10 May 2016 Internal T.I. 2016-0644761I7 - RPP borrowing

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: Whether a registered pension plan contravenes the borrowing restriction in Regulation 8502(i).

Position: Yes.

Reasons: The plan fails to meet the exception for real estate borrowings as the amount of borrowed money exceeded the cost of the property acquired.

		May 10, 2016

Registered Plans Directorate	HEADQUARTERS
RPP Policy and Technical Services Section	Income Tax Rulings Directorate
		D. Wurtele
Attention: Jeff Boxer
		2016-064476

RPP Borrowing

We are writing in response to your request of April 28, 2016 for our assistance on a matter relating to a registered pension plan (RPP). In a memo dated April 6, 2016, the representative of the particular plan (the “Plan”) describes, on a no-names basis, a possible violation of the borrowing restriction in paragraph 8502(i) of the Income Tax Regulations (the “Regulations”) and outlines a proposed corrective measure. You have asked for our preliminary views as to whether there is non-compliance and whether the proposed solution is reasonable.

Background

The Plan invests in real estate directly as opposed to through a tax-exempt real estate corporation commonly used by other RPPs. Over the years the Plan has borrowed money to finance its real estate investments. As a result of the direct ownership of real estate and the co-mingling of the borrowed funds in its general account, there is concern that the Plan may have inadvertently used funds for a purpose other than acquiring real property and thus failed to satisfy the express exception for real estate borrowings in the Regulation. The concern stems from timing differences from when the funds were initially borrowed to the time the real estate was acquired or re-financed.

Although they do not go so far as to admit non-compliance, the representative has advised their client that the best course of action would be to make a disclosure to the CRA, propose a solution to correct the matter on a go-forward basis and seek assurance that the CRA would not revoke the registration of the Plan. They would like to get your initial reaction to the proposed approach before making a formal disclosure.

Comments

As you know, subparagraphs 8502(i)(iv) to (vi) provide an exception so as to permit an RPP to borrow money “for the purpose of acquiring real property that may reasonably be considered to be acquired for the purpose of producing income from property”, provided that the amount borrowed (and other debt) does not exceed the cost of the property acquired and that none of the plan’s property besides the real property is given as security for the borrowed money. The representative states that the purpose of a borrowing is a less rigorous and more flexible test than the use of borrowed money test found elsewhere in the Income Tax Act (e.g., subparagraph 20(1)(c)(i) of the Income Tax Act (the “Act”)), which requires a tracing of funds to their current use. As a result, they suggest that there is an argument that the Plan is fully compliant.

In order to determine whether the Plan actually met the purpose test in subparagraph 8502(i)(iv) we would need a more thorough description of the Plan’s borrowing and investment activities than what was provided in the memo. However, it is clear from the examples cited that some of the borrowings would not have met the quantum test in subparagraph 8502(i)(v) as “the amounts outstanding in respect of certain properties have, at some point, exceeded the cost of the Plan’s interest in the properties”. Consequently, it is our view that the Plan contravened paragraph 8502(i) and thus is a revocable plan pursuant to paragraph 8501(2)(a) of the Regulations.

Proposed solution

To cure any past non-compliance, the representative proposes to transfer all real properties in respect of which there are any potential borrowing issues to a newly-formed real estate corporation that would be wholly-owned by the Plan and exempt from tax under subparagraph 149(1)(o.2)(ii) of the Act. The real estate corporation would assume all of the relevant debt and the Plan would be released as a borrower (although it may still be required to guarantee some of the debts). All future real estate investments and any associated borrowings would be made by the real estate corporation in accordance with subparagraph 149(1)(o.2)(ii).

Based on the limited information provided and barring any unforeseen issues that may come to light in the formal disclosure, the proposed approach appears to be a reasonable solution to resolve past non-compliance and avoid future issues.

To assist in making a final determination, we would suggest that you request the following information be provided, in addition to basic plan information and any other information you consider necessary:

• The years in which the Plan was potentially non-compliant.
• For each year, an estimate of the total amount by which the Plan’s borrowings (and other debt) exceeded the cost of its real property acquisitions. This will serve to identify the extent to which the Plan was making leveraged investments outside of the real estate context. Whether the Plan is a defined benefit or money purchase plan. If the Plan is a defined benefit plan, there is perhaps less of a concern about leveraged investing as the income tax rules provide for a self-adjusting mechanism. A higher rate of return than appropriate results in lower employer contributions. However, if the Plan is a money purchase plan, the concern about leveraged investing takes on greater importance as the borrowing would have served in effect to circumvent the RPP contribution limits. In this case, consideration should be given to requiring any excess investment earnings to be withdrawn from the Plan.
• Confirmation that no property of the Plan besides the real property was given as security.

We trust these comments will be of assistance and would be pleased to assist you in reviewing the formal disclosure.

Mary Pat Baldwin, CPA, CA
for Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch