Section 207.5

Targeting of loan-back structures (p. 1074)

The Department of Finance borrowed these rules as a mechanism to deal with certain so-called "loan back" structures involving RCAs that the CRA found offensive. In their simplest form, an employer would make a tax-deductible contribution to an RCA trust, [fn 4: Paragraph 20(1)(r)...] which in turn would remit 50% of the contribution to the federal government as a refundable tax. [fn 5: "Refundable tax" is defined in subsection 207.5(1) and required to be paid under subsection 207.7(1). Withholding and remitting requirements apply to contributions to the RCA trust – see paragraph 153(1)(p)] The RCA trust would then borrow from a third-party financial institution and in turn loan those funds to the sponsoring employer on terms that did not reflect "market" conditions in terms of interest rate, security and/or repayment terms.

Resulting impoverishment of RCA (p. 1074)

In some cases, the CRA believed the loan, in the future, could potentially impoverish the RCA in such a way that refundable tax paid by the RCA trust would be recoverable [fn 6: An election is available to permit refunds of the tax in specific situations – see subsection 207.5(2). In addition to the prohibited investment and advantage rules, the Act was amended to limit the availability of the election where the decline in value of the RCA property is attributable to a prohibited investment for, or an advantage in relation to, the RCA trust.] but no benefits would be paid by the RCA to its beneficiaries. Often, the RCA trust invested contributions to the trust in a life insurance policy on the life of a shareholder/employee, which was in turn pledged as security, together with the RCA trust's refundable tax account, for the loan to the RCA trust.

Advantage rule (pp. 1074-5)

Under the definition of "advantage," any benefit, loan or indebtedness that is conditional in any way on the existence of the RCA, other than certain enumerated exceptions (including a loan or indebtedness the terms and conditions of which are essentially arm's length), will be an advantage [fn 7: See the definition of "advantage" in subsection 207.5(1) of the Act.] In addition, any income or capital gain that is reasonably attributable, directly or indirectly, to a prohibited investment gives rise to an advantage. This latter inclusion is important as a prohibited investment acquired before March 29 is not subject to the prohibited investment tax, but advantages arising from such otherwise grandfathered investments can give rise to the advantage tax.

Refund mechanics (p. 485)

When the employer makes a contribution to an RCA, one-half of the contribution must be remitted to the CRA [fn 22: Subsection 207.5(1), the definition of "refundable tax," paragraph (a).] and placed in a refundable tax account (RTA). Similarly, one-half of the return generated by the invested portion of the assets must be transferred to the RTA. [fn 23: …paragraph (b).]

When benefits are paid from the plan, the funds are refunded from the RTA to the RCA at the rate of $0.50 for each $1 of benefit paid. [fn 24: … paragraph (c).]

In the event of termination of the plan, the assets in the RTA are refunded to the RCA. [fn 25: Subsection 207.5(2).]

Table 1 provides an illustration of how an RCA and RTA would work over a period of four years.

As noted above, the balance at the end of the year in the RCA and the RTA are equal, since one-half of all contributions and investment income must be remitted to the CRA. Upon termination of the RCA, the assets remaining in the RTA (if any) are refunded to the plan. However, the terms of the plan will dictate whether such surplus assets belong to the employer or to the plan members….

Letter of credit arrangements (p. 489-90)

…An alternative to using cash, where cash may not be available, is to obtain a letter of credit (LOC) from a financial institution. The LOC provides that in certain circumstances, such as the employer's failure to renew the LOC or to pay employee benefits, the bank that issued the LOC would pay the face value of the LOC into the RCA, fully funding the benefit. The employer would than owe the bank the face amount of the LOC. This arrangement provides security to the member while not requiring the employer to contributed directly to the RCA.

The LOC is typically renewed annually. The LOC is held by the RCA, and when the employer pays the annual tax-deductible fee to the bank for the LOC, an equal amount must be paid into the RTA. The LOC fee may vary depending on the credit worthiness of the employer. The face value of the LOC is usually determined on an actuarial basis, and it is meant to represent the amount sufficient to fully fund the pension promise.

Funds held in the RTA equal to the LOC fees may not be recoverable to the employer until many years later when the plan is terminated.

Generally, employers and employees are entitled to a deduction from income in respect of contributions they make to an RCA. [fn. 2: Paragraph 8(1)(o.2) of Act.] Plan members are not taxed on employer contributions made to the RCA. Instead, an RCA is liable to pay a "refundable" tax at the rate of 50% on the contributions it receives and on the net income and net capital gains it earns (referred to as the "refundable tax account"). [fn. 3: Subsection 207.5(1) of the Act, definition of "refundable tax."]

Plan members must include distributions from an RCA (typically in the form of retirement benefits) in income at the time of receipt. [fn. 4: Paragraphs 56(1)(x) or (z) of the Act.] In turn, distributions the RCA pays to its plan members will also generate a refund of tax to the RCA, from its refundable tax account equal to 50% of the amount of the distributions made in the year. [fn. 5: Subsection 207.5(1) of the Act, definition of "refundable tax."] …

The definition allows an RCA to have more than one specified beneficiary. Moreover, it appears that the phrase "had a significant interest in the employer" could apply, for example, to treat a plan member who acquires and divests of a significant interest over a brief period (e.g., upon the exercise of stock options immediately followed by a disposition of underlying shares as a specified beneficiary and would continue to do so at all subsequent times.

It appears, based on discussions with Finance, that the definition of a specified beneficiary is intended to have such broad scope; however, it should be noted that the definition of a prohibited investment for an RCA generally includes a debt of a specified beneficiary or a share of, an interest in or a debt of, a person, trust or partnership in which the specified beneficiary has a significant interest, does not deal at arm's length or is affiliated with the specified beneficiary. Thus, notwithstanding the intended breadth of the definition of "specified beneficiary," it does not appear that the legislation has the effect of causing a previously held significant interest by a plan member to result in a prohibited investment in a person, trust or partnership, if such plan member no longer held significant interest in, and was dealing at arm's length and was not affiliated with, such person, trust or partnership.…