Feds looking to stop some RRSP swaps

Under the “advantage” rules in the proposed legislation, RRSP swaps, which involve the swapping of an investment in a non-registered account with an investment of equal value in an registered account, effectively will be stopped — thanks to a 100% penalty tax assessed on any income, gain or other advantage realized on the investment swapped into the RRSP.

Under the “prohibited” investment rules, investors will face a one-time 50% tax on certain investments held in an RRSP — most notably, any investment in which the RRSP-holder owns more than a 10% interest. In addition, there would be a 100% tax on any “advantage” realized on that investment. The concept of “prohibited” investments is new to the rules that govern RRSPs.

And there are changes to the rules governing “non-qualified” investments — an existing term in current RRSP legislation. RRSP accountholders will be assessed a one-time tax penalty of 50% on the fair market value of any “non-qualified” investment; this replaces the previous penalty of 1% a month on the value of such an investment. Non-qualified RRSP investments include the shares of a company that is under a cease-trade order.

Although the government says it has had some success in battling aggressive RRSP tax schemes using existing legislation, including applying the general anti-avoidance rule within the Income Tax Act, the feds felt more tools were needed in its kit. The proposed rules are meant to prevent taxpayers from using the tax characteristics of an RRSP in a way that contravenes the spirit of the law.

However, financial services industry groups and tax practitioners have been suggesting that the proposed legislation, in its attempt to thwart tax avoidance, casts too wide a net and ensnares legitimate tax-planning strategies.

In an Oct. 31 submission to the House of Commons’ standing committee on finance, the Toronto-based Investment Industry Association of Canada took issue with the scope of the bill: “Measures taken to prevent those who deliberately try to take advantage of the tax laws beyond what was intended should not be implemented at the expense of taxpayers trying legitimately to accumulate savings for retirement or to issue shares for productive capital investment.”

Draft legislation for the revised anti-avoidance rules was first released in August, and formal legislation was introduced in early October. That bill has passed first and second readings in the House of Commons, and, as of early November, was being reviewed by the finance committee. At press time, financial services industry groups and other stakeholders were still in contact with Finance Canada to suggest changes to the legislation.

Regarding swaps, the government is looking to stop those strategies that are considered to be abusive. A frequently cited example of such a swap is one in which the investor takes advantage of the bid/ask spread for an infrequently traded stock, swapping the shares in at the lower bid price and then, in short order, swapping the shares back out at the higher ask price. The “gain” on the investment remains inside the RRSP.

However, tax experts suggest that most swaps undertaken by investors are executed solely so that an investor can rebalance assets between non-registered and registered accounts in a tax-efficient manner and not to obtain an inappropriate tax advantage.

“[These investors] are trying to arrange their affairs in a way that makes sense,” says Allison Marshall, senior manager of financial advisory support with Royal Bank of Canada’s wealth-management division in Toronto.  “And now they’re caught under these [proposed] rules.”

The government appears unmoved by that argument. Wrote a spokesperson for Finance Canada: “Swap transactions in general represent a serious tax-planning concern the government needed to address.”

There is some slack, however, in the legislation regarding swaps. Swaps undertaken between “like” plans, such as between two RRSPs owned by the same accountholder, would not face any penalty taxes, although swaps between a TFSA and an RRSP would. The government may review and allow certain swaps, on a case-by-case basis.

The proposed rules governing prohibited and non-qualified investments are complex, involving, for example, different dates at which the tax penalties become effective.

Under the prohibited investment rules, RRSP accountholders will be allowed a transition period to remove such investments, either by withdrawing the investment or by swapping it out. (Swaps to remove prohibited investments will be allowed.) RRSP accountholders who remove a prohibited investment, within a set period of time, will be refunded the 50% tax.

Financial services groups have raised several issues with the feds regarding the complexity of the proposed rules and the various unintended consequences. A small-business owner, for example, who holds most of the shares of his or her company in his or her RRSP, and who has seen the value of those shares grow, perhaps into the millions of dollars, may be forced to find a way to remove that now large, “prohibited” investment out of his or her RRSP. Says Marshall: “Not everyone has millions of dollars in their non-registered accounts to be able to swap [investments out].”

The definition of “prohibited investment” also encompasses mutual funds, including funds that are regulated under National Instrument 81-102, the regulatory regime under which most retail funds fall. For example, as the proposed legislation stands now, an investor who owns more than 10% interest in a fund in his or her RRSP will be considered to have a prohibited investment.

“The consequences of holding a prohibited investment in a retirement plan are draconian,” wrote Joanne De Laurentiis, president and CEO of the Toronto-based Investment Funds Institute of Canada in an Oct. 28 letter to the finance committee. “These rules will inadvertently and inappropriately penalize retirement plans that hold what should otherwise be considered legitimate
investments.”  IE