Your client works for
a private company and wants to put his company shares into his RRSP. He turns to you for help. What do you tell him?

The issue of an RRSP holding private shares is one of the most complex and restrictive areas of Canada’s Income Tax Act. The rules “hurt your brain,” says Kim Moody, a chartered accountant with RSM Richter in Calgary: “The requirements are very, very specific. The shares have to be considered a ‘qualified investment’.”

Because of this, putting shares of a private company into an RRSP is more a rarity than a common occurrence. In fact, says William Hawley, a lawyer and managing director at Hawley Financial Group Inc. in Calgary, the complexities and restrictions are such that “we have discussed it with clients, but have not pursued it through to implementation with anyone.”

One reason is cost. The hoops and hurdles a shareholder has to go through to satisfy the restrictions make it expensive to put such shares into an RRSP. “If you’re spending less than $5,000 to $10,000 on professional fees, there’s something wrong,” says Moody. “It’s not easy and quite complicated. A lot of times, it’s not worth doing.”

Another hurdle in placing such shares inside an RRSP is figuring out what constitutes a qualified investment. An RRSP can hold private shares of either an “eligible corporation” or a “small business,” says Chris-tina Diles, a chartered accountant with Deloitte & Touche LLP in Vancouver. Each category “must satisfy certain conditions” or tests.

One such condition relates to the percentage of shares that the RRSP planholder can own. The number is limited to 10% of the company shares, which essentially limits participation to minority shareholders. Moreover, the beneficiary is deemed to own shares held by other family members, such as parents, spouses, kids or siblings, which makes it hard to meet the 10% limit in family-controlled companies.

A beneficiary can own more than 10% — provided he or she deals with the company at arm’s length and that the value of the shares is less than $25,000.

The Canada Revenue Agency’s Interpretation Bulletin IT-320R3, which can be found at www.-cra-arc.gc.ca/E/pub/tp/it320r3/README.html, provides guidance on what constitutes a qualified investment under Canada’s tax laws.

In the case of a small business, the tests are applied at one point in time, Diles says. If the company meets the tests, the shares can be transferred into an RRSP and there’s no need to monitor them to ensure they stay onside. In the case of an eligible corporation, however, the tests are ongoing and the shares must meet the requirements during the time they are held in the RRSP.

IT-320R3 also notes that the RRSP trustee, known as the “plan trust,” can only acquire shares that meet the tests. Otherwise, the trustee is offside, which creates a taxable event.

“Trust companies have quite stringent terms,” says Robin Mac-Knight, a tax lawyer at Wilson Vukelich LLP in Markham, Ont. “They want to make sure they are not offside and blow their trust.”

Another big challenge with private companies is ascertaining the value of the shares at the time they go into the RRSP. “It’s difficult to value the shares of a private company,” Moody says. It means the shareholder has to hire a valuation expert, which drives up costs and makes the process unattractive. There can also be the need to have regular valuations to ensure that the shares still qualify, creating ongoing costs.

There can also be challenges should the planholder decide to sell the shares. “You get into all kinds of issues,” says MacKnight.

In one case, an employee-owned company, in which employees held the shares in their RRSPs, decided to sell to another firm and, as payment, receive a blend of cash, shares and notes — only to learn later that some of those items were ineligible investments for their RRSPs. The items had to be removed from the RRSPs and included in income.

A problem can also arise if one person wants to sell his or her shares. Unless the private company has set up a structure to buy such shares in those circumstances, it can be difficult to sell them and determine their fair value, MacKnight says. It’s particularly problematic if a person dies, quits or retires.

@page_break@There are other tax considerations when putting private company shares into an RRSP. Diles notes that, at the time the shares go into the RRSP, the shareholder is deemed to have sold them, which may trigger a capital gain. Some of that may be sheltered under the small-business capital gains exemption. However, if there’s a capital loss, it will be denied.

There is also the challenge of overall RRSP limits. If a client doesn’t have enough contribution room, then he or she might not be able to transfer all the shares in one year, but may have to flow them in over time. However, as Diles writes in an article posted on her firm’s Web site (www.deloitte.com) : “The need for a valuation at the time of each transfer may make it impractical to do so.”

As well, MacKnight warns, the RRSP contributor could “be shooting him- or herself in the foot” by putting private shares in an RRSP. That’s because he or she is forgoing the capital gains exemptions that come with such shares. If the shares are held outside the RRSP, there is not only a $500,000 small-business capital gains exemption to be used, but also a lower inclusion rate that is applied to taxing capital gains. Once a client puts such shares into an RRSP, he or she forgoes those benefits. Instead, the money is taxed as income when it is removed, which can be at a higher rate than the capital gains tax, depending on the client’s marginal tax rate.

Despite the numerous hurdles, the strategy should not be dismissed entirely. Diles says there are some instances in which it makes sense to put shares of a private company into an RRSP, assuming they qualify. That’s when a client “expects a significant appreciation in the value of the shares to occur relatively soon, and the client sells the shares within the RRSP so that money can generate some income on a tax-free basis.”

Her paper cites the examples of two shareholders. One acquires shares at age 35 and keeps them outside his RRSP. He then sells them at 40 and realizes a $100,000 capital gain. After paying taxes as a British Columbia resident, he has $78,000 to invest; it earns 5%. When he retires at 65, he has $156,000.

That contrasts with the man’s twin sister, who, at the time of acquiring her shares, puts them in her RRSP. When the shares are sold at age 40, the entire $100,000 proceeds are invested at 5% and sheltered in her RRSP. At 65, she has $339,000. If she withdrew it all and paid taxes at the top rate, she would still be left with $190,000 — about $34,000 more than her brother. Of course, she could defer taxes by withdrawing funds over a number of years.

The bottom line, Diles says: “You have to do the financial analysis to make sure it makes economic sense.” IE