Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: 1. Various questions on the transitional rule for pre-March 29, 2012 debt obligations that provide for "commercially reasonable" payments of principal and interest. 2. Whether the advantage tax would apply if an RCA were to guarantee or secure a third-party loan on behalf of a specified beneficiary of the RCA?
Position: 1.See reply. 2. Yes.
Reasons: 1. See reply. 2. The provision of the guarantee or security constitutes an advantage on the basis that it is conditional on the existence of the RCA, it is an RCA strip or both.
XXXXXXXXXX 2012-047018
D. Wurtele
February 21, 2013
Dear XXXXXXXXXX:
Re: RCA advantage tax rules
This is in reply to your letter of November 14, 2012 in which you ask a number of questions on the new anti-avoidance rules for retirement compensation arrangements (RCAs) introduced in the 2012 federal budget and enacted by Bill C-45.
The first set of questions involves a transitional rule that provides a mechanism for RCA custodians to avoid the application of the advantage tax in section 207.62 of the Income Tax Act (the "Act") in respect of certain debt obligations acquired by an RCA before March 29, 2012.
The remaining question concerns the potential application of the RCA strip definition in subsection 207.5(1) of the Act if an RCA were to guarantee or secure a third-party loan on behalf of a specified beneficiary of the RCA.
Our comments
New section 207.62 of the Act imposes a tax on the custodian of an RCA where an advantage is provided to a specified beneficiary of the RCA, a person not dealing at arm's length with a specified beneficiary or the RCA itself. The tax is equal to the amount of the advantage.
An advantage may generally be described as a transaction or event in respect of which unintended tax benefits could be obtained. More specifically, the definition includes any benefit, loan or indebtedness that is conditional in any way on the existence of the RCA, subject to certain enumerated exceptions. An advantage also includes income and gains on a prohibited investment (generally an RCA investment to which a specified beneficiary is closely connected) and an RCA strip. An RCA strip occurs where there has been a reduction in value of the property held in connection with the RCA as part of a series of transactions or events one of the main purposes of which was to enable a specified beneficiary (or a person or partnership who does not deal at arm's length with a specified beneficiary) to obtain a benefit in respect of the RCA property or as a result of that reduction, and there has been no related income inclusion. The terms "advantage", "prohibited investment", "RCA strip" and "specified beneficiary" are defined in subsection 207.5(1) of the Act.
The advantage tax rules apply after March 28, 2012, subject to two exceptions involving property acquired on or before that date. The first exception ensures that the amount of what would otherwise be an advantage will not be treated as an advantage if the amount is included in the income of a beneficiary of the RCA, or an employer in respect of the RCA, for the taxation year in which the amount arose or the following year.
The second exception, which is set out in paragraph 44(3)(b) of Bill C-45, is the main subject of your queries. It is relevant where an RCA holds a promissory note or similar debt obligation that was acquired by the RCA before March 29, 2012 and that would or could give rise to an advantage. This transitional rule provides that the retention of the debt obligation by the RCA will not cause the advantage tax to apply if commercially reasonable payments of principal and interest are made at least annually after 2012 in respect of the obligation and no RCA strip occurs. For this purpose, an amendment to the terms of a debt obligation to provide for such payments is deemed not to be a disposition or acquisition of the debt obligation. This rule will commonly apply where the debt obligation is part of a series of transactions or events that was not yet completed as at March 29, 2012, but that may constitute an RCA strip, and the RCA custodian wishes to rectify the situation. It will also apply where the debt obligation is a prohibited investment for the RCA (regardless of whether it was part of an RCA strip).
A. Pre-March 29, 2012 debt obligations
You have asked the following questions concerning this transitional rule:
1. Is it acceptable for an existing debt obligation to be amended at any time in 2013 in order to ensure that its terms provide for payments of principal and interest that reflect a commercially reasonable total for the entire 2013 calendar year and each subsequent year? In other words, please confirm that the amendment to the debt obligation does not have to be made by January 1, 2013.
In our view, this would be acceptable provided that the amendment to make the terms of the debt obligation commercially reasonable is made by December 31, 2013 and the total payments of principal and interest made for 2013 reflect a commercially reasonable total for the entire year. For example, if the terms of the debt obligation were not amended until November 30, 2013, it would not be acceptable to reflect commercial terms for only 1/12 of the year. Rather, it would be necessary to ensure that the total payments of principal and interest to be made in 2013 will equal the total that would have been made if those terms had been in place as at January 1, 2013.
2. The transitional rule applies to a promissory note or similar debt obligation. What constitutes a similar debt obligation?
The Act does not define the term "promissory note". However, the Bills of Exchange Act defines a promissory note as "an unconditional promise in writing made by one person to another person, signed by the maker, engaging to pay, on demand or at a fixed or determinable future time, a sum certain in money to, or to the order of, a specified person or to bearer." This definition is consistent with the common dictionary definition.
On this basis, we would consider conventional types of bonds, debentures, notes and mortgages with fixed repayment terms to be, or similar to, a promissory note.
3. The main condition of eligibility for the transitional relief is that "commercially reasonable" payments of principal and interest be made in respect of the debt obligation.
(i) Will the CRA be providing any guidelines on what it considers "commercially reasonable" for this purpose? Would an amendment to an existing debt obligation to provide the RCA with appropriate security be sufficient if the debt already provided for a commercially reasonable interest rate?
It is a question of fact as to whether commercially reasonable payments of principal and interest are made in respect of a particular debt obligation. However, the condition would likely be met where the terms and conditions of the debt obligation (including principal amount, interest rate, term and security) reflect terms and conditions to which an arm's length lender would reasonably be expected to agree.
(ii) Not all commercial debts require actual payments of principal and/or interest. Provided there was appropriate security and a commercially reasonable interest rate, would the CRA accept that the annual commercially reasonable payment of principal could be nil?
No. The transitional rule contemplates that annual payments of both interest and principal must be made.
(iii) Please confirm that the "commercially reasonable" test is based on the creditworthiness of the borrower at the time the amendment to the debt obligation is made in 2012 or 2013, and not at the time the debt obligation initially arose.
For the purposes of applying the transitional rule, we would generally look to current credit conditions in determining whether a debt obligation satisfies the "commercially reasonable" test.
(iv) Would it be sufficient for the RCA custodian to obtain a letter from a business valuator or an arm's length financial institution, whose ordinary business includes the lending of money, attesting to the review of the lending arrangement and verification that the terms are commercially reasonable?
We are not in a position to provide much guidance on this question as it does not involve an interpretation of the law and thus falls outside of our Directorate's purview. We would note that, although there is no requirement in the Act for a formal attestation to support a position taken by an RCA custodian with respect to the application of the transitional rule to a particular debt obligation, the RCA custodian will need to be able to demonstrate, in the event of an audit or review, that the debt obligation satisfies the "commercially reasonable" test.
B. RCA provides guarantee or security for third-party loan to specified beneficiary
You ask whether we would consider an RCA strip to have occurred if the specified beneficiary pays the RCA custodian an "arm's length commercial" fee as consideration for the RCA custodian guaranteeing, or permitting the RCA property to be used as security for, a loan made to the specified beneficiary from an arm's length financial institution.
In our view, the advantage tax rules will apply where an RCA is used to guarantee or secure a loan made to (or other debt of) a specified beneficiary of the RCA (or a person or partnership who does not deal at arm's length with a specified beneficiary). There are two provisions of the advantage definition that are applicable.
First, we would consider that the loan and guarantee are conditional on the existence of the RCA and thus constitute an advantage under paragraph (a) of the definition "advantage". The exception for arm's length loans would not apply since there is no reference to a guarantee or security in subparagraph (a)(ii). This is in contrast to the comparable "advantage" definition in subsection 207.01(1) of the Act that applies to RRSPs, RRIFs and TFSAs. That definition expressly refers to TFSAs being used as security for a loan, which reflects a clear policy to allow taxpayers to use their TFSA to secure a loan. This is not the case for RCAs, RRSPs and RRIFs.
It is also our view that this situation would likely give rise to an RCA strip at the time the guarantee or security is provided. In an "arm's length commercial" setting, we would expect that the fee that would have to be paid to the RCA custodian to enter into an arrangement that, if called on, would expose the RCA custodian to a tax equal to the amount of the guarantee or security (in addition to the loss associated with having to honour the guarantee or security) would have to be so high that it would render the arrangement unfeasible. If an RCA custodian were to enter into such an arrangement and not charge a reasonable fee having regard to the liability it assumed, then that would constitute an RCA strip and by extension an advantage.
Finally, we would add that we have some difficulty understanding why a person acting in a fiduciary capacity in administering property of an arrangement that was purportedly established to fund and secure payment of employee retirement benefits would engage in an activity that would undermine the very purpose for which the arrangement was established.
While we hope that our comments will be of assistance to you, they are given in accordance with the practice referred to in paragraph 22 of IC 70-6R5 and are not binding on the Canada Revenue Agency in respect of any particular situation.
Yours truly,
Mary Pat Baldwin, CA
for Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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