A Retirement Compensation arrangement is perhaps the most effective and misunderstood tax deferment opportunity that exists in Canada today. It may be used for a wide range of situations, including small business owners, athletes, incorporated professionals, highly paid executives receiving yearly bonuses, and those approaching retirement. In 1986 it was recognized by the CRA that individuals not participating in a defined benefits plan suffered from pension discrimination. In other words, because of RRSP and IPP contribution caps, there was no effective way to use existing Canadian pensions provisions to duplicate the ability to save for one’s retirement under the defined benefits formula of: (average of best five earning years) * (number of years worked) * 2%. Without this, those not participating in a defined benefits plan may not be able to reach a full pension of 70% of pre-retirement income (known in pension circles as an 85 or 90 factor, depending upon the specific defined benefits plan). In response to this inequity, CRA created the Retirement Compensation Arrangement as defined by section 248(1) of the Income Tax Act (ITA). It allows incorporated entities to make tax deductible contributions to key employees to reach the maximum level of retirement income. At the time of the contribution, there is not a taxable event to the employee, but the contribution is a deductible expense for the corporation. It should be noted that this is not considered to be a pension plan but rather a taxable account structure subject to the rules laid out in ITA section 248(1).
Who should consider Retirement Compensation Arrangements?
The use of an RCA should be considered for anyone making more than $150,000 per year under the following circumstances, including:
- Small business owners
- Athletes, both resident and those playing outside of Canada
- Top executives
- Members of Parliament
- Executives receiving a yearly bonus
- Owners of Professional Corporations (physicians, dentists, lawyers)
- Executives receiving a package associated with a change of employment status (severance packages).
- American citizens currently living and working in Canada but who are preparing to return to the U.S. in the future
What are the advantages of an RCA?
- Extremely flexible and based on actuary calculations
- Contributions are 100 percent deductible for the employer. Taxes do not apply to the beneficiary until the money is withdrawn at retirement or change of employment status
- They are exempt from provincial pension regulators
- Assets in the investment account compound on a tax-deferred basis
- An RCA allows buyback of past RRSP room
- Assets are credit proof
- Assets may be used for transgenerational transfer
- Exempt from payroll taxes
This is by no means an exhaustive list of potential benefits of an RCA. Circumstances that are unique to the individual must be considered when reviewing the effectiveness of employing this structure. Its benefits to American citizens living in Canada and planning on returning to the U.S. can be very attractive.
When is an RCA most often used?
- Sale of a small business
- Small business owners saving for retirement
- Individuals receiving a severance package
- Senior executive’s supplemental pension plans
- Athletes playing for Canadian based sports organizations
How these work
The potential candidate for this structure must go through a number of steps to validate the amounts to be contributed to the RCA. A contribution calculation based on the age of the applicant, the average of their last 3 years’ income, past service shortfalls, and their projected date of retirement is generated by an actuarial firm specializing in these structures. Two contribution room figures are generated. One is for the years associated with past employment and the second is for the top up amount needed for a full pension between the original date of funding and the number of years until retirement. Analysis for future service contributions are made every 3 years so that the contribution amounts reflect the reality of the recipient’s current status.
An application is then made with CRA to open two accounts. One is held in trust with CRA, called the Refundable Tax Account (RTA). The other is an Investible Account (IA) held at a custodian. Each account is funded with equal amounts of the total principal and must be rebalanced once per year with any realized income associated with the investments inside the IA . When the account owner begins to withdraw funds from the IA, for every two dollars withdrawn, one dollar flows back from the RTA. In essence the recipient decides on the amount to be withdrawn and timing of withdrawal. The amounts, along with the addition of other income, determine the tax rate under which the funds are withdrawn.
In our first example we have a candidate born in 1967 who has averaged total yearly compensation of approximately $290,000 per year and is a principal in a privately held business that would be considered a Canadian Controlled Private Corporation (CCPC). His anticipated date of retirement (age 65) is 15 years away. In his case the past service amount – calculated by an actuarial firm – that can be contributed is $3,361,000. His yearly contributions for the next three years would be $54,000, $166,200 and $170,400 for years 2018 through 2020 inclusive. The entire structure would be reexamined in 2021 and adjustments would be made based on the new projections and the returns generated by the IA.
This candidate’s circumstances differ considerably from the first. In this instance the candidate is an American citizen living in Canada, born in 1958 and retiring in 5 years (age 65). The plan is to relocate back to the U.S. and to become non-residents of Canada sometime after their retirement. Their average income for the last three years is $642,233 per annum. In this case their past service calculation is $1,199,000. Their yearly contributions for the next three years would be $141,300, $347,500 and $356,200.
Other than the time differential between their respective retirement dates, it important to note both the citizenship of candidate two and the fact that they plan to retire to the U.S. The American citizenship issue complicates the yearly contribution amounts that we would realistically make in any given tax year. The actuarial calculations that originally generated the potential funding limits in our example are based on a scenario of Canadian T4 income, assumes that the candidate resides in Canada, works for an incorporated entity and is a non- U.S. person for tax filing purposes.
The specific complications are that U.S. citizens are taxable on worldwide income and file annual U.S. federal tax returns regardless of where they reside in the world. As well, the IRS does not view the contributions to an RCA as a deduction for U.S. purposes in the year of the contribution and instead views the RCA as a taxable account. Because of this, the income reported on the Canadian and U.S. tax returns related to the RCA will not match, which impacts the utilization of foreign tax credits. Foreign tax credits generated in the contribution year, as well as credits that have been carried forward or carried back, can be used to eliminate some or all of the U.S. tax liability related to the RCA in any given year. On the other hand, since the contributions and annual investment income have already been taxed in the U.S., no U.S. federal tax would be payable upon withdrawal from the RCA. Because of these complications, it should be stressed that a yearly U.S. tax assessment should be completed prior to any funding decision. For the purposes of our illustration, we will assume that all U.S. federal tax considerations have been dealt with during the funding phase and that sufficient annual foreign tax credits exist to offset the U.S. tax liability related to the RCA.
The second candidate has two primary options based on their stated desire to retire in the U.S. as a non-resident of Canada.
As part of their exit strategy, they may elect to redeem the total amount of their RCA while a non-resident of Canada and pay the Canadian nonresident withholding tax of 25%. Since the total funding of this account, as well as the accrued investment income since the time of funding, have already been taxed in the U.S. at the federal level, the distribution would not be subject to U.S. federal tax. As such, it is possible that their total combined tax rate for both U.S. and Canadian tax purposes is only 25%. The caveat being the state chosen as a retirement destination. If there is no state tax, such as is the case in Florida, then no additional state tax would be payable.
Or they may elect to take periodic distributions from the RCA in the form of pension payments. In this scenario, they would incur a 15% Canadian non-resident withholding tax on the distributions. As mentioned above, it is possible that this income would not be taxable in the U.S. at either the federal or state levels.
If you decide that a Retirement Compensation Arrangement might work in your circumstances, it is critical that you contact a team that has experience with these structures. At Cardinal Point Capital Management, we’d be happy to explore how a Retirement Compensation Arrangement might become an important part of your unique financial and tax plans.