“Advisors should review these new rules with clients who are contemplating acquiring private company shares.”
The March 22, 2011 federal budget has resulted in changes that adversely affect RRSP and RRIF investments. For investments made after March 22, 2011 and for investments held on that date, the changes now extend the term “prohibited investment” from its original TFSA application to RRSPs and RRIFs.
Generally speaking, a prohibited investment includes shares of a corporation, interests in or debt of a partnership or trust held by a RRSP or RRIF and either:
- in the case of shares of a corporation, 10% or more of any class of shares of the corporation (or of a corporation, partnership or trust that does not deal at arm’s length with that corporation), are owned by the taxpayer (alone or with persons with whom the taxpayer does not deal at arm’s length),
- in the case of partnership or trust, 10% or more of the fair market value of all interests (or of a corporation, partnership or trust that does not deal at arm’s length with that partnership or trust), are owned by the taxpayer (alone or with persons with whom the taxpayer does not deal at arm’s length),
or
- the taxpayer does not deal at arm’s length with the corporation, partnership or trust, as the case may be.
Since the 10% rule relies on the “non-arm’s length” test, advisors should review all the relevant facts with their clients in order to definitively determine the status of these investments.
The legislation now imposes two new penalties on the holder of a RRSP or RRIF that holds a prohibited investment. The first penalty is 50% of the fair market value of the prohibited investment on the date it is acquired. If the investment was not a prohibited investment prior to March 23, 2011 but became a prohibited investment, under the new rules, after March 22, 2011 or before October 4, 2011, this penalty will not apply. Where the 50% tax applies, it can be refunded if the investment is sold or ceases to be a prohibited investment by the end of the calendar year following the year in which the tax arose (or on a later date if the Minister allows).
The second penalty is a 100% tax on all realized income or capital gains attributable to prohibited investments, that accrued after March 22, 2011. A special transitional measure is available to eliminate this tax if the taxpayer files an election in prescribed form by June 30, 2012 and the income earned or gains realized before 2022 are paid out of the RRSP or RRIF within 90 days after the end of the year in which the income or gains are earned or realized. Presumably the relief from the penalty is provided because the amounts paid out will be subject to regular income tax in the annuitant’s hands. Please note that this penalty will apply even if the investment is exempt from the 50% penalty, based on the grandfathering rules mentioned above.
Advisors should review these new rules with clients who are contemplating acquiring private company shares (or more than 10% of a public corporation) or partnership or trust interests in their RRSP’s. Taxpayers who already own prohibited investments in their RRSP’s should also be advised accordingly.
In most situations, extracting the investment (or not acquiring it at all) will be the best course of action. Extractions will usually be carried out with swaps of investments that are outside of the registered plans. Such swaps are still permitted until the end of 2021.
To explore these issues further, please contact your TSG representative.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.
The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.
