RRSP Prohibited & Non-Qualified Investments - Income Tax - Canada (2024)

RRSP BACKGROUND – RRSP ANTI-AVOIDANCE RULES: PROHIBITEDAND NON-QUALIFIED INVESTMENTS

Registered retirement savings plans (RRSPs) are a tax efficientmethod of investment for individuals created by the government toencourage Canadians to save for retirement.

The basic structure of an RRSP is that a financial institution(the issuer) holds investments in trust (the RRSP) for anindividual with whom the issuer has a contract or arrangement thatmeets certain requirements. When the individual makes eligiblecontributions to the RRSP, then the individual receives an incometax deduction in the same amount as the contribution. Theindividual is called the "controlling individual" of theRRSP. The RRSP can then invest the contributions into various typesof investments. RRSPs are not allowed to own certain"non-qualifying" or "prohibited" investments.For example, cryptocurrencies cannot be held in a RRSP directly,although it is possible to hold them in a RRSP indirectly throughanexchange traded fundor similarsecurities.

The RRSP itself is exempt from income tax. When the individualeventually withdraws funds from the RRSP, the individual has anincome inclusion for the amount of the funds withdrawn. This meansthat RRSPs functionally allow individuals to invest with"pre-tax income" and have their investments compound taxfree until withdrawal.

RRSP contribution room is determined by an individual's"earned income", which among other things includesemployment income or business income earned while a tax resident ofCanada. Taxpayers can contribute to their RRSPs until December 31of the year in which they turn 71 years old. Individuals are alsorequired to collapse their RRSPs by December 31 of the year theyturn 71. The main options are transferring your RRSP to aregistered retirement income fund (RRIF) on a tax deferred basis,purchasing eligible annuities on a tax deferred basis, orwithdrawing the funds and having an income inclusion. A RRIFoperates in a similar manner to an RRSP, but it requires thebeneficiary of the RRIF to withdraw a minimum amount everyyear.

To maintain the integrity of the RRSP system, theCanadianIncome Tax Actcontains numerousanti-avoidance rules which can result in severe tax penalties fortaxpayers, which can be avoided with tax planning from aknowledgeable Canadian tax lawyer. This article focuses on theanti-avoidance rules regarding prohibited and non-qualifiedinvestments.

QUALIFIED AND NON-QUALIFIED INVESTMENTS – RRSPANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS

Qualified investments are the types of investments that theGovernment of Canada intends for individuals to hold in theirRRSPs. TheIncome Tax Actprovides a list oftypes of qualified investments which include:

• Money and deposits with banks, trust companies, or creditunions;
• Securities listed on a designated stock exchange;
• Shares or debt of a public corporation;
• A unit of a mutual fund trust or share of a mutual fundcorporation;
• Debt of the Government of Canada, a province, a municipality,or a Crown corporation;
• Gold and silver coins, bullion and certificates; and
• Shares of a specified small business corporation.

A specified small business corporation is generally acorporation incorporated in Canada that is not controlled bynon-resident persons and substantially all the fair market value ofthe corporation's assets are attributable to assets thatare:

• used principally in an active business carried on in Canada bythe corporation or a corporation related to it or
• shares or debt of connected small business corporations.

If an investment in a specified small business corporation meetsthe criteria for being a prohibited investment as described belowthe investment will not be a qualified investment. As such,taxpayers should be very cautious when investing in privatecorporations through a RRSP and should always consult with anexpert Toronto tax lawyer before proceeding with theinvestment.

TheIncome Tax Act defines a non-qualifiedinvestment as any investment that is not a qualified investment.However, an investment that is not a qualified investment but alsomeets the criteria for prohibited investment status will beconsidered a prohibited investment only and deemed not to be anon-qualified investment. One example of a non-qualified investmentis shares in a private non-resident corporation.

PROHIBITED INVESTMENTS – RRSP ANTI-AVOIDANCE RULES:PROHIBITED AND NON-QUALIFIED INVESTMENTS

TheIncome Tax Actdefinition of prohibitedinvestment includes the following:

• a debt of the holder of the RRSP;
• a debt, share of, or an interest in, a corporation, trust orpartnership in which the holder of the RRSP has a significantinterest;
• a debt, share of, or an interest in a person or partnershipwith which the holder of the RRSP does not deal at arm'slength; or
• an interest in or right to acquire any of the aboveinvestments.

The term "a significant interest" generally refers tothe holder of the RRSP having at least a 10% interest in thecorporation, partnership, or trust. In making this assessment, theinterests held by persons who do not deal at arm's length withthe holder of the RRSP are also counted towards the 10%threshold.

TAX ON NON-QUALIFIED AND PROHIBITED INVESTMENTS – RRSPANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIED INVESTMENTS

If during a calendar year, a RRSP acquires a non-qualified orprohibited investment, or if an existing investment held by theplan becomes a non-qualified or prohibited investment, then theholder of the RRSP is required to pay a special tax. The amount ofthe tax is 50% of the fair market value of the investment at thetime the event that led to the tax applying occurred.

The person liable to pay the tax on non-qualified or prohibitedinvestments in a calendar year is required to file a correspondingform RC339 tax return and pay the tax before July of the followingcalendar year. As with regular income tax, interest will accrue ona late payment and penalties may apply if a return is filed late ornot filed at all.

If the RRSP subsequently disposes of the non-qualified orprohibited investment then the holder of the RRSP becomes entitledto refund of the tax unless either:

• it is reasonable to consider the holder of the RRSP knew orought to have known at the time the relevant investment wasacquired by the RRSP that it was non-qualified or prohibited orthat it would become so, or
• the relevant investment was not disposed of by the RRSP beforethe end of the calendar year following the calendar year in whichthe tax arose, or any later time that the Canada Revenue Agencyconsiders reasonable in the circ*mstances.

INCOME EARNED ON NON-QUALIFIED AND PROHIBITED INVESTMENTS– RRSP ANTI-AVOIDANCE RULES: PROHIBITED AND NON-QUALIFIEDINVESTMENTS

Income earned by a RRSP from a non-qualified investment isconsidered taxable income for the RRSP which pays tax on thatincome at the top marginal rate. So for example if a RRSP holdsshares in a private non-resident corporation which constitutes anon-qualified investment, then the RRSP will need to pay tax on thedividends it earns for holding the shares or the capital gain itrealizes when it eventually sells the shares. Income from aprohibited investment constitutes a RRSPadvantage.

Subsequent generation income earned on taxable income earned bythe plan from a non-qualified investment or on income from aprohibited investment generally also gives rise to a RRSPadvantage. For example, if a RRSP reinvests dividend income fromeither a non-qualified investment or a prohibited investment, eveninto a qualified investment, then all the income generated by thenew investment constitutes a RRSP advantage.

A special RRSP advantage tax is payable by the holder of a RRSPthat has given rise to a RRSP advantage during a calendar year. Theamount of the tax is 100% of the RRSP advantage for the calendaryear. The person liable to pay the tax on the RRSP advantage in acalendar year is required to file a corresponding form RC339 taxreturn and pay the tax before July of the following calendar year.As with regular income tax, interest will accrue on a late paymentand penalties may apply if a return is filed late or not filed atall.

DISCRETIONARY RELIEF – RRSP ANTI-AVOIDANCE RULES:PROHIBITED AND NON-QUALIFIED INVESTMENTS

CRA has the discretion to waive or cancel part or all of ataxpayer's RRSP advantage tax or tax on non-qualified orprohibited investments owing in circ*mstances where the CanadaRevenue Agency determines that it would be just and equitable to doso. Some of the circ*mstances in which CRA may exercise itsdiscretion are:

• when the tax arose as a consequence of a reasonable error,
• when the transactions that gave rise to the tax also gave riseto another tax under theIncome Tax Act,
• when payments have already been made from the RRSP.

To request that RRSP tax be waived or cancelled, thetaxpayer's experienced Canadian tax lawyer must submit awritten application to the CRA's Pension Workflow Team locatedat either the Sudbury Tax Centre or the Winnipeg Tax Centredepending on the location of the taxpayer's residentialaddress. The application should describe in detail thecirc*mstances giving rise to the tax and why it would be just andequitable for the tax to be waived or cancelled.

Note that the CRA's taxpayer relief and voluntarydisclosures programs which offer penalty and interest relief insome circ*mstances cannot be utilized in order for the RRSP taxitself to be waived or cancelled because it is a tax and not apenalty. It is possible however to get relief under those programsfrom penalties or interest associated with the RRSP tax.

PRO TIP

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circ*mstances.

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