Module 3: Leveraging the Tax Regime in Plan Design Flashcards
Outline the government’s stated objectives for the current income tax regime governing registered pension and non-pension retirement plans.
The government’s stated objectives in implementing the regime were:
(a) To establish a tax framework to encourage increased private retirement savings
(b) To eliminate inequities that resulted in some taxpayers being unable to benefit from as much tax assistance as others, depending on the type of their pension and retirement savings plans
(c) To enhance the flexibility in the timing of retirement savings
(d) To introduce a system under which dollar limits on contributions and benefits are adjusted for inflation and therefore do not decline in real value.
Explain the taxation rules for registered pension plan (RPP) contributions, benefits, investment income and capital gains.
Contributions to an RPP are deductible up to certain limits.
Employer contributions to a DB pension plan must generally be supported by an actuarial valuation. Eligible DB contributions made in a taxation year or within 120 days of the end of the taxation year are deductible by the employer as long as the contributions are made to fund benefits provided to employees and former employees in respect of periods before the end of the taxation year. DC pension contributions made in a taxation year are deductible by the employer if made in accordance with the plan as registered and in respect of periods before the end of the taxation year.
Eligible employee contributions are deductible in the year made (except for past service defined benefit plan contributions made in respect of years of service prior to 1990).
Benefits are fully taxable to employees when paid directly to them. Individuals age 65 or older may claim a federal tax credit in respect of the first $2,000 of pension income from most types of registered pension or savings plans, up to a maximum credit of $300. Individuals under age 65 may claim a similar tax credit in respect of income received from similar plans as the result of the death of their spouse or common-law partner.
Income and capital gains earned by investing the assets of an RPP are not taxable.
Describe the comprehensive savings limit on tax-assisted retirement savings, the rationale for its existence and the consequences of failure to respect that limit.
Legislation regarding retirement savings limits is based on the principle that the availability of tax assistance should be the same for all individuals with the same incomes, whether they save for retirement through participation in a registered pension plan, RRSP or DPSP or through a combination of those plans.
The comprehensive savings limit is equal to 18% of the member’s compensation, subject to a dollar maximum called the money purchase limit. Note that the use of “money purchase” in references to the Canada Revenue Agency (CRA) “money purchase limit” is correct.
Failure to respect the limit will cause the deregistration of an RPP or DPSP under the ITA and will result in a penalty tax under an RRSP.
Describe the purpose of pension adjustments (PAs) and outline the steps taken by employers to determine PAs.
The existence of a comprehensive savings limit on tax-assisted retirement savings and the great diversity among employer-sponsored registered plans in Canada calls for a mechanism that attempts to fairly identify the “value” of any one employee’s participation in their employer’s plan(s). While this is a simple exercise for DC registered plans, whether pension or non-pension, the range of types of DB pension plans requires a more complex approach for participants in those plans. The PA is the mechanism used by CRA to approach this matter. PAs are used by CRA to monitor the tax savings limits for registered pension plans and deferred profit-sharing plans (DPSPs) as well as to calculate the RRSP contribution room for a plan member for the following year.
Employers are responsible for reporting PAs to CRA. Steps required are as follows.
(a) Determine each plan member’s benefit accrual in the pension plan or DPSP for the year in question (e.g., 2% of employees’ earnings in a DB plan or the employer contribution in a DPSP plan). If employees participate in more than one plan sponsored by the employer (e.g., two separate pension plans, or a pension plan and a DPSP), this must be done for each plan.
(b) Determine the dollar value of the pension plan or DPSP benefit accrual. In a DB plan, step (b) will be nine times the benefit accrual from step (a), minus $600. If only a DPSP, then the amounts in step (a) and step (b) will be the same. This amount is known as the member’s “pension credit.”
(c) The pension credit is the Pension Adjustment to be reported by the employer on each plan member’s T4 slip for the year in question. If employees participate in more than one pension plan or DPSP with the same employer, the employer must total the pension credits from each plan for each member, and that total will be the PA.
Since a member’s PA for a year with respect to an employer must not exceed the money purchase limit, the employer must ensure that the PAs are within that upper limit. Typically, this is dealt with through plan design that ensures that benefit accruals will not lead to excessive PA values. For example, by limiting the DB pension accrual to 2% of compensation, the result is that the PA equals 9 X 2% (which equals 18% of compensation) - $600. In a combination DB RPP and DPSP, the DB pension accrual is usually set lower than 2% to provide the ability to make some degree of DPSP contribution.
Outline the rationale behind the “factor of nine” used to determine the PA for a DB pension plan and identify situations when it is more or less an appropriate factor.
The “factor of nine” was chosen by the Department of Finance as an appropriate average factor to produce the approximate value or cost of a dollar of lifetime pension income under a generous DB pension plan.
While it is appropriate for estimating the value of pension benefits under generous DB pension plans for employees who participate over their full careers in those plans, it is used to determine the PA under all DB pension plans. The PA formula is based on the benefit accrual, which looks only to current year earnings and assumes that earnings for all other years are the same. The benefit accrual also ignores ancillary benefits such as early retirement reductions and indexation. Accordingly, the PA treats career average plans with no ancillaries the same as final average plans with generous ancillaries. The use of the factor of nine and the inability of the PA calculation to differentiate between generous and less generous plans will result in a substantial over-calculation of the value of the plan’s tax assistance in many cases. If a PA is overstated, a plan member’s RRSP contribution room is less than it should be.
Explain how a PA is determined in a DC pension plan, DPSP and a DB pension plan.
In a DC pension plan, the PA is generally calculated as the sum of employer and employee contributions in the year, plus reallocated forfeited amounts (from unvested terminated members), if any. DPSPs do not allow member contributions; otherwise, the PA is generally calculated in the same way. In a DB pension plan, the PA is nine times the benefit accrual in the year, minus $600. This formula applies regardless of the design of the DB pension plan and whether or not the employee is vested.
Chen accrued $1,250 of pension in his employer’s DB pension plan in the past year. His co-worker Ester accrued $1,500 of pension in the same DB pension plan last year. Their co-worker Josh contributed $1,500 to a separate DC pension plan that their employer sponsors for recently hired employees, and the company also contributed $1,500 to that pension plan. Calculate the PAs that their employer will report on their T4.
For the DB pension plan, the PA is nine times the approximate amount of annual pension accrued in the year, minus $600.
Chen’s PA will be (9 X $1,250) – $600 = $10,650.
Ester’s PA will be (9 X $1,500) – $600 = $12,900.
For the DC pension plan, the PA is the total of employee and employer contributions.
Josh’s PA will be $1,500 + $1,500 = $3,000
Describe the purpose of a past service pension adjustment (PSPA) and the events that generally will create a PSPA. Identify two types of RPP benefit improvements that do not create PSPAs.
PSPAs are an attempt to maintain equity within the application of the ITA comprehensive retirement savings limit when DB pension plan sponsors grant retroactive pension improvements. Without the PSPA mechanism, members of such DB plans would have access to retirement savings at levels that exceed the comprehensive limit of the ITA.
A PSPA is intended to recognize the difference between PAs reported in previous years in respect of pension plan members and the PAs that would have been reported had plan benefits been higher through those years. A PSPA is calculated for each affected member of an RPP when an employer amends the plan to increase pensions already earned. A PSPA is applied against unused RRSP contribution room and it reduces the amount that the affected member may otherwise contribute to an RRSP.
Generally, a PSPA is created if the benefit formula in a DB pension plan is increased for years after 1989, or if past service benefits are added for those years.
A PSPA does not arise in two situations:
(a) If ancillary benefits are improved, such as early retirement subsidies or increased death benefits, and
(b) If pensions for service before 1990 are upgraded or improved.
Describe in general the requirements for pension plan administrators to report PSPAs to the CRA.
When PSPAs are created by a benefit improvement, the plan administrator must report them to the CRA. One of two situations will then apply:
(a) Some PSPAs must be reported but are exempt from a process called “certification.” Generally, certification is not required if benefits are increased for at least 90% of the members and if certain requirements are met around the nature of the members who receive a benefit improvement. An example of a PSPA that is exempt from certification is when a plan improves benefits for more than nine active members, none of whom are considered “specified individuals” by CRA. Specified individuals are generally members who own at least 10% of the sponsoring company or whose earnings are at certain defined high levels.
(b) Some PSPAs must be both reported to CRA and then “certified” prior to implementation of the benefit improvement. Certification is normally provided as long as the PSPA does not exceed the member’s unused RRSP contribution room at the end of the previous year by more than $8,000. If this is not the case, it is possible that the member’s PSPA will be certified after the member withdraws funds from their RRSP. Such withdrawals are called “qualifying withdrawals,” and they are taxable to the individual.
Explain the purpose of pension adjustment reversals (PARs) and describe their impact upon plan members.
PARs are another attempt to maintain equity within the application of the ITA comprehensive savings plan limits. Their purpose is to remedy the overstatement of PAs (and resulting reduction of RRSP contribution limits) that would occur without the PAR mechanism in two circumstances:
(a) In DB pension plans, the use of the “factor of nine” often overstates the value of members’ pension credits
(b) At time of termination, not all pension and DPSP members are fully vested, yet historical PAs assumed full vesting.
PARs help where a terminated employee’s benefit (either a lump-sum payment or transfer to an RRSP or RRIF) is less than the cumulative PAs and PSPAs reported for that employee. The PAR, which is reported to CRA by the plan administrator, generally equal to the amount of the excess, restores RRSP contribution room to the extent of that excess. There is no PAR if the member simply collects his or her pension from the plan.
Describe in general terms the approach for registering a pension plan under ITA.
Government requires that pension plans be bona fide retirement savings vehicles and is concerned that the tax-deductible contributions made to pension plans should not exceed amounts that are considered reasonable in the circumstances.
Before it will grant registration under ITA, CRA requires a plan sponsor to also apply for registration under the provincial or federal pension standards legislation (where there is such legislation applicable). Each province, except Prince Edward Island, has its own laws and regulations that govern pension plans in industries that are not under federal jurisdiction. The Office of the Superintendent of Pensions (OSFI) regulates private pension plans in federally regulated industries such as banking, airlines and telecommunications as well as plans established in the Yukon, Northwest Territories and Nunavut.
A pension plan sponsor may apply for registration retroactively, but the effective date must be in the same calendar year in which the application for registration is submitted. ITA regulations apply to all registered pension plans, regardless of when those plans were submitted for registration. There are prescribed registration rules for all types of pension plans.
Discuss the consequences of noncompliance with the pension plan registration rules set under ITA.
Failure to adhere to the registration rules at any time after initial registration causes the plan’s registered status to become revocable. If the plan’s registration is revoked, the arrangement is then classified as a Retirement Compensation Arrangement (RCA) from the date it ceases to comply with the rules and ceases to benefit from the preferential tax treatment afforded to RPPs.
Explain the primary purpose of an RPP in the context of ITA.
The primary purpose of an RPP is to provide employees with periodic payments after retirement and until death in respect of their service as employees. The pensions must be payable for the plan member’s lifetime in equal periodic amounts, except where they are adjusted for inflation or reduced after the death of the plan member or their spouse.
Explain how the ITA requires that members’ benefits from pension plans be protected from most creditors.
All RPPs must include a specific clause prohibiting plan members from assigning or transferring their rights under a pension plan to another or pledging their rights under a pension plan as security for a debt. Plan members cannot surrender or voluntarily forfeit their pension rights. Creditors cannot charge or apply to seize a member’s rights under an RPP in order to satisfy debt owed by the plan member.
However, these provisions do not prevent the assignment of benefits pursuant to a court order or settlement agreement upon the breakdown of a marriage or conjugal relationship. It does not prohibit the surrender of benefits to avoid revocation of a plan’s registration, nor does it prohibit the distribution of benefits by a deceased plan member’s legal representative. The government of Canada does have the right to recover taxes owing by attaching the pension owing to a member.
Explain the ITA restrictions placed on the types of assets acceptable for the investment of RPP monies under ITA.
Income tax regulations require that RPPs comply with all minimum standards investment regulations of the jurisdictions of registration. ITA registration rules prohibit RPP assets from being invested in shares or debt instruments of any plan member, any employer that participates in the plan and generally any individual connected or related to a plan member or participating employer. The prohibition does not extend to shares or debt obligations of a participating employer where shares of the corporate employer are listed on a prescribed stock exchange inside or outside of Canada, certain government debt obligations, in interest to acquire such a listed security, and certain mortgages on real property.
An RPP may not borrow funds, with two specific exceptions:
(1) Where the term of the loan does not exceed 90 days and none of the RPP’s assets are used as security for the loan (except where the borrowing is necessary for current payment of benefits or purchase of annuities)
(2) Where the borrowed money is used to acquire real property to earn income from property, as long as no RPP asset other than the real property acquired is used as security for the loan and the loan does not exceed the cost of the property.
There is no foreign content limit on investments held under pension plans.
