Retirement Compensation Arrangements

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1 Retirement Compensation Arrangements When saving for retirement through registered Retirement Savings Plans (RSPs) and similar arrangements such as defined contribution pension plans there may be restrictions on the maximum contribution permissible for a high-income earner. Defined benefit pension plans also have limitations on the maximum income payable in retirement. This may make it difficult for high-income earners to maintain a retirement lifestyle similar to the pre-retirement lifestyle to which they are accustomed. A vehicle that may help them achieve their retirement objectives is the Retirement Compensation Arrangement (RCA). Overview A Retirement Compensation Arrangement (RCA) is a non-registered pension plan funded by an employer (employee may contribute as well) for the benefit of an employee. Payments from the RCA may occur when: an employee retires; the employee s job is terminated; or an employee leaves one position and accepts another job with significantly different services for the same employer, for example an athlete retires from his/her sport and is hired as a scout for his/her team. How RCA Works Annual contributions are: placed in an RCA trust for the employee; made by the employer or employee, however employee contribution amounts cannot exceed employer contribution amounts; either a pre-determined amount or can be based on a formula; subject to limitation, details of the contribution amounts must be stated in the trust agreement, however, contribution amounts are not restricted by Canada Revenue Agency (CRA) maximums for RSPs or pensions.

2 Tax Rules for an RCA Contributions are deductible by the employer from its business income and deductible by the employee from his/her employment income. Income paid out of the plan is taxable to the employee. If the employee is a non-resident when income payments begin, the payment is subject to a 25% withholding tax. This could be reduced if a tax treaty exists. 50% of any contributions made to the plan are remitted to CRA as a refundable tax. 50% of any net income (interest, dividend, capital gains) earned inside the RCA plan is remitted to CRA as a refundable tax. Refundable tax is refunded to the RCA trust as the employee starts to draw income. One dollar of refundable tax is recovered for every two dollars of income paid to the employee. The employee (if resident of Canada) is taxed at regular income tax rate. Refundable tax account maintained by CRA earns no income. In other words, interest is not paid on the refundable tax account. Who Should Consider an RCA? Note: This article does not reflect the proposed tax changes introduced in the 2012 federal budget. The article will be updated once the proposed changes are enacted into law An RCA should be considered for key employees and business owners who: have significant income usually in excess of $100,000 a year and seeking a means of supplementing their retirement or pension income; are looking to replace the bonus down strategy. Business owners seeking to reduce their corporation s income to the small business deduction limit of $500,000 federally for the 2012 calendar year may wish to defer immediate tax by transferring funds to the RCA, rather than paying bonus, which they can draw out at a later date when they may be in a lower tax bracket; have spent considerable time building their business and have neglected their retirement savings. This is an opportunity to flow company funds to a retirement planning vehicle; will become a non-resident at retirement (e.g. professional athlete); are looking for creditor protection. 2

3 Consider a $200,000 contribution to an RCA. One-half of this amount or $100,000 will go into the RCA trust itself to be invested, while the remaining $100,000 will be held in a refundable tax account with the CRA. When income payments begin at retirement, income will be paid out of the RCA trust. For every $2 paid to the employee from the RCA trust, $1 is put back into the RCA trust from the refundable tax account. Employer/Participant 100% Tax Deductible Contribution 50% 50% A $200,000 contribution by the employer directs $100,000 to the RCA and $100,000 to the RTA RCA Investments 50% of Investment Income 50%nt 50% Inc of RCA Trust Distribution RTA Refundable Tax Employee Taxable Income Key Advantages and Disadvantages of an RCA A key advantage of an RCA is that it can be used to defer recognition of income. RCA contributions are tax deductible and the employee is not subject to tax on any RCA contributions until such time as he/she starts to receive payment from the RCA when he/she is presumably in a lower tax bracket. Another advantage of an RCA as a supplementary vehicle to an RSP lies in its flexibility. Unlike an RSP, an RCA has no statutory restrictions on annual contributions, which could play a significant role in achieving your overall retirement goals. RCAs may potentially provide a degree of creditor-protection and you can use your RCA as collateral should you need to borrow against it. The key tax disadvantage lies in an RCA s unique refundable tax concept, which requires that 50% of every contribution made as well as 50% of all income earned in the RCA is to be paid into CRA s Refundable Tax Account (RTA). This limits the tax-deferral effectiveness of an RCA. Another downside to an RCA largely stems from the numerous regulatory requirements to which RCA must adhere to. These requirements make the use of an RCA a complex strategy, entailing additional administrative costs to adhere to the stringent requirements, and additional tax issues to consider. 3

4 Parties to an RCA and Tax Implications There are three parties involved in an RCA for which there are tax implications: the Custodian, the Employer, and the Employee. CRA has published a guide entitled Retirement Compensation Arrangement Guide. This guide contains useful information on the forms required, responsibilities of each party and penalties for not following the RCA requirements. Some of the parties responsibilities are summarized below: The Custodian With regards to taxation, the custodian has the following responsibilities: Applying for a remittance account number for income tax withheld on distributions. Receiving employee contributions. Remitting refundable tax to CRA on amounts received directly from an RCA member (employee). Providing CRA with any information on changes to the RCA s custodian. Filing a T3-RCA tax return and remitting the refundable tax owing. Withholding income tax on distributions made out of the RCA trust. Filing a T4A-RCA information return to report distributions made out of the RCA trust. Filing an NR4 information return to report distributions to non-residents. The Employer With regards to taxation, the employer has the following responsibilities: To remit to CRA, 50% of all contributions to the RCA. These funds will be held as refundable tax in an account, which must be applied for by the employer. To send an information report to CRA, annually, reporting the contributions made by the employer to the RCA. To report on the employee s T4, any deductible RCA contributions withheld from the employee s employment income. Any funds distributed from the RCA to the contributing employer, must be claimed as income on the part of an employer. An example of this occurring could be as a result of forfeiture of an amount by the employee, due to certain terms of the agreement not being adhered to. The Employee With regards to taxation, the employee has the following responsibilities or considerations: To report any distributions received, as income for the year in which they are received. Any employee contributions are also subject to the 50% refundable tax. Employee contributions are only tax-deductible if: 4 1. The trustee of the RCA is a resident of Canada;

5 2. The employee is required by the terms of his or her employment to make the contributions; and 3. The employee s contributions do not exceed the contributions of the employer for any given year. The distributions to an employee may be rolled into an RSP, tax-free, subject to certain limitations. RCA Investments The Income Tax Act does not restrict the type or amount of a particular investment which may be held within an RCA. For example, an RCA may hold cash, debt instruments and shares. Since 50% of income generated must be remitted to CRA on an annual basis, the holder of an RCA may want to consider investing in vehicles where the income does not have to be reported until it is realized. The less frequently income is realized, the greater the long-term rate of return, due to the compounding of the unrealized gains. Life Insurance policies and annuity contracts are also possible investments in an RCA. The advantage of investing in a permanent insurance contract with an investment component (such as a universal life (UL) or whole life policy) inside the RCA is that any investment income within the investment component of the insurance contract is not subject to the refundable tax. Death benefits from the insurance contract can be received tax-free by the RCA, but is taxable when paid to the employee or beneficiary of the employee. Implementation Due to the complex nature of RCAs, however, it is best to consult your tax advisor to properly investigate the feasibility of an RCA and to determine the most suitable funding method for your particular situation. A lawyer may also be required for the drafting of the RCA trust agreement. Additional Resources 1. Canada Revenue Agency (CRA) website: The information contained herein has been provided by TD Wealth and is for information purposes only. The information has been drawn from sources believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, trading or tax strategies should be evaluated relative to each individual s objectives and risk tolerance. TD Wealth, The Toronto- Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. TD Wealth represents the products and services offered by TD Waterhouse Canada Inc. (Member Canadian Investor Protection Fund), TD Waterhouse Private Investment Counsel Inc., TD Wealth Private Banking (offered by The Toronto-Dominion Bank) and TD Wealth Private Trust (offered by The Canada Trust Company). The TD logo and other trade-marks are the property of The Toronto-Dominion Bank. Revised 01/06/2012 5

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