The 2011 federal budget, which was tabled June 6, 2011 (after the defeated March 23, 2011 budget), proposed various broad anti-avoidance tax measures to counter the implementation of tax planning strategies involving investments in registered retirement savings plans ("RRSP")1. One such anti-avoidance measure targets the shares of certain private corporations held in an RRSP after March 22, 2011. Such shares could now be considered as a "prohibited investment"2 with the result that the RRSP holder will be subject to severe special tax consequences. With proper planning before the end of 2012, the effects of that special tax could be alleviated.
GENERAL REVIEW OF THE RULES
As a general rule, an individual who deals at arm's length with a particular small business corporation ("SBC") and who, alone or with non-arm's length persons, owns less than 10% of the shares of any class of the capital stock of that SBC, may hold the shares of that SBC in his RRSP. In that respect, an SBC is a Canadian-controlled private corporation, all or substantially all of whose assets are used primarily in an active business carried on in Canada or are shares or debts of related SBCs.
Before March 23, 2011, an exception to the above rule provided that an individual who, alone or with non-arm's length persons, owned 10% or more of the shares in a class of the capital stock of an SBC or of a related corporation, could nevertheless hold the SBC's shares in his RRSP if the following conditions were satisfied:
- At the particular time that the RRSP acquired the investments, the RRSP holder, alone or with non-arm's length persons, dealt at arm's length with the SBC; and
- At that particular time, the RRSP holder, alone or with non-arm's length persons, owned shares in the capital stock of the SBC or of a related corporation, the total cost of which shares was less than $25,000.
This exception provided that the applicable conditions had to be satisfied at the time that the RRSP acquired the investments, with the result that all subsequent variations in the value of the shares did not affect the "qualified investment" status of the SBC's shares.
PROPOSED TAX MEASURE
Effective March 23, 2011, the rule remains unchanged, but the exception is no longer available. Thus, investments in the shares of an SBC in which the RRSP holder, alone or with non-arm's length persons, holds 10% or more of the shares of a class of the capital stock of that corporation or of a related corporation, at a particular time, are now prohibited investments3.
Consequently, on or after March 23, 2011, these new anti-avoidance measures could have the effect of transforming a qualified RRSP investment into a prohibited RRSP investment. An RRSP holder who, after March 22, 2011, holds a prohibited investment is therefore subject to a special tax for the given calendar year, corresponding to 50% of the fair market value of the prohibited investment at any time in the year when it was acquired or when it became a prohibited investment4.
However, a number of measures make it possible to eliminate the special tax. Thus, unless the RRSP holder knew or should have known at the time the shares were acquired that they were or would become a prohibited investment, the RRSP holder could obtain a refund of the special tax in question if the prohibited investment is disposed of and is no longer held in the RRSP by the end of the calendar year following the year in which the special tax applied5. For example, if on March 23, 2011 a qualified investment became a prohibited investment, the RRSP holder has until the end of 2012 to dispose of it.
In addition to the above-mentioned special tax, the RRSP holder is subject to a tax equal to 100% of the "advantage"6, namely the income and capital gain earned by the RRSP on the prohibited investment, that it is reasonable to attribute to the investment in the calendar year7. In this regard, the holder may avail himself of a transitional measure allowing him to make a tax election before December 31, 2012, (deadline that was recently extended) so that the tax equal to 100% of the "advantage" attributed to a prohibited investment as of March 23, 2011 does not apply, as long as the amount of the advantage is paid to the holder out of the RRSP in the ninety (90) days following the end of the applicable fiscal year8. If such tax election is made, incomes made on a prohibited investment as of March 23, 2011 in an RSSP will never be subject to a tax equal to 100% of the "advantage". RRSP holders who do not make such an election will be taxed at 100% of the "advantage" in each calendar year.
An RRSP holder who held a prohibited investment on March 23, 2011 should consider transferring that investment outside the RRSP before the end of 2012 in order to obtain a refund of the applicable special tax. In that respect, tax planning should be considered in order to reduce the onerous tax consequences that may result from the transfer of an investment held in an RRSP.
If you think you were holding a prohibited investment in your RRSP on or after March 23, 2011, you still have time to implement certain tax planning measures to minimize the tax consequences. We strongly urge you to discuss this with your advisers and to consult a tax professional.
1 Note that the proposed tax measures that are the subject of this article apply equally to registered retirement income funds ("RRIF").
2 Definition of "prohibited investment" in paragraph 207.01(1) of the Income Tax Act, R.S.C. (1985), 5th supp., c. 1 and amendments (the "ITA").
3 Paragraphs 207.01 (1) and (4) of the ITA.
4 Paragraphs 207.04 (1) and (2) of the ITA.
5 Paragraph 207.04 (4) of the ITA.
6 Definition of "advantage" in paragraph 207.01 (1) of the ITA.
7 Paragraphs 207.05(1) and (2) of the ITA.
8 Section 207.05(4) of the ITA.
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.