by the end of June. If the transitional relief does not apply, investors will need to consider ways of removing the investments from their RRSP and whether they should apply for a waiver to reduce or cancel all or part of the tax owing under the new rules.
Prohibited Investment and Advantage Taxes
The "prohibited investment" and "advantage" rules were introduced to the RRSP tax regime by the 2011 Federal Budget. The enabling legislation received royal assent on December 15, 2011.
In general, a prohibited investment held by an RRSP includes debt of an annuitant and investments in entities in which the annuitant (and/or persons with which the annuitant does not deal at arm's length) has a significant interest (generally, an ownership interest of 10% or more) or with which the annuitant does not deal at arm's length. Where an RRSP holds a prohibited investment, the annuitant is liable for a tax equal to 50% of the fair market value of the investment on the date it is acquired or the date it becomes a prohibited investment. The 50% tax is generally refundable if the prohibited investment is disposed of by the RRSP by the end of the year following the year in which the tax was applied.
In addition to the tax on prohibited investments, the new rules introduce a tax on an advantage to the annuitant. An advantage is defined very broadly, and generally includes: (a) any benefit, loan or debt that is conditional on the existence of an RRSP; (b) any increase in the fair market value of property held in connection with an RRSP where the increase is attributable to (i) a non-open market transaction that attempts to benefit from the tax-exempt status of an RRSP, (ii) a payment on account of services or on account of income from property held by the annuitant (including income and capital gains attributable thereto), or (iii) a swap transaction (a transfer between an RRSP and the annuitant or a person who does not deal at arm's length with the annuitant); (c) income or capital gains attributable to a prohibited investment; and (d) an RRSP strip (an amount extracted from an RRSP without being subject to income tax). Where an annuitant has an advantage in connection with his or her RRSP, the annuitant is liable for a tax equal to 100 % of the advantage (i.e., either the fair market value of the benefit or the amount of the loan or debt, as applicable).
Important Payment and Tax Election Deadlines
With the new prohibited investment and advantage taxes came certain grandfathering provisions for existing investments held in an RRSP on the date the new rules were introduced. In particular, prohibited investments held on March 22, 2011 will not be subject to the 50% tax. In addition, income earned and capital gains realized on such grandfathered prohibited investments will not be subject to the advantage tax until 2022, so long as: (a) the income and/or gains arising therefrom are paid out of the RRSP to the annuitant within 90 days after the end of the taxation year in which such income or gains are earned or realized; and (b) the annuitant files a tax election in respect of the investment by June 30, 2012.
As 2011 is the first year to which the new rules apply, investors should review their RRSP investments and determine whether such investments may be subject to the prohibited investment or advantage taxes. Investors that held a prohibited investment in their RRSP on March 22, 2011 must determine whether any income earned or capital gains realized by their RRSP are attributable to such prohibited investment, and if so, they would likely want to avail themselves of the grandfathering provisions by paying such income or gains out of their RRSP in the first 90 days of 2012, in additional to filing the prescribed tax election on or before June 30, 2012 (Form RC341). Investors who are eligible for this transitional relief in respect of a prohibited investment held in their RRSP on March 22, 2011 can continue to hold the prohibited investment in their RRSP until 2022 so long as they make an annual withdrawal of the income earned or gains realized by their RRSP attributable to such prohibited investment in the first 90 days of the year following the year in which such income or gains arise. However, investors may also want to consider removing any grandfathered prohibited investments from their RRSP as soon as possible, being mindful of the swap transaction rules described below, since the overall tax result may be worse from a long term perspective.
Investors whose RRSP holds investments that do not qualify for transition relief (i.e., investments that are not prohibited investments but are nevertheless subject to the advantage tax) must determine whether such investments should be withdrawn from their RRSP and whether they should apply for a waiver to reduce or cancel all or part the tax owing under the new rules.
Other Impacts of the New Taxes
As a consequence of the new rules, there are a number of additional considerations in determining whether an investment is, and will continue to be, suitable for RRSP purposes. In the context of private companies whose shares are qualified investments on the basis that the company is a "specified small business corporation", the requirements formerly only had to be met on the date the shares were acquired by an RRSP whereas the activities of the corporation now have to be monitored on a continuous basis to ensure that the corporation complies with the requirements at all times. For example, an investment in a private corporation can become a prohibited investment in the following circumstances:
- the annuitant's ownership percentage in the corporation increases to more than 10% as a result of an acquisition or disposition of shares, whether or not the annuitant was involved in the acquisition or disposition;
- the ownership percentage in the corporation of persons who do not deal at arm's length with the annuitant (including siblings, nieces and nephews) increases;
- all or substantially all of the fair market value of the assets of the corporation are no longer attributable to assets that are used principally in an active business carried on primarily in Canada; or
- the corporation becomes controlled by non-residents.
In addition, there are a number of restrictions on transactions that can be undertaken between an RRSP and its annuitant that were formerly allowed under the old rules. For example, if an RRSP purchases property from its annuitant (or from a person who does not deal at arm's length with the annuitant) for cash, it will be considered a "swap transaction", and therefore, subject to the advantage tax, even if the RRSP purchases the property for fair market value.
These are just a few of the many examples of changes and technical considerations that now must be dealt with when examining whether an investment is RRSP eligible.
Investments currently held in an RRSP should be reviewed to determine whether they are subject to the new rules. Investments in private corporations are particularly vulnerable to the application of the new rules, and therefore, should be reviewed in order to determine whether they are subject to the prohibited investment or advantage taxes, even in circumstances where they were acquired prior to the introduction of the new rules.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.