Pension income splitting

Some RCA payments may now qualify for pension income splitting

At issue

In recent years, the federal government has taken steps to address concerns it has about the inappropriate use of some retirement income plans and other registered vehicles. This includes the introduction of ‘advantage’ and prohibited investment rules applying to RRSPs, TFSAs, IPPs and RCAs.

The 2012 Budget took direct aim at abusive practices associated with some RCAs – retirement compensations arrangements. New rules were prompted by certain RCA practices that lead to unintended tax benefits. Impugned activities included large contributions being stripped out of an RCA while claiming tax refunds, and the use of insurance products to allocate costs to an RCA while benefits arose outside the plan.

Somewhat lost in those policing measures (at least to this writer, though I suspect I’m not the only one) was a favourable change for some RCA beneficiaries, enabling pension income splitting in some circumstances.

Pension amount credit – ITA 118(7) “eligible pension income”

Section 118 of the Income Tax Act is a definitional section for personal tax credits, including “eligible pension income” for the purposes of determining the pension amount tax credit. This in turn rests on the definitions of “pension income” for those 65 and over, and “qualifying pension income” for those who have yet to reach age 65.

Pension income splitting was introduced for the 2007 taxation year, allowing a recipient to allocate up to 50% of certain income to a spouse for tax purposes. The foregoing definitions for pension credit qualification (with some amendments) were effectively shared with the new pension income splitting election. (And see ITA s.60.03 below.)

Income from an RCA is not included in any of these definitions.

2013-0497761E5 – Income splitting for RCA income

A letter sent to the Minister of National Revenue in June, 2013 sought clarification whether distributions out of or under an RCA may be eligible for pension income splitting. In response, the CRA representative recounted the general rules for pension income splitting, and specifically the absence of RCA income from the definition of eligible pension income.

However, for the 2013 taxation year and onward, amendments to the Income Tax Act now allow for RCA payments to qualify for pension income splitting in limited circumstances. “In general, the conditions that must be satisfied are the following:

the taxpayer is at least 65 years of age,
the RCA payments must be in the form of life annuity payments and be supplemental to a pension received out of a RPP, and
the RCA payments to be split cannot exceed a limit specified in the Act ($94,383 for 2013) minus the taxpayer’s other eligible pension income.”

Pension income splitting – ITA 60.03

This section provides definitions and the effect of making a pension splitting election. It includes its own definition of “eligible pension income”, which since enactment in 2007 had been merely a direct importation of the s.118(7) definition. An amendment proposed in the 2012 Budget and later enacted that year amended the definition in 60.03, as summarized generally in the foregoing CRA letter.

Very importantly, note that the amended section does not extend this favourable treatment of RCA income to individual pension plans (IPPs) with fewer than four members where at least one of them is related to a participating employer in the plan.

Practice points

Generally, RCA income continues to be ineligible for pension income splitting except in these limited circumstances where the plan supplements RPP income.
Non-arm’s length IPPs will likely not qualify for pension splitting under this exception.
Be careful as some government sources may continue to show the general exclusion of RCA income from pension income eligibility (without reference to this exception), including for example the CRA’s own webpage explaining “eligible pension income” (at time of writing in October 2013).

Your quinquennial retirement check-in: A five-year tax retrospective

No, “quinquennial” is not part of my everyday vocabulary. It is however a handy milestone for evaluating retirement planning progress, if not on an immediate personal basis then at least in terms of changes in the tax landscape.

By its nature, the retirement/tax system evolves incrementally, principally in step with the annual federal budget process. To those of us involved day-to-day in the financial advisory field, at times such change may seem to flow as slow as molasses in January. By contrast, the general population might only contemplate these matters periodically – often only when prompted by their advisors – so developments may appear more momentous once brought to their attention.

However, over the most recent five-year stretch, it could be argued that the sum of these developments is nothing short of astounding, whether planning your own retirement or advising others. With that in mind, consider how the following items will affect retirement planning conversations today compared to a mere quinquennium ago.

2008 – Pension income splitting

Technically a little outside the timeframe, pension income splitting was announced in the Halloween 2006 Economic Statement and introduced in the 2007 Budget. The first opportunity to elect to split up to 50% of such income with a spouse would have been in filing one’s 2007 tax return in/by April 2008.

In addition to the obvious potential to push income to a lower bracket spouse, the maneuver could help preserve the pensioner’s age credit, fend off OAS clawback and assist in making fuller use of the spouse’s pension credit.

2009 – Tax-free Savings Account

Introduced in the 2008 Budget, Canadian residents over the age of 18 received their first $5,000 annual allotment of TFSA room on January 1, 2009.

The structure allows for contribution of after-tax funds, with any subsequent growth and withdrawals being tax-free. In addition, there is a dollar-for-dollar credit on those annual withdrawals that increases contribution room the next January 1st. Apart from being a welcome gift for those with excess cash to invest, the TFSA offers lower bracket individuals a more viable alternative or complement to the traditional RRSP structure.

The indexing formula boosted the annual dollar limit to $5,500 beginning in 2013.

2010 – Canada Pension Plan

While it is patently obvious that this is not a new program, the 2009 triennial review proposed significant changes to the CPP. These changes were legislatively approved in 2010.

With the elimination of the work cessation test, it became administratively simpler to commence a retirement pension, and all future pensions will be marginally improved as the low earnings drop-out increases from 7 to 8 years. However, the decision as to when to commence that pension has become more complicated with new mandatory premium payments for working beneficiaries (voluntary after 65), an increased monthly early take-up penalty from 0.5% to 0.6%, and an increased monthly deferral premium from 0.5% to 0.7%.

2011 – Registered Disability Savings Plan

The RDSP was actually introduced in the 2008 Budget, but took 2 or 3 years of tweaking before those in the target population could fully avail themselves of the program.

A key benefit is the access to matching Grant and free Bond support money. The 2010 Budget made provision for carryforward of unused Grant and Bond entitlements. Perhaps the most important modification occurred in the 2011 Budget with the relaxation of stringent rules that up to then would have forced mass repayment of Grant and Bond money at inopportune times.

The RDSP is now coordinated in many ways with the beneficiary aspects of RRSPs, RRIFs and RESPs, making for much more flexible planning options for individuals and families with disability planning needs.

2012 – Old Age Security

The 2012 Federal Budget will probably be most remembered for raising the OAS qualification age from 65 to 67. Those born prior to April 1958 will remain eligible at 65, with those born after January 1962 having to wait all the way to 67. The rest of us will be somewhere in between, with the phase-in period ranging from April 2023 to January 2029.

As well, as of July 2013 an eligible individual may defer OAS pension for up to five years, in exchange for a 0.6% increase in the pension amount per month deferred.

2013 – Pooled Registered Pension Plan

As we head into the next quinquennium, the PRPP warrants mention before signing off.

Discussed since 2010, the program is aimed at encouraging workplace savings where no current pension arrangement is in place. The federal tax amendments out of the 2012 Budget are now passed, but there is yet to be any concrete action from the provinces. As the program design dovetails contribution room with RRSPs, ever more opportunities and trade-offs may lie ahead, further feeding those retirement planning conversations.

Pension splitting discrimination – Charter argument fails

There are many parts of the Income Tax Act (ITA) where relevant distinctions are made as to income sources and taxpayer circumstances. Then there are the pension income splitting rules, which suffer from irrelevant source distinctions and in turn lead to discriminatory treatment of many taxpayers.

In an informal procedure case reported this past November (Hotte v. R.), the taxpayer brought a Charter challenge to the age 65 aspect of the pension splitting rules.

The dubious distinction in the splitting rules

The income-splitting provisions in the ITA rely upon a number of definitions to determine what income may be included for splitting. Chief among these definitions for these purposes:

All “pension income” if the person is 65 years or older; and
Only “qualified pension income” if the person is younger than 65.

With the exception where there is a pre-deceasing first spouse, a person whose pension income arises solely out of RRSP/RRIF sources cannot split that income until age 65. For those who receive RPP source income, the splitting may commence before age 65. Notably in this case, Mr. Hotte had both RPP and RRSP (life annuity) sourced pension income, and his challenge was based on the ineligibility of the latter source for splitting.

After canvassing key Charter cases, the judge stated that Mr. Hotte had not led any evidence of a “disadvantaged class” or “prejudicial stereotyping” hinging on age 65.

Court limitations where Parliament has spoken

As acknowledged by the court, “the choice of age 65 as the threshold was a policy choice open to Parliament to make and they have made it.” These comments flow from a letter from the Minister of Finance to Mr. Hotte that was entered into evidence. I repeat in full here the excerpt as it appeared in the case:

“The purpose of the age-65 requirement for RRSP annuity and RRIF income is to target the Pension Income Credit (upon which eligibility for pension income splitting is based) to retired individuals. Individuals have much greater personal control over the timing of withdrawals under RRSPs and RRIFs compared to RPPs. Without the age-65 eligibility rule, many individuals who are not retired could gain significant tax advantages well before they attain age 65 by arranging to withdraw money each year as RRSP annuity or RRIF income while still saving for retirement. Individuals in receipt of RPP income, on the other hand, generally have little control over the timing of their pension payments — they usually only receive such payments when they are retired.”

Frankly, I don’t agree that there is a real concern about RRSP/RRIF holders acting in a strategic manner that is a threat to the retirement system, nor that RPP holders would fail to take advantage where possible. On the contrary, most people would see a much greater existing financial advantage for those entitled to large pension plans – often indexed government-guaranteed defined benefit plans at that.

In fact, the suggestion of the possibility of so-called advantages for RRSP/RRIF holders, appears to have given way to the certainty of favouring RPP holders. Given that the actual average retirement age is closer to age 60 than 65, the reality is that RPP holders have been granted increasing favour relative to RRSP/RRIF holders.

Next time or next Budget?

Mr. Hotte made a valiant effort, but he did so self-represented under the informal procedure. Understandably he focused upon age eligibility, but arguably it is the prior characterization of the source/definition that pre-ordains the result.

Thus, a future taxpayer-litigant may stand a better chance by framing the issue in terms of source rather than taxpayer. This would focus the light on the unfair structural divide in the retirement system between RRSP/RRIF holders and RPP holders.

Better yet, maybe the forthcoming Federal Budget will formally recognize this inequity and put all retirees on an even footing.