RRSP BACKGROUND – RRSP ANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS
Registered retirement savings plans (RRSPs) are a tax efficient method of investment for individuals created by the government to encourage Canadians to save for retirement.
The basic structure of an RRSP is that a financial institution (the issuer) holds investments in trust (the RRSP) for an individual with whom the issuer has a contract or arrangement that meets certain requirements. When the individual makes eligible contributions to the RRSP, then the individual receives an income tax deduction in the same amount as the contribution. The individual is called the "controlling individual" of the RRSP. The RRSP can then invest the contributions into various types of investments. RRSPs are not allowed to own certain "non-qualifying" or "prohibited" investments. For example, cryptocurrencies cannot be held in a RRSP directly, although it is possible to hold them in a RRSP indirectly through an exchange traded fund or similar securities.
The RRSP itself is exempt from income tax. When the individual eventually withdraws funds from the RRSP, the individual has an income inclusion for the amount of the funds withdrawn. This means that RRSPs functionally allow individuals to invest with "pre-tax income" and have their investments compound tax free until withdrawal.
RRSP contribution room is determined by an individual's "earned income", which among other things includes employment income or business income earned while a tax resident of Canada. Taxpayers can contribute to their RRSPs until December 31 of the year in which they turn 71 years old. Individuals are also required to collapse their RRSPs by December 31 of the year they turn 71. The main options are transferring your RRSP to a registered retirement income fund (RRIF) on a tax deferred basis, purchasing eligible annuities on a tax deferred basis, or withdrawing the funds and having an income inclusion. A RRIF operates in a similar manner to an RRSP, but it requires the beneficiary of the RRIF to withdraw a minimum amount every year.
To maintain the integrity of the RRSP system, the Canadian Income Tax Act contains numerous anti-avoidance rules which can result in severe tax penalties for taxpayers, which can be avoided with tax planning from a knowledgeable Canadian tax lawyer. This article focuses on the anti-avoidance rules regarding prohibited and non-qualified investments.
QUALIFIED AND NON-QUALIFIED INVESTMENTS – RRSP ANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS
Qualified investments are the types of investments that the Government of Canada intends for individuals to hold in their RRSPs. The Income Tax Act provides a list of types of qualified investments which include:
- Money and deposits with banks, trust companies, or credit unions;
- Securities listed on a designated stock exchange;
- Shares or debt of a public corporation;
- A unit of a mutual fund trust or share of a mutual fund corporation;
- Debt of the Government of Canada, a province, a municipality, or a Crown corporation;
- Gold and silver coins, bullion and certificates; and
- Shares of a specified small business corporation.
A specified small business corporation is generally a corporation incorporated in Canada that is not controlled by non-resident persons and substantially all the fair market value of the corporation's assets are attributable to assets that are:
- used principally in an active business carried on in Canada by the corporation or a corporation related to it or
- shares or debt of connected small business corporations.
If an investment in a specified small business corporation meets the criteria for being a prohibited investment as described below the investment will not be a qualified investment. As such, taxpayers should be very cautious when investing in private corporations through a RRSP and should always consult with an expert Toronto tax lawyer before proceeding with the investment.
The Income Tax Act defines a non-qualified investment as any investment that is not a qualified investment. However, an investment that is not a qualified investment but also meets the criteria for prohibited investment status will be considered a prohibited investment only and deemed not to be a non-qualified investment. One example of a non-qualified investment is shares in a private non-resident corporation.
PROHIBITED INVESTMENTS – RRSP ANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS
The Income Tax Act definition of prohibited investment includes the following:
- a debt of the holder of the RRSP;
- a debt, share of, or an interest in, a corporation, trust or partnership in which the holder of the RRSP has a significant interest;
- a debt, share of, or an interest in a person or partnership with which the holder of the RRSP does not deal at arm's length; or
- an interest in or right to acquire any of the above investments.
The term "a significant interest" generally refers to the holder of the RRSP having at least a 10% interest in the corporation, partnership, or trust. In making this assessment, the interests held by persons who do not deal at arm's length with the holder of the RRSP are also counted towards the 10% threshold.
TAX ON NON-QUALIFIED AND PROHIBITED INVESTMENTS – RRSP ANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS
If during a calendar year, a RRSP acquires a non-qualified or prohibited investment, or if an existing investment held by the plan becomes a non-qualified or prohibited investment, then the holder of the RRSP is required to pay a special tax. The amount of the tax is 50% of the fair market value of the investment at the time the event that led to the tax applying occurred.
The person liable to pay the tax on non-qualified or prohibited investments in a calendar year is required to file a corresponding form RC339 tax return and pay the tax before July of the following calendar year. As with regular income tax, interest will accrue on a late payment and penalties may apply if a return is filed late or not filed at all.
If the RRSP subsequently disposes of the non-qualified or prohibited investment then the holder of the RRSP becomes entitled to refund of the tax unless either:
- it is reasonable to consider the holder of the RRSP knew or ought to have known at the time the relevant investment was acquired by the RRSP that it was non-qualified or prohibited or that it would become so, or
- the relevant investment was not disposed of by the RRSP before the end of the calendar year following the calendar year in which the tax arose, or any later time that the Canada Revenue Agency considers reasonable in the circumstances.
INCOME EARNED ON NON-QUALIFIED AND PROHIBITED INVESTMENTS – RRSP ANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS
Income earned by a RRSP from a non-qualified investment is considered taxable income for the RRSP which pays tax on that income at the top marginal rate. So for example if a RRSP holds shares in a private non-resident corporation which constitutes a non-qualified investment, then the RRSP will need to pay tax on the dividends it earns for holding the shares or the capital gain it realizes when it eventually sells the shares. Income from a prohibited investment constitutes a RRSP advantage.
Subsequent generation income earned on taxable income earned by the plan from a non-qualified investment or on income from a prohibited investment generally also gives rise to a RRSP advantage. For example, if a RRSP reinvests dividend income from either a non-qualified investment or a prohibited investment, even into a qualified investment, then all the income generated by the new investment constitutes a RRSP advantage.
A special RRSP advantage tax is payable by the holder of a RRSP that has given rise to a RRSP advantage during a calendar year. The amount of the tax is 100% of the RRSP advantage for the calendar year. The person liable to pay the tax on the RRSP advantage in a calendar year is required to file a corresponding form RC339 tax return and pay the tax before July of the following calendar year. As with regular income tax, interest will accrue on a late payment and penalties may apply if a return is filed late or not filed at all.
DISCRETIONARY RELIEF – RRSP ANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS
CRA has the discretion to waive or cancel part or all of a taxpayer's RRSP advantage tax or tax on non-qualified or prohibited investments owing in circumstances where the Canada Revenue Agency determines that it would be just and equitable to do so. Some of the circumstances in which CRA may exercise its discretion are:
- when the tax arose as a consequence of a reasonable error,
- when the transactions that gave rise to the tax also gave rise to another tax under the Income Tax Act,
- when payments have already been made from the RRSP.
To request that RRSP tax be waived or cancelled, the taxpayer's experienced Canadian tax lawyer must submit a written application to the CRA's Pension Workflow Team located at either the Sudbury Tax Centre or the Winnipeg Tax Centre depending on the location of the taxpayer's residential address. The application should describe in detail the circumstances giving rise to the tax and why it would be just and equitable for the tax to be waived or cancelled.
Note that the CRA's taxpayer relief and voluntary disclosures programs which offer penalty and interest relief in some circumstances cannot be utilized in order for the RRSP tax itself to be waived or cancelled because it is a tax and not a penalty. It is possible however to get relief under those programs from penalties or interest associated with the RRSP tax.
The full definition of what constitutes a non-qualified or prohibited investment is quite comprehensive and the consequences of making a mistake are severe. Taxpayers should be extremely weary of making any investment in a RRSP if they are closely connected with the investment or if the investment is in a private business and consult with an experienced Toronto tax lawyer prior to proceeding with the plan.
In the event that you think you may have made a non-qualified or prohibited investment or if CRA has assessed you as such in a tax audit, it is highly recommended that you speak with an expert Canadian tax lawyer regarding whether any steps can be taken dispute whether there was a non-qualified or prohibited investment or apply for discretionary relief.
What is a RRSP?
A Registered Retirement Savings Plan effectively allows individuals to contribute funds to a special account, up to a contribution limit, and invest the funds on a tax deferred basis. Specifically, individuals can get a deduction from their income when they contribute to the account and income earned in the account is exempt from income tax. When amounts are eventually withdrawn from the account, the full amount of each withdrawal is included in the individual's income.
What is a Non-qualified Investment?
A type of investment that is not intended to be allowed in a RRSP. The full details of what is qualified are complex, but generally investments in public companies, mutual funds, or government debt are qualified investments, while private investments are at risk of being non-qualified.
What is a Prohibited Investment?
A type of investment that is not intended to be allowed in a RRSP. The full details of what is prohibited are complex, but generally investments in a business where you own at least 10% of the business or investments where you are not at arm's length from the recipient of the investment are prohibited.
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.