Do you hold private company shares in your RRSP?

June 2011 If you hold your private company shares in your RRSP, measures introduced in the recent federal budget may have an impact on you. Current rules The income tax rules specifically permit certain types of private company investments to be qualified investments for RRSP purposes. Generally, private company shares are a qualified investment if, at the time your RRSP acquires the shares, you (and others related to you) hold, directly or indirectly, less than 10% of the issued shares of any class of the capital stock of the corporation or of any related corporations; or where the ownership is 10% or more, you and related parties dont control the company and the total cost amount of all shares held in the corporation and any other related corporations is less than $25,000. In determining whether you satisfy either of these tests, you are deemed to own any shares owned by non-arms length persons. Proposed rules The 2011 budget proposals provide that shares in companies in which you (and related parties) have an interest of 10% or more will now become a prohibited investment for RRSP purposes. Unless such investments are disposed of by your RRSP before 2013, youll be subject to a special tax equal to 50% of the fair market value of the investment at the time it becomes a prohibited investment. These rules were briefly covered in our recent release titled Proposed changes to IPPs and RRSPs. Also, although you have until the end of 2012 for your RRSP to dispose of the prohibited investment, a 100% tax can also apply to any increase in the value of your shares after March 22, 2011unless the shares are removed from your RRSP before July 2011.1 Will you be impacted by these changes? These new proposals could impact you if your ownership was less than 10% at the time the investment was made, but has since increased to or beyond 10%. Under the current rules, if a subsequent acquisition or disposition of shares occurs that results in the ownership increasing to 10% or more, the investment will continue to be a qualified investment for RRSP purposes but will now be a prohibited investment (as defined by the new rules). In addition, private company share investments, where the ownership was 10% or more at the time of the investment in your RRSP, but below the $25,000 threshold, will also now be a prohibited investment and subject to the penalty tax. Example Assume you made a qualifying investment in your RRSP 20 years ago when you used your RRSP to finance the cost of a business you started with four other unrelated persons (20% each). The cost of the investment was $10,000. The company is now worth $5 million. Since you (and your RRSP) own more than 10% of the company, the shares are now a prohibited investment for RRSP purposes. If they are not removed from your RRSP before 2013, youll be subject to a $500,000 penalty tax (50% of $1 million). In almost all cases, withdrawing the shares from your RRSP and including the amount in your income wont be a desirable option. To provide relief, there are transitional rules that will let you avoid paying tax on the RRSP withdrawal if you swap the shares for cash or other property with the same value. This must be completed before the end of 2012. This is likely easier said than done, since it may not be practical to expect that taxpayers will have the available cash or borrowing capacity to buy the private company shares from their RRSP accountin the above example, you would have to come up with $1 million in cash or other property.

Conclusion If you have private company shares in your RRSP that would become prohibited investments under these proposals, youll need to start planning soon to mitigate the tax consequences. Although its hoped that these proposals will be reconsidered so the legislation thats enacted doesnt produce such harsh results, this cant be counted on and its possible that these rules could become law without significant changes.

Proposed changes to IPPs and RRSPs

May 2011 The March 22, 2011 federal budget proposed major changes to the rules for individual pension plans (IPPs) as well as the introduction of new anti-avoidance rules for registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs). Its very likely that these measures will be reintroduced unchanged with the new budget, which is expected to be announced before Parliament breaks for the summer. Individual pension plans An IPP is a defined benefit registered pension plan (RPP) set up for an individual or group of individuals.1This type of plan is generally established for the benefit of an employee, usually an employee of a corporation that the person controls. Other family members, who are employed by the corporation, may also be members of the plan. The March 22 federal budget proposes two new IPP measures. Contributions for past service When contributions are made to an RPP for past service, the current tax rules require that the employee either gives up accumulated RRSP contribution room for earlier years or, if the employee has made RRSP contributions in those earlier years, to withdraw a portion of RRSP assets (calculated by a formula). These assets would generally be transferred to the RPP. One of the IPPs key advantages is the possibility of making contributions for past service. Under the current rules, when an employee switches from RRSP savings to RPP savings and is able to have past service recognized under an IPP, the amount required to fund the IPPs obligation in relation to the past service can be much greater than the amount by which the employee is required to reduce his or her RRSP assets or accumulated RRSP contribution room. Another benefit is that the past service contributions paid by the corporation are deductible in computing the corporations income. As a result, not only can significant amounts be invested tax-free within the plan, but the corporation also benefits from immediate tax savings. Proposed change The budget proposes that contributions to an IPP for a participants prior years of employment will first have to be funded from the current assets in the participants RRSP2or by reducing the participants unused contribution room before new deductible contributions for past service can be made. This change will considerably reduce, or in some cases even eliminate, deductible past service contributions to an IPP. Effective date Its proposed that this measure will apply to contributions for past service paid into an IPP after March 22, 2011, except that it wont apply to IPP past service contributions credited to an IPP member before March 22, 2011 under terms of an IPP submitted for registration on or before March 22, 2011. Its unknown if these measures, once reintroduced, will have retroactive effect. Therefore, the effective date could change.

Minimum withdrawal In some cases, individuals establish IPPs as a transfer vehicle for the commuted value of a pension under a defined benefit RPP. A large portion of the amounts received by the IPP in these circumstances can constitute pension surplus, which isnt subject to withdrawal requirements under the existing rules that apply to RPPs. As a result, an IPP member is able to defer more of his or her retirement savings for a longer period than is generally possible for members of other registered plans. Proposed change The budget proposes to subject IPPs to a minimum withdrawal obligation as of the year in which the participant reaches the age of 72. This obligation is similar to the rules that currently apply to RRIFs. Once the plan member turns 72, the IPP will be required to pay out each year an amount equal to the greater of either the regular pension amount payable to the member in the year pursuant to the plan terms, or the minimum amount that would be required to be paid from the IPP to the member if the members share of the IPP assets were held in a RRIF. Effective date Its proposed that this measure will apply as of 2012. Anti-avoidance rules applicable to RRSPs and RRIFs3 The budget proposes that RRSPs will be subject to new anti-avoidance rules, similar to those that currently apply to tax-free savings accounts (TFSAs). These measures are intended to attack certain tax planning schemes that provide RRSP owners with an unintended tax advantage. For example, the current rules provide that non-qualified investments held in an RRSP are subject to a 1% per month penalty tax for as long as they remain in the plan. Some taxpayers intentionally put nonqualified investments in their RRSP on the belief that they can realize a rate of return on the investment much higher than the penalty. This strategy will no longer work under the proposed rules. An RRSP that acquires either a non-qualified investment or a prohibited investment (prohibited investment is a new concept for RRSPs) will be subject to a special tax equal to 50% of the fair market value of the investment. Investment income earned on a non-qualified investment in an RRSP will remain taxable to the RRSP. The 50% tax may be refunded if the RRSP owner disposes of the investment from the RRSP within a specified time limitgenerally, by the end of the year following the year in which the tax applied. However the tax wont be refunded if the plan owner knew or should have known that the investment was prohibited or non-qualified when it was acquired. An additional tax will be assessed where an advantage in relation to an RRSP is extended or received by a holder of the RRSP, a trust governed by the RRSP or any other person who doesnt deal at arms length with the holder of the RRSP. In this case, the tax is a 100% tax equal to the fair market value of the benefit.4 These rules are very complex and include several exceptions. However, the particular types of transactions being targeted include: Transactions relating to the sale and purchase of assets (swap transactions) between RRSPs and other accounts controlled by the RRSP annuitant5for example, removing cash and replacing it with shares of a private company of dubious value. The concern with swaps is that the taxpayer can move value from an RRSP without paying tax or add to the value of an RRSP without using contribution room. Payments made to an RRSP for servicesfor example, getting a corporate client to pay a dividend on a special class of its shares held in a taxpayers RRSP instead of paying the taxpayer directly for his or her services.

Transactions that involve holding one security in an RRSP and another related security outside an RRSP with the objective of having the returns from both go to whichever account gives the greatest tax advantage. Transactions that wouldnt have occurred in an open market between parties dealing with one another at arms length, if its reasonable to conclude that the transaction was carried out to benefit from the tax attributes of RRSPs.6

As noted above, the proposals also introduce a prohibited investment concept for RRSPs thats based on the TFSA rules. A prohibited investment for RRSP purposes will include: the plan holders debt; investments in entities in which the plan holder or a person with which the plan holder doesnt deal at arms length has a significant interest, i.e., generally 10% or more; and investments in entities in which the plan holder does not deal at arms length.

Notes:
1. The March 22, 2011 federal budget proposes to define an IPP as referring, in particular, to a defined benefit RPP that includes three participants or less, if at least one of the participants is related, for tax purposes, to an employer participating in the plan, or, on the basis of certain conditions, where 50% or more of the total of all pension credits of each plan participant is attributable to individuals connected to an employer or highly compensated employees. For the purposes of these proposals, an individuals RRSP assets includes the account balances of an individuals defined contribution RPP. Generally, throughout this article, any reference to RRSP also includes a reference to a RRIF. This tax may be waived where the Minister considers that its just and equitable to do so having regard to all the circumstances. Theres an exception with regards to transfers between two RRSPs held by the same taxpayer. The tax authorities have already stated that for the purposes of the TFSA, this rule could target the issuance of a corporations shares to a key employees TFSA.

2. 3. 4. 5. 6.

Update on private and public company shares held in your RRSP1

October 2011 If you hold private or public company shares in your RRSP, new measures originally proposed as part of the 2011 federal budget could have an impact on you. These rules were summarized in our June 2011 release titled Do you hold private company shares in your RRSP and our September 2011 release titled Draft rules address private company shares in your RRSP.2 Since the release of the draft legislation in August, the Department of Finance has tabled a Notice of Ways and Means Motion (NWMM)3to implement these rules. The NWMM has again included some significant changes. Whats the issue? The federal budget proposals provide that certain RRSP investments which were qualified investments at the time they were made may now become a prohibited investment. Specifically, the new rules provide that shares in companies in which you (and related parties) have an interest of 10% or more will now become a prohibited investment for RRSP purposes.4 Although a prohibited investment is subject to a 50% penalty tax until its withdrawn from your plan, the new rules provide that this tax will not apply to an investment acquired before March 23, 2011 that becomes a prohibited investment on or before October 4, 2011 due to the application of these new rules. 5 New transitional rule for certain investments

There can be an additional tax where an advantage in relation to an RRSP is received by a holder of the RRSP, a trust governed by the RRSP or any other person who doesnt deal at arms length with the holder of the RRSP. In this case, the additional tax is 100% of the fair market value of the benefit. This tax is assessed annually (on a calendar year basis) and can apply to any increase in the fair market value of a prohibited investment after March 22, 2011. However, for investments acquired before March 23, 2011 that become a prohibited investment on March 22, 2011,6 the taxpayer must elect in prescribed form before July 2012 to take advantage of this transitional rule. theres a transitional rule to provide relief from this 100% tax. This tax will not apply in a given year where the amount of the transitional prohibited investment benefit (discussed below) is paid to the individual from the RRSP within 90 days after the end of the taxation year. Although the August draft legislation provided that this transitional relief would apply up to the end of 2016, the October NWMM has extended this relief by an additional five years to the end of 2021. What is the transitional prohibited investment benefit for a year? For investments which become a prohibited investment on March 22, 2011, the transitional prohibited investment benefit for a taxation year is calculated by the formula (A B), where: A equals the income earned in the taxation year (and after March 22, 2011) plus any capital gains that have accrued after March 22, 2011 and are realized in the year; and B equals any capital losses that have accrued after March 22, 2011 and are realized in the year.7

The key change introduced by the NWMM is that capital losses realized in the year have now been factored into the calculation. The amount of the transitional prohibited investment benefit must be paid out to the individual within 90 days from the end of the taxation year and will be subject to Part 1 tax (at the individuals marginal rate of tax). Although the draft legislation had originally provided that a special tax equal to 42.9% of the amount would have to be paid (in lieu of Part 1 tax), this special tax has now been removed. Investments acquired before March 23, 2011 that become a prohibited investment on March 22, 2011 can be removed from the plan and swapped for cash or other property with the same value, provided the exchange is completed by the end of 2021. The draft legislation had provided that this swap transaction had to be completed before the end of 2012 to avoid being caught by the advantage rules. The NWMM has extended this period by nine years to be consistent with the transitional prohibited investment benefit rules. How do these changes impact you? If you have an investment in your RRSP that became a prohibited investment on March 22, 2011, the changes introduced in the NWMM have provided some additional relief. One key burden that remains for private company share investments is that affected shareholders will still have to value their companies as at March 22, 2011 in order to be able to calculate the capital gains accruing after this date. In addition, although the time period for removing the prohibited investments has increased by nine years, this can still place an undue burden on certain RRSP holders (in particular, for shares that have grown significantly in value since their acquisition). Finally, the rules still only provide relief until the end of 2021. At that time, the 100% tax will start to apply, with no relief, until the investment is withdrawn from the registered plan. If you hold private company shares in your RRSP and the investment didnt become a prohibited investment on March 22, 2011, but a subsequent acquisition or disposition of shares occurs that results in the ownership increasing to 10% or more, the investment will continue to be a qualified investment for RRSP purposes, but will now be a prohibited investment and subject to the 50% penalty tax.8The transitional relief noted above will not apply. You will be subject to the 50% penalty tax and 100% advantage tax for as long as the investment remains a prohibited investment. In the event your RRSP acquires a prohibited investment after March 22, 2011 and you want to remove it from your plan, the draft rules provide that you may be able to avoid paying tax on the RRSP withdrawal by swapping the prohibited investment for cash or other property with the same value. 9 This relief is intended to apply to situations where you hold an investment that becomes a prohibited investment after March 22, 2011, through the actions of third parties (e.g., the purchase of additional equity by a relative, or the redemption of existing investments held by others that increases your percentage ownership in the business to 10% or more).

1 The rules apply equally to investments in your RRIF. 2 Although both of these articles were targeted at private company investments, the rules apply equally to public company investments. 3 Tabled as Bill C-13. 4 These rules also apply where you and related parties own 10% or more of the fair market value of all interests in a partnership or trust. 5 The day on which Bill C-13 was tabled in Parliament. 6 Due to the application of these new rules. 7 Variable B recognizes that its appropriate to allow losses to offset gains; however, the loss offset doesnt include a carry-forward or carry-back mechanism.

8 Note that any investment that becomes a prohibited investment on any day between March 23, 2011 and October 4, 2011 inclusive will not be subject to the 50% penalty tax; however, the RRSP holder will not be able to benefit from the transitional prohibited investment benefit rules. 9 This will generally be permitted as long as you would be entitled to a refund of the 50% penalty taxi.e., its reasonable to consider that you didnt know at the time the property was acquired by your RRSP that is was, or would become, a prohibited investment.