Strict new tax measures creating a class of so-called “prohibited investments” (PI) in registered accounts are likely to be revised. The new rules, put forward in the March, 2011 federal budget and partly aimed at preventing large shareholders from unfairly sheltering their gains, carry punitive enforcement measures and have been widely criticized by tax experts.

But in late June, the Department of Finance indicated that it is prepared to soften some of the effects of the new regime. Those changes have been hailed as welcome relief for innocent taxpayers who could be caught in the wide net cast by the PI rules.

The PI rules use a complex set of mechanisms to end the practice by some taxpayers of sheltering shares in the companies they own, control or have significant interests in by placing these shares in registered accounts (see Investment Executive, mid-November, 2011). For instance, many taxpayers who own or control private companies and place the shares of these companies in an RRSP could unknowingly run afoul of the new rules.

The rules include punitive penalties. PI’s are subject to a tax penalty equal to 50% of the fair market value of the PI. In addition, any growth derived from the PI in the registered account is 100% taxable. Transitional rules allow taxpayers to move their PI’s out of sheltered vehicles within certain time periods, but with potentially big tax hits.

PI’s are defined, in simple terms, as a “significant interest” in the issuer of shares in the investment. A significant interest is generally ownership of 10% or more of the shares (including ownership together with non-related persons).

Prior to the rule changes in the 2011 budget, taxpayers could use registered vehicles for this class of investments as long as their acquisition cost was less than $25,000 and the taxpayer and related persons did not control the issuer.

The new rules were quickly met with a wall of concern from a variety of groups involved in tax planning. A particular criticism was that some taxpayers might have no way of knowing whether their investments fell within the new PI rules.

As a result, a joint committee of the Canadian Bar Association and the Canadian Institute of Chartered Accountants was formed to address perceived unfairness. Finally, on June 12, the Department of Finance wrote to the committee recommending a series of changes designed to alleviate some of the effects of the new rules, especially those likely to catch innocent taxpayers.

Among the recommended changes are:

* Revising the definition of a PI to exclude the so-called “indirect significant interest test.” That provision of the existing PI rules defines a PI as including a significant interest in another entity that is related to the entity (i.e., a company) whose shares are held in the taxpayers registered vehicle. This rule was faulted for being overly complex and leaving the taxpayer open to innocently contravening the rules.

Finance has now proposed eliminating the indirect significant interest test. A comment on this change by law firm Borden Ladner Gervais LLP noted: “[The change] means that an investment in a mutual fund will not be a prohibited investment for a registered plan simply because the planholder holds, for example, 10% or more of a class or series of shares of the fund’s manager.”

* Creation of a “safe harbour” from the application of the PI rules. In simplified terms, the safe harbour is designed to exclude investments in situations in which 90% of substantially similar investments are held by arms length owners and there is no tax-avoidance purpose.

Tax experts have noted, however, that this exemption mostly reflects situations not covered by the existing PI rules. In other words, it is a different way of restating existing rules and provides no significant relief. In a comment on the changes, law firm McMillan LLP noted: “Since [the new definitions] are (almost) the inverse of the tests contained in the definition of prohibited investment, in most circumstances, the [new] conditions will not be satisfied.”

* Expanding the exclusion for investment funds. The PI rules currently include some relief for the founding investors in new mutual funds, who can be expected to hold more than 10% of the fund’s units or shares on start-up. These investments receive an exemption from the PI rules for two years, provided the funds comply with NI 81-102 of the Canadian Securities Administrators, which regulates most aspects of how mutual funds are managed.

In response to criticism that the exclusion is too narrow, Finance has proposed extending the exclusion to mutual funds not covered by NI 81-102, provided they meet basic diversification tests and are not created to avoid tax. However, the McMillan note points out that the exclusion still leaves out “a significant number of mutual funds available for purchase by Canadian investors.” In addition, the exclusion is only available for the first and last two taxation years of a fund, the note says.

Review of further changes and commentary is available at: