Tag: RCA

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

  1. Generally, RCA income continues to be ineligible for pension income splitting except in these limited circumstances where the plan supplements RPP income.
  2. Non-arm’s length IPPs will likely not qualify for pension splitting under this exception.
  3. 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).

Are RCAs are more palatable now, with the return of the 50% bracket?

The 50% tax bracket is back.

In case you missed it, Nova Scotia residents will be subject to a 50% tax rate on income over $150,000 when they file their returns for 2010. And if recent tax platform reversals in British Columbia and New Brunswick indicate the broader political mood, there could be company coming to that 50-plus party.  

There’s something magical — not in a good way — about the 50% threshold. The notion that the government gets more of your earnings than you do can be a powerful incentive to explore tax-planning options. Unfortunately for those of us who are straight-up employees, there are relatively few avenues to relief.

By contrast, business corporation owners and incorporated professionals have much greater latitude to organize their affairs strategically. One vehicle that may return to the planning radar due to its close association with the 50% bracket is the retirement compensation arrangement (RCA).

RCA tax fundamentals

Though RCAs may lead to tax benefits, they are not inherently tax beneficial. In fact, the rules were created in 1986 to forestall what were perceived as abusive ‘top hat’ pensions, which aggressively supplemented beyond RPP limits. The RCA rules have not outlawed these supplemental executive retirement plans (SERPs), but are sufficiently onerous to make planners weigh the issues before heading down that road.

The key rules are:

  • An employer may deduct contributions to a funded SERP, termed an RCA.
  • Out of the amount contributed to the RCA, 50% must go to a refundable tax account (RTA) with the CRA.
  • Earnings within the RCA are not entitled to the capital gains inclusion tax rate, or to preferred dividend gross-up and tax credit treatment.
  • As with contributions, 50% of realized RCA earnings must be paid to the RTA.
  • For each $2 paid out to the employee from the RCA, $1 is refunded by CRA from the RTA to the RCA; on wind-up, the whole RTA is refunded to the employee.
  • Payments from the RCA to the employee are regular income.  

At first blush, it appears the employee’s personal marginal tax rate would have to be greater than 50% to consider an RCA. While that might be preferred, the RCA might be better viewed as a coordinated component of a broader plan comprising current compensation, creditor protection, business succession, retirement income and estate planning.  

Still, the ultimate value of the RCA depends on good tax management, and that in turn relies upon tax-informed investment management. 

RCA investment practices

The RTA is like an interest-free loan to the government. While this may be unavoidable with respect to the initial deposit, careful management of the RCA can limit further additions to the RTA that would otherwise arise out of realized earnings.

Sophisticated strategies go so far as housing exempt life insurance policies, or even shared interests in such vehicles, within the RCA. Acknowledging that such arrangements may have benefits, they may not be appropriate where the RCA is intended to operate principally — if not exclusively — as a pension supplement.

On a general operational level, then, what considerations inform an RCA’s investment management?

The RCA should not be viewed in isolation from other investment and income sources. For the RCA, one may be inclined to choose assets designed or expected to generate unrealized gains; the drawback, however, is that those gains will eventually be treated as regular income, despite the accompanying market risk.  

It may be preferable to skew the owner or employee’s non-registered asset allocation toward such investments, to be eventually rewarded through preferred capital gains and dividend treatment in that tax environment.

As a corollary, that would mean that the RCA assets would lean towards fixed income. The drawback here is that annual realized income forces payments over to the RTA. While this causes a drag in accumulation years, it may not matter so much once the drawdown phase has begun, as RCA payments to the employee will recover RTA deposits.  

During the accumulation period, it may be useful to defer annual recognition while maintaining a conservative risk profile. This might be achieved by holding a structure like mutual fund corporation shares that carry underlying fixed income instruments.

Ultimately, whether prompted by tax developments or personal circumstances, the RCA discussion is worth having with appropriate entrepreneurs and professionals, and is probably best framed in that broad planning context.