Individual Pension Plans: Non-Compliance with the Primary Purpose Test

An individual pension plan (IPP) is a defined benefit registered pension plan (RPP) typically set up for one individual--the owner-manager of a private corporation. Although an IPP can be an effective method of deferring income and providing for retirement, advisers should be aware that many IPPs are not in compliance with the Act. In particular, the use of an IPP to receive funds from the RPP of the owner-manager's previous employer raises a red flag.

Consider the following situation: An individual who has worked for many years for a large employer with a defined benefit RPP wants to retire and transfer the commuted value--an amount equal to the present value of her right to a pension under that plan--to a vehicle in which it can continue to be sheltered from tax.

If she simply transfers the commuted value to her RRSP under subsection 147.3(4), the amount that she can transfer is limited by regulation 8517, and the excess must be brought into income. Thus, for example, if the commuted value is $700,000, it is possible that she will be able to transfer only $500,000 to an RRSP under subsection 147.3(4). In contrast, if she sets up a corporation, establishes an IPP for that corporation, and transfers the commuted value to the IPP, the entire $700,000 can be fully sheltered.

The potential compliance problem arises because regulation 8502(a) provides that the primary purpose of an RPP must be to provide periodic payments to individuals after retirement and until death in respect of their service as employees. This test is easily met in a normal private corporation with business operations and employment duties for the owner-manager. However, in some corporations that are set up for commuted-value transfers to IPPs, no business is being carried on, there is no remuneration, and there is no bona fide employment relationship between the plan sponsor and the member.

In such a situation, the CRA will likely apply section 147.1 to revoke the plan's registered status as of the date of inception of the IPP. Unless the year is statute-barred, the full $700,000 will have to be brought into income, and tax on that amount plus interest will be due. In addition, if the individual has transferred an amount to an RRSP from the revoked plan, the transfer will be ineligible, the amount transferred will be an excess contribution to the extent that RRSP deduction room did not exist, and a further penalty of 1 percent per month will apply.

An appeal from the CRA's decision to revoke an IPP's registered status is made directly to the FCA, which has issued several decisions upholding the CRA's interpretation. (See 1346687 v. Canada (2007 FCA 262); Jordan Financial v. Canada (2007 FCA 263); Boudreau v. Canada (2007 FCA 32); 1398874 v. Canada (2010 FCA 14); Loba v. Canada (2004 FCA 342); Loba v. Canada (2008 FCA 403); and Hodge v. Canada (2009 FCA 210).) One can expect little sympathy from the court. In Hodge, for example, the FCA refused to alter the date of revocation to mitigate the burdensome tax consequences of revocation because "[i]f there were no adverse tax consequences on the revocation of the registration of employee pension plans that never complied, there would likely be many more such schemes."

Nabeel Peermohamed
Toronto
nabeel.peermohamed@mail.utoronto.ca

Canadian Tax Focus
Volume 3, Number 2, May 2013
©2013, Canadian Tax Foundation