Bad News for RRSP and RRIF Investments in Private Companies
Legislation stemming from the 2011 federal budget that received royal assent in December 2011 has made the rules for RRSP and RRIF investments in private company shares so restrictive that new investments may not be feasible in most circumstances. Investments that existed as at March 22, 2011 should be reviewed, because the grandfathering provisions are limited in scope.
Under the old rules, an investment in private company shares for an RRSP or RRIF account could be considered a qualified investment if, at the time of purchase, the private company was a specified small business corporation (regulation 4901(2)), and the annuitant and non-arm's-length persons held less than 10 percent of the company's shares. The 10 percent rule did not apply if the annuitant dealt at arm's length with the company and the original cost of the investment was less than $25,000.
The new rules are phrased in terms of what is not allowed. A "prohibited investment" (subsection 207.01(1)) for an RRSP or RRIF includes, among other things, an investment in an entity (corporation, partnership, or trust) in which the annuitant and non-arm's-length parties have a significant interest (10 percent or more, in most cases) and a prescribed property. If a prohibited investment is acquired or an existing investment becomes a prohibited investment, the RRSP or RRIF annuitant will be required to pay a 50 percent tax on its fair market value (subsection 207.04(1)), and a 100 percent tax will apply on any income and capital growth (subsection 207.05(1)). These rules, which previously applied only to TFSAs, now apply to RRSPs and RRIFs.
Much recent discussion has focused on the fact that it is no longer possible to go beyond the 10 percent limit on the basis that the original cost of the investment is less than $25,000. While this point is important, it is the inclusion of prescribed property in the definition of a prohibited investment that could catch taxpayers off-guard. Essentially, regulation 5001 provides that in order for private company shares to avoid becoming prescribed property, the company must be a specified small business corporation at all times--not just at the time of purchase.
If the company begins to accumulate a significant amount of non-active business assets, or if it increases its foreign operations or becomes subject to a non-resident acquisition, its status as a specified small business corporation could be jeopardized. Thus, taxpayers will need to monitor their private company investments at all times during their ownership. It may be difficult, in some circumstances, to obtain the required financial information.
Grandfathering provisions allow taxpayers to avoid the taxes described above for investments that became prohibited investments under the new rules immediately after their announcement on March 22, 2011. The grandfathering provisions provide a mechanism to remove the prohibited investment from the RRSP or RRIF account over a period of time (before 2022), and any income related to those investments will not be subject to the 100 percent tax as long as that income is taxed as a withdrawal from the RRSP or RRIF within 90 days after year-end. Investments that become prohibited after the grandfathering provision dates have less favourable tax consequences.
In addition to all the problems noted above, owning private company shares in an RRSP or RRIF account prevents the taxpayer from accessing the capital gains deduction (if available) on those shares. The lifetime capital gains deduction, now $750,000, can permanently save the taxpayer a significant amount of tax. That permanent tax saving could be greater than any long-term tax benefit of a tax deferral available in an RRSP or RRIF account.
Deloitte & Touche LLP, Edmonton