Running afoul of the CRA on RRSP withdrawals can be a costly mistake

National Post


In my experience, most taxpayers seem to have a pretty good understanding of the tax consequences of making an RRSP contribution, namely that you get a tax deduction from your income for the amount you contribute. But it seems that fewer taxpayers have a comprehensive grasp of what happens to that RRSP on the flip side, when funds are withdrawn.

The truth is, it’s actually quite simple: any funds withdrawn from your RRSP (or its successor, a RRIF) are included in your income. The amount of tax you pay on that withdrawal, however, will depend on your total income for the year. In other words, you will end up paying tax on the RRSP withdrawal at your marginal tax rate. That rate could be as low as zero, if you have sufficient credits and deductions to offset the tax on the RRSP income inclusion. Or, it could be as high as 54 per cent, depending on your income level and your province of residence.

What seems to confuse some taxpayers, however, is that when you request an RRSP withdrawal, the financial institution at which you hold your RRSP is required to withhold a certain percentage of the funds and remit them directly to the Canada Revenue Agency. This is essentially a “prepayment” towards your ultimate tax liability, which can only be known with certainty when you file your tax return for the year of withdrawal. The percentage required to be withheld depends on the dollar amount withdrawn. For withdrawals up to $5,000, the withholding amount is 10 per cent (20 per cent for Quebec), for amounts between $5,000 and $15,000 it’s 20 per cent (25 per cent for Quebec) and for amounts over $15,000 the rate increases to 30 per cent.

A tax case decided earlier this month highlights the confusion, along with the severe consequences, of what can happen if you forget to include an RRSP withdrawal on your tax return, despite the fact that taxes were withheld at the time of withdrawal.

In 2014, the taxpayer, a “bright, well-educated, retired businessman” who used to run his own investment banking firm, wished to use some of the money in his RRSP to invest in real estate. He called his brokerage firm and told them to withdraw $700,000 from his RRSP and remit the net proceeds to him. His broker withheld the requisite 30 per cent withholding tax of $210,000 and paid the balance of $490,000 to the taxpayer. It reported the RRSP withdrawal and associated withholding tax on a T4RSP slip.

In 2015, when the CRA matched the various T-slips that it had received for 2014 with the amounts reported on the taxpayer’s 2014 income tax return, the CRA noticed that income totalling nearly $710,000 shown on three T-slips had not been reported on the taxpayer’s return: the $700,000 RRSP withdrawal from the T4RSP slip and almost $10,000 of investment income, reported on T3 and T5 slips.

Unfortunately, this was not the first time the taxpayer failed to report an amount of income. While the taxpayer used an international accounting firm for many years to prepare his annual income tax returns, he ultimately began to prepare his tax returns himself, using electronic tax-return-preparation software. The taxpayer testified that when the accounting firm was preparing his tax returns, he never had any difficulty in reporting all of his income; however, when he started preparing his own returns, there was a series of tax years for which he either “did not receive … misplaced or overlooked” some or all of his T-slips. As a result, there were several years (2007, 2008, 2010 and 2011) for which the taxpayer was reassessed for unreported income and was hit with penalties.

Under the Income Tax Act, a “repeat omission penalty” can be assessed for failing to report income in any two tax years within a four-year period. The amount of the penalty is 10 per cent of the amount of income not reported. An equal provincial penalty can also be imposed.

In December 2015, the CRA reassessed the taxpayer’s 2014 tax return for the tax owing on his $710,000 of unreported income and added a penalty of $71,000, equal to 10 per cent of the unreported income. An additional provincial penalty of $71,000 was also assessed under the corresponding Ontario tax legislation.

The taxpayer first attempted to argue, citing a number of prior tax cases, that the penalties should be cancelled as “there was not actually a failure to report income, given that all of the amounts identified by the CRA as unreported income were the subject of various T-slips that had been filed with the CRA, albeit by the issuers of those T slips, and not by (the taxpayer).”

The judge, however, did not agree and felt that this taxpayer, “who obtained … degree(s) from prestigious business schools (Ivey and Wharton),“ was in a markedly different situation than the prior cases, two of which involved recent immigrants to Canada who were not familiar with the Canadian tax system.

The taxpayer then testified that when he learned from his broker that 30 per cent withholding tax was to be withheld from his RRSP withdrawal, he “mistakenly understood that he had no further reporting obligation in respect of the RRSP withdrawal, particularly since no one at (his brokerage firm) told him that he was required to report the RRSP withdrawal on his tax return.”

He further explained that “most of the growth in his RRSP had arisen by reason of capital gains realized in respect of the properties held in the RRSP, and he knew that capital gains are taxed at an effective rate less than that applicable to other forms of income. Accordingly, he concluded that the 30 per cent withholding rate represented his entire tax obligation in respect of the RRSP withdrawal, such that there was no need to report it on his income tax return.”

The judge felt that relying on his investment advisor for tax advice was not a good enough excuse for not reporting the RRSP withdrawal on his return. He upheld the penalty, saying: “A reasonable person would have sought tax advice from a tax advisor, such as a tax accountant or a tax lawyer, and not from an assistant stockbroker, investment representative or other similar person.”

Fortunately for the taxpayer, relief may still come from the CRA. The taxpayer applied for relief, stating that he was no longer employed and that payment of such severe penalties “would create a hardship.” The judge was sympathetic and encouraged the CRA (and Ontario) “to cancel, or at least reduce, the repeated-failure-to-report-income penalties.”