5 October 1999 External T.I. 9916245 - INDIAN ACT EXEMP. RESP - EDUCATION

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current

Position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Are refunds of accumulated income payments out of RESP taxable and subject to the 20% penalty tax, when received by status Indian subscribers?

Position:

Yes.

Reasons:

Contributions to RESP's are not linked to "earned income". As a result the earnings of an RESP should be taxed consistently with the taxation of other investment earnings. The investment income is the property in question and if it was not generated on reserve it is considered to be earned in the economic mainstream and is not tax exempt.

XXXXXXXXXX 5-991624
Karen Power, CA

October 5, 1999

Dear XXXXXXXXXX:

Re: Registered Education Savings Plans and Indian Band Members

We are writing in reply to your correspondence of May 28, 1999, in which you requested our opinion on the following scenario.

An Indian band member funds a Registered Education Savings Plan (RESP) with income earned on reserve. If the beneficiary of the plan decides not to pursue post-secondary education and the subscriber is eligible to take the earnings as an accumulated income payment (cash), would the subscriber have to pay withholding tax and the 20% penalty tax since the plan was funded with income earned on the reserve. You also inquire whether our comments would differ if the RESP was held by an issuer on the reserve or off the reserve.

Our Comments

We have assumed for purposes of our comments that the Indian band members are status Indians as defined in the Indian Act. Subsection 2(1) of the Indian Act defines an "Indian as "a person who pursuant to this Act is registered as an Indian or is entitled to be registered as an Indian". Sections 6 and 7 of the Indian Act describe persons who are and who are not entitled to be registered as Indians.

Commencing in 1998, paragraph 146.1(2)(d.1) of the Act permits a refund of RESP earnings/accumulated income payments to a contributor where none of the intended beneficiaries is pursuing post-secondary education by age 21 and the plan has been running for at least 10 years. Refunds of accumulated income payments will be included in the contributor's income pursuant to subsection 146.1(7.1) of the Act. In addition, a 20% tax under Part X.5 of the Act will be charged on the amount of the accumulated income payment. The amount on which the 20% Part X.5 tax is applied may be reduced if, in the year of the income inclusion for the accumulated income payment, an amount is deducted under subsection 146(5) or (5.1) (i.e. the rules for RRSP deductions)

Unlike registered retirement saving plans (RRSP) in which contributions are based on "earned income" as defined in subsection 146(1) of the Act, contributions to an RESP are not linked to "earned income" or employment income. An individual may choose to fund an RESP from any source of income to which he/she has access. Accordingly, in our view, any refund of the income earned within an RESP should be taxed similarly to ordinary investment income.

Taxation of Investment Income Earned by Status Indians

In general terms, it is section 87 of the Indian Act, along with paragraph 81(1)(a) of the Income Tax Act, that establish the exemption from taxation for status Indians. Section 87 of the Indian Act exempts from taxation the personal property of an Indian situated on a reserve, and the courts have previously concluded that the reference to personal property in section 87 includes income. In determining whether the income earned by an Indian is situated on reserve, and thus exempt from taxation, the approach taken by the Supreme Court of Canada in the 1992 case of Glenn Williams V. Her Majesty the Queen (92 DTC 6320) is followed, This approach requires the examination of all factors connecting income to a reserve to determine if the income is located on the reserve. The Supreme Court also indicated that the ultimate question is to determine to what extent each connecting factor is relevant in determining whether taxing the particular kind of property in a particular manner would erode the entitlement of an Indian to personal property situated on a reserve. One general direction provided in Williams was that "an overly rigid test which identified one or two factors as having controlling force , would be open to manipulation and abuse". The Supreme Court rejected the situs of the debtor test as the sole test for determining whether the personal property of an Indian or band was situated on a reserve.

In the case of Arnold Recalma v. The Queen, 96 DTC 1520, 98 DTC 6238, the Tax Court of Canada, as confirmed by the Federal Court of Appeal considered the taxation of income earned by an Indian living on reserve, from investments purchased from an on reserve branch of a bank. It should be noted that the nature of the property in question was the income from the investments and not the investments themselves. The court had to determine if the investment income was situated on the reserve. This determination required a review of all relevant connecting factors and consideration as to how much weight should be given to each factor. The following were considered in determining the situs of the investment income:

a) the residence of the taxpayer;

b) the origin or location of the capital used to buy the securities;

c) the location of the bank branch where the securities were bought;

d) the location where the investment income is used;

e) the location of the investment instruments;

f) the location where the investment income payment is made; and

g) the nature of the securities and in particular:

(i) the residence of the issuer;

(ii) the location of the issuer's income generating activity from which the investment is made, and

(iii) the location of the issuer's property in the event of a default that could be subject to potential seizure.

In Recalma, the courts placed considerable emphasis on the location of the bank's income generating activity. The investments in Recalma were bankers acceptances and mutual fund units and the income generated from these was earned in the economic mainstream and was connected to a reserve. Basically, the Court concluded that income from these investments started with companies off the reserve and was passed through a bank on reserve to the taxpayers. It was held that the investment income of the taxpayer was not personal property situated on a reserve. The Court concluded that in making these investments, the taxpayer chose to invest in the economic mainstream of normal business conducted off .the reserve. Consequently the Department's position is that income earned in the economic mainstream is so strongly connected to a location off reserve that it generally outweighs other factors that connect it to a reserve.

Based on the Recalma decision, it is necessary to determine the location of the issuer's income generating activity of the investment instrument. In our view, the income stream from investments held within an RESP, whether the issuer is located on or off reserve, will not be connected to a reserve. As such income will generally be generated off the reserve, it would be considered to be earned in the normal economic mainstream and, accordingly, not considered personal property situated on a reserve. In our view, unless the income can be identified as exclusively generated on the reserve, the income is not exempt from tax and would be subject to withholdings and the 20% penalty tax.

We trust our comments will be of assistance to you.

Yours truly,

Roberta Albert, CA
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch