Clients who hold private company shares in their RRSPs or RRIFs should be aware of recent changes that might expose them to a punitive new tax regime. If an individual holds shares of a private company in an RRSP, in which his or her ownership exceeds 10% on his or her own or in combination with a related person, those shares could face taxes of 50% of the assets and 100% of any income or gains.

“Take stock of your RRSP and see what’s in there, see if there’s anything potentially offside,” says John Waters, vice president and head of technical expertise for tax, estate and trust planning at Toronto-based BMO Nesbitt Burns Inc. in Toronto. “If there is, you need to deal with it as soon as possible.”

The changes were introduced in the 2011 federal budget. Before, an individual could hold shares of a private company in an RRSP, provided that the individual and other related persons held less than 10% of the shares in his or her RRSP at the time that the shares were first acquired by the RRSP. It was also permitted if the cost base of the shares was less than $25,000.

Under the new rules, holding shares of a private company in an RRSP when the total ownership exceeds 10%, whether individually or with a related person, would be considered ownership of a prohibited investment, which is subject to two possible tax liabilities.

If the RRSP acquires a prohibited investment after March 22, 2011, or if a previously qualified investment first becomes prohibited after Oct. 4, 2011 – due to the share ownership of the individual and any related party exceeding 10% – then a tax of 50% of the value of the shares applies.

There is an exemption from the 50% tax for investments that were acquired by an RRSP before March 22, 2011, but which became prohibited investments either immediately on March 23, 2011, or before Oct. 4, 2011.

The 50% tax, if applicable, may be refunded if the RRSP disposes of the prohibited investment by the end of the year following the application of the tax and if the Canada Revenue Agency concludes that the RRSP-holder did not know the investment was prohibited at the time of its acquisition.

The other tax on prohibited investments is the so-called “RRSP advantage tax,” which levies a tax of 100% on any income and gains on a prohibited investment after March 22, 2011, regardless of when the investment was acquired.

The rules do offer transitional relief from the advantage tax. That relief would allow any income or gains realized on the prohibited investment to be taxed at the individual’s marginal tax rate rather than the 100% rate. In order to obtain this relief, the investment must have been acquired before March 23, 2011, and the RRSP-holder must file an election. The election was originally due June 30, but the Department of Finance Canada has recommended this deadline be extended to Dec. 31. If the election is made, the relief is available until Dec. 31, 2021.

Last June, Finance Canada indicated it might consider extending both the deadline to make such an election and the transitional period related to holding prohibited investments. As of press time, the original deadlines stand.

Most tax experts are suggesting that RRSP-holders who find themselves holding prohibited investments should first make the election, in order to avoid the 100% advantage tax, then look for a way to remove the investments from the RRSP.

“Even though you have 10 years, do it sooner rather than later,” says David Ablett, director of tax and estate planning with Investors Group Inc. in Winnipeg. “Once you get the investment outside the RRSP, only 50% of any future growth [in the form of capital gains] will be subject to taxes.”

Apart from simply withdrawing the prohibited investment (and taking the tax hit), some clients may be able to swap their prohibited shares for another investment or cash of equal value from the individual’s non-registered account.

Swaps usually are prohibited in RRSPs, but will be allowed for the purpose of removing prohibited investments until the 2021 deadline. IE

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