Prohibited investment rules
Impact on investment funds
Canadian Tax Alert, November 22, 2011
Draft legislation released on October 3, 2011 (now contained in Bill C-13) would extend the “prohibited investment” rules to registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) (collectively, “registered plans”). These rules, which already affect tax-free savings accounts (TFSAs), will apply to investments held on, or acquired after March 22, 2011 by a registered plan.
The prohibited investment rules were introduced by the Department of Finance to address concerns they have regarding certain types of investments that have been acquired by registered plans. The scope of the rules is very broad and they arguably catch many investments that are not the target of the rules. Specifically, investments in mutual funds, hedge funds and other investment funds that are otherwise RRSP-eligible may be inadvertently caught by the rules. Many investors as well as employees or principals of the managers that offer these funds to the public may be surprised to learn that they currently have prohibited investments in their registered plans.
Significant adverse tax consequences are imposed on a registered plan that holds a prohibited investment. There is some transitional relief for investments held in a registered plan on March 22, 2011 and some penalty taxes are refundable when the investment is withdrawn from the plan. However, the normal benefit of investing through a registered plan, the tax-deferred accumulation of income, would be defeated by leaving the prohibited investments in the plan. Investors that hold prohibited investments in a registered plan will have to do some careful planning to determine when and how to bring themselves outside of these rules.
Several submissions have been made to the Department of Finance seeking amendments to limit the breadth of these rules. However, at this point it is not clear whether and how Finance may respond.
How the prohibited investment rules impact investment funds
There are two ways that the prohibited investment rules could impact investment funds held by registered plans. First, an interest in a trust or a corporation is a prohibited investment if the plan, the annuitant and non-arm’s length parties together hold 10% or more of the interests in the fund or 10% or more of a class of shares of a corporation. This 10% rule could catch a client of an investment fund manager or the employees, principals or shareholders of the manager. The clients of most investment counselors and hedge fund managers expect that the principals of the manager will invest in the funds that they manage, so that the managers’ interests are aligned with those of their clients. In addition, new entrants into the funds industry will usually put their money and that of their relatives in the funds to provide “start-up seed capital”. In either of these situations, the 10% threshold may be exceeded by the principals and/or their relatives.
Second, if the annuitant of a registered plan does not deal at arm’s length with an investment fund, any interest in the fund would be a prohibited investment, even if it is less than 10%. While, there are other potential non-arm’s length scenarios that could apply, the non-arm’s length issue is probably limited to the principals or employees of the fund manager who invest alongside their clients.
1) The 10% rule
Where a registered plan, the annuitant of the plan, and persons that do not deal at arm’s length with the annuitant together hold 10% or more of the interests in an investment fund, the interests held by the plan are prohibited investments. The 10% test applies at the fund level, where the fund is a trust. Where the fund is a corporation, the 10% test applies to each class of share issued by the corporation.
For example, if an individual were to hold 5% of the units of a mutual fund trust personally (outside of his RRSP) and 3% of the units in his RRSP, and his spouse were to hold 3% of the units personally, then the units in his RRSP would be prohibited investments. If the spouse were to hold her units in a registered plan, then those units would also be prohibited investments for her plan.
There is one proposed exception where the 10% threshold can be exceeded. Units of a mutual fund trust or a share of a mutual fund corporation that is subject to and substantially complies with National Instrument 81-102, Mutual Funds will not be a prohibited investment for the fund’s first two taxation years. A registered plan may hold more than 10% of the units or shares of such a fund for those first two years. This exception is intended to cover off the start-up period of a fund. However, there are many investment funds that either are not mutual fund trusts or are not sold pursuant to a prospectus and thus would not be governed by 81-102.
2) Investments by non-arm’s length persons
Where the annuitant under a registered plan does not deal at arm’s length with the fund, any units of the fund held by the plan will be a prohibited investment. This rule may affect funds differently depending upon whether they are structured as trusts or as corporations. It will be a question of fact whether or not a particular annuitant deals with a trust at arm’s length. There is no “deeming rule” that could treat a person as being non-arm’s length with a trust. It is conceivable that an investor may be deemed to be non-arm’s length with a corporate fund. However, based upon our understanding of how funds are typically structured, it is unlikely that a retail investor could be considered to be non-arm’s length with a fund of any type.
As noted above, it is quite common for the shareholders, principals and employees of a fund manager to invest in their funds alongside their clients. Those investors would include the portfolio managers of the funds, the individuals who decide which securities will be bought, held or sold by the funds. It may not be as clear that such individuals do act at arm’s length with the funds. In addition, the management company may be the trustee of a fund structured as a trust or hold the voting shares of a fund structured as a corporation. If the management company does not deal at arm’s length with the fund by virtue of such a relationship and an individual holds 10% or more of the shares of the management company, any investment in the fund by the individual’s registered plan would be a prohibited investment.
Consequences of holding a prohibited investment
Subject to certain relieving provisions, the consequences of holding a prohibited investment are quite punitive.
First, the annuitant of the plan is subject to a tax equal to 50% of the fair market value of the prohibited investment on the date it is acquired or otherwise becomes a prohibited investment. Second, the annuitant must pay a tax equal to 100% of the income earned and capital gains realized on the prohibited investment, to the extent the income is earned or capital gains accrued after March 22, 2011.
Existing investments that became prohibited investments on March 23, 2011 are generally grandfathered with respect to the 50% penalty tax.
For new investments acquired after March 22, 2011 that are or subsequently become a prohibited investment, the 50% tax is refunded if the plan disposes of the investment before the end of the calendar year following the calendar year for which the tax arose (or at such other time as permitted by the Minister of Revenue). However, no refund is available if it is reasonable to consider that the annuitant knew or ought to have known at the time the property was acquired by the plan that the property was or would become a prohibited investment.
Transitional relief is also provided with respect to the 100% tax on income and capital gains accrued on investments that became prohibited investments on March 23, 2011. The transitional relief allows the recognition of a “transitional prohibited investment benefit”. A transitional prohibited investment benefit is defined as income earned and capital gains accrued after March 22, 2011 and realized before January 1, 2022, less certain capital losses.
The transitional prohibited investment benefit is not subject to the 100% penalty tax, but instead is included in the annuitant’s income and subject to tax at his marginal tax rate. The individual must make an election in the prescribed form by the end of June 2012 to take advantage of this relieving provision. In addition, the transitional prohibited investment benefit must be paid to the annuitant from the plan within 90 days after the end of the taxation year in which it is earned or realized.
Investment managers should consider alerting any of their clients who may be caught by the prohibited investment rules.
Investors and fund managers that are impacted by the prohibited investment rules should carefully consider what steps they need to take to comply with the prohibited investment rules.
Investors should continually monitor their fund investments, both inside and outside of their registered plans (TFSAs, RRSPs and RRIFs) to ensure that the investment funds held by their registered plans do not become prohibited investments.
This publication is produced by Deloitte & Touche LLP as an information service to clients and friends of the firm, and is not intended to substitute for competent professional advice. No action should be initiated without consulting your professional advisors. Your use of this document is at your own risk.