As part of the 2012 budget, the government of Canada is proposing new prohibited investment and advantage rules to prevent retirement compensation arrangements from engaging in non-arm’s length transactions. These rules are based closely on existing rules for tax-free savings accounts and RRSPs. In addition, the government is proposing a new restriction on RCA tax refunds in circumstances where RCA property has lost value.

An RCA is a type of employer-sponsored, funded retirement savings arrangement. RCAs are normally used to fund the portion of a higher-income employee’s pension benefit that exceeds the maximum pension benefit permitted under the registered pension plan (RPP) contribution limits.

The government says the Canada Revenue Agency has identified a number of arrangements it says take advantage of features of the RCA rules in order to obtain unintended tax benefits. It cites as an example arrangements that involve the deduction of large contributions that are indirectly returned to the contributors through a series of steps ending with the purported RCA having little or no assets but still being able to claim the refundable tax.

The government says it is challenging these tax-motivated arrangements, which it says are not consistent with the policy intent of the RCA rules. However, because the challenges are both “time-consuming and costly,” the government says, it is now introducing legislative measures to prevent the use of similar schemes.

“We’ve known for a number of years that the RCAs have been on the CRA’s radar,” says Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth Management. “And these developments should not come as a surprise to the industry, which has been warned about the potential abuses of the RCA rules.”

Prohibited investments
The government is proposing that the new prohibited investment rules apply to RCAs that have a “specified beneficiary.”

According to budget documents, a specified beneficiary of an RCA will be an employee who is entitled to benefits under the RCA who has a significant interest in the employer. The custodian of an RCA will be liable to pay a 50% tax on the fair market value of any prohibited investment acquired or held by the RCA. A specified beneficiary of an RCA that participates in the acquisition or holding of a prohibited investment by the RCA will be liable, to the extent of participation, for the tax.

This tax will be refundable if the RCA disposes of the prohibited investment by the end of the year following the year in which it was acquired unless any of the people liable for the tax knew or ought to have known that the investment was a prohibited investment. The government will also have the power to waive or cancel the tax in certain circumstances.

This measure will apply in respect to investments acquired, or that become prohibited investments, on or after budget day.

Advantages
The government is proposing that the definition of “advantage,” as it is understood in rules governing TFSAs and RRSPs, be adapted to address certain tax planning in relation to RCAs.

For example, if an RCA buys a high-value property and that value is later intentionally eroded or transferred from the RCA without adequate consideration, an “RCA strip” transaction will be considered to have taken place and to constitute an advantage.

An “RCA strip” will be a new definition similar to the existing definition of “RRSP strip” in the RRSP rules, with modifications as the circumstances require to apply to transactions involving RCAs.

As with existing advantage rules, an RCA advantage will be subject to a special tax equal to the fair market value of the advantage. The custodian of the RCA will be liable for the special tax.

A specified beneficiary of the RCA that participates in extending the advantage will be liable, to the extent of his or her participation, for the special tax.

The Minister of National Revenue will have the power to waive or cancel the special tax.

According to budget documents, the special tax will generally apply to advantages extended, received or receivable on or after budget day, including advantages that relate to RCA property acquired, or transactions occurring, before budget day. However, advantages that relate to property acquired, or transactions occurring, before budget day will be eligible for special transitional rules on an elective basis, as is the case under the existing advantage rules.

Transitional Rules
If RCA property acquired, or transactions occurring, before budget day cause an advantage to be obtained by a specified beneficiary of the RCA (or a person who does not deal at arm’s length with the specified beneficiary) on or after budget day, then the amount of the advantage will not be subject to the special tax provided that the amount is included in computing the income of the specified beneficiary.

If RCA property acquired, or transactions occurring, before March 29, 2012 cause an advantage to be obtained (such as income earned, and capital gains accrued and realized, on a prohibited investment) by the RCA on or after budget day, the amount of the advantage will not be subject to the special tax provided that the amount is distributed from the RCA and included in the income of a beneficiary or an employer in respect of the RCA. Such distributions will be treated as regular taxable distributions for the purpose of determining RCA tax.

RCA tax refunds
Finally, the government is proposing that, if RCA property has declined in value, the RCA tax be refunded only in circumstances where the decline in value of the property is not reasonably attributable to prohibited investments or advantages, unless the minister makes an exception based on circumstances.

This measure will apply in respect to RCA tax on RCA contributions made on or after budget day.