The new RRSP/RRIF advantage rules
With the summer now behind us, it’s a good time to review some developments that came into effect over the past few months. The June 2011 federal budget introduced new anti-avoidance rules to prevent taxpayers from exploiting the tax attributes of a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF). The rules provide for a 100 per cent tax on “advantages” obtained from these plans, including benefits from swap transactions and income from prohibited investments. Similar rules are already in place for tax-free savings accounts.
A “swap” is a transaction whereby an investment in a non-registered account is transferred into or out of a registered account (such as an RRSP or RRIF). Swaps are sometimes used to rebalance portfolios among accounts without having to incur commissions. Note that a swap does not include a one-way transaction, such as an “in-kind” contribution of a security to an RRSP.
The government was concerned that these swaps, when performed frequently with a view to exploiting small changes in asset value, could potentially be used to shift value from RRSPs and RRIFs without paying tax. As of July 1, swaps could be subject to a new 100 per cent penalty tax on an increase in the total fair market value (FMV) of property held in connection with the RRSP/RRIF.
For example, Debbie owns 50,000 thinly traded shares with a bid price of 10 cents but an ask price of 30 cents. Debbie transfers the shares from her non-registered account to her RRSP for cash, using the 10-cent price (for a total of $5,000). A few hours later, the shares are swapped back to Debbie’s non-registered account for cash for 30 cents per share (for a total of $15,000), leaving a $10,000 “gain” in the RRSP. Under the new rule, the entire gain would be taxed back at 100 per cent, causing Debbie to forfeit her $10,000 profit.
Private company shares are “qualified investments” for registered plans if, at the time of the acquisition, the shareholder (together with non-arm’s length parties) did not control the company and the original cost of the shares was less than $25,000, and the shareholder deals at arm’s length with the corporation.
Although the 2011 Budget left the definition of “qualified investments” intact, it added a more restrictive concept of “prohibited investments” for RRSPs and RRIFs. Shares are prohibited investments if the shareholder (or a non-arm’s length party) owns 10 per cent or more of the corporation, or does not deal at arm’s length with the corporation. Investments may now be considered “prohibited” even if they remain “qualified.”
Prohibited investments attract a penalty of 50 per cent of the FMV of the investments upon acquisition, plus a penalty of 100 per cent of the income earned on the investments (including capital gains accrued after March 22, 2011, the date of the original 2011 budget proposals subsequently reintroduced in June). Removing prohibited investments from an RRSP prior to 2013 would prevent the 50 per cent FMV penalty from applying; however, the 100 per cent penalty on income will continue to apply until the asset is removed.
For example, Liam founded a company many years ago with unrelated parties, and Liam acquired 25 per cent of the company’s shares for $10,000. The fair market value of the company increased over time and Liam’s shares were worth $1 million on March 22, 2011. Although Liam’s shares are still “qualified investments,” they are now also “prohibited investments,” since he owns more than 10 per cent of the company’s shares. Suppose Liam were to remove the shares from the RRSP in February 2012, when the shares were worth $1.2 million. Liam would not face a $500,000 penalty (50 per cent of the $1 million FMV on March 22, 2011,) given that the shares were removed from the RRSP prior to 2013. Liam would, however, pay a penalty of $200,000 (100 per cent of the increase in the value of the shares between March 22, 2011, and the time the shares were removed from the plan).
As you can see from the example, the new rules can cause unexpected financial hardship since Liam would need to have $1.2 million outside of his RRSP: $1 million to substitute for the shares plus $200,000 to pay the penalty.
At the time of writing, draft legislation has not yet been released, so the details for implementation of these measures and any potential relief have yet to be seen. It is therefore prudent to be aware of the potential dangers of swap transactions, and be sure to remove private company shares, where appropriate, from registered plans to avoid significant penalties.