TaxMatters@EY – September 2021

Lucie Champagne, Toronto

In a recent press release, the Canada Revenue Agency (CRA) has issued a stern warning to investors about participating in tax-free savings account (TFSA) maximizer schemes.

As explained below, TFSA maximizer schemes attempt to reduce the income tax liability on accumulated wealth in a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) by increasing tax-free withdrawals from a TFSA. The CRA considers these schemes to be abusive, as they artificially shift value between an investor’s registered investment plans using transactions that are viewed as “commercially unreasonable.”

Basic characteristics of RRSPs, RRIFs and TFSAs

Broadly speaking, TFSA maximizer schemes focus on a key difference between RRSPs (or RRIFs) and TFSAs — the ability to withdraw funds from a TFSA on a tax-free basis. To better understand how the schemes operate, it’s important to first review a few basic characteristics of each plan.

An RRSP increases retirement savings in two ways. First, contributions are tax deductible, subject to statutory limits. Second, the income earned in an RRSP is not subject to tax until the funds are withdrawn, thus allowing for tax-deferred growth within the plan.

Funds from the RRSP may be withdrawn at any time, but gross withdrawals will generally be included in the investor’s income in the year of withdrawal and so will be subject to tax at the investor’s current marginal tax rate.

An investor’s deductible 2021 RRSP contribution is generally limited to the lesser of 18% of earned income¹ for 2020 and a maximum of $27,830.² If the investor does not contribute the maximum allowable amount in a particular year, the excess can be carried forward.

The tax-deferred growth continues if the investor converts the RRSP to a RRIF on or before the RRSP matures, which is at the end of the calendar year in which the investor reaches 71 years of age. A RRIF is essentially a continuation of the RRSP, except that minimum withdrawals are required each year.  These withdrawals have no maximum limits.

On the other hand, an investor can currently only contribute up to $6,000 annually to a TFSA and the contributions are not tax deductible.³ Unused contribution room may be carried forward in any subsequent year, but since TFSAs were only introduced in 2009, the cumulative contribution limit for 2021 is $75,500.

Income and capital gains earned in the TFSA are not taxable, even when withdrawn. Any funds withdrawn from the TFSA — both the income and capital portions — are added to the individual’s contribution room in the next year. As such, an individual can recontribute all withdrawals in any subsequent year without affecting their allowable annual contributions.

Since the maximum annual contribution limit for TFSAs is much lower, it’s easier to accumulate wealth at a faster rate in an RRSP. Consequently, using a complex series of transactions, which includes shares of a special-purpose mortgage investment company (MIC) and secured loans from the MIC, TFSA maximizer schemes purport to allow investors to transfer funds on a tax-free basis from their RRSP or RRIF into a TFSA without regard to the annual TFSA contribution limit.

How the scheme works

The scheme is generally marketed to a sophisticated investor who has a large balance in their RRSP or RRIF and TFSA, as well as significant equity in a personal residence.

Broadly speaking, the key components of the scheme are as follows:

1. The promoter operates a MIC⁴ that invests solely in mortgage loans to scheme participants.
   
   
2. The investor converts the investments in their RRSP or RRIF and TFSA into cash to purchase shares of the MIC.
   
   
3. The MIC issues two classes of shares. The first class of shares pays dividends at a lower rate (e.g., 3%) while the second class of shares pays dividends at a much higher rate (e.g., 15%).
   
   
4. The investor purchases low-dividend shares in their RRSP and high-dividend shares in their TFSA.
   
   
5. The MIC lends the share proceeds back to the investor in the form of a first and second mortgage loan, which is secured by the investor’s personal residence and TFSA balance.
   
   
6. The interest rates on the first and second mortgages are equal to the respective dividend rates on the two classes of shares (i.e., 3% and 15%, respectively). Promoters of the schemes consider the higher rate “normal” for second residential mortgages.
   
   
7. The investor uses the loan proceeds to earn taxable investment income.
   
   
8. Each year, the investor withdraws funds from their RRSP or RRIF, which are included in the investor’s taxable income, but are fully offset by the interest expense deduction on the loans.
   
   
9. Interest earned by the MIC is distributed to its shareholders in accordance with the dividend rates.
   
   
10. Over several years, the scheme purports to shift the investor’s RRSP or RRIF balance into the TFSA without triggering tax.

CRA’s warning

The CRA considers the entire plan to be commercially unreasonable. The high rate of interest on the second mortgage, and consequently the high dividend rate on the second class of shares, are not justified since “the participants are essentially borrowing from themselves.” Given that the second mortgage is secured by the wealthy investor’s residence and growing TFSA balance, the lender’s actual risk is low, making the higher rate of interest unreasonable.

Thus, as outlined below, the CRA concludes the schemes result in an artificial increase in the TFSA’s value that is subject to the advantage tax, and the interest expense on the loans may not be fully deductible.

The advantage tax

The advantage rules are a complex set of restrictions applicable to registered plans. The rules are intended to guard against transactions designed to artificially shift taxable income or to circumvent contribution limits. This is accomplished by discouraging transactions that would not normally occur absent these motivations. The rules impose a penalty tax at a rate of 100% on certain “advantages” obtained from transactions intended to exploit the tax attributes of registered plans.

An advantage can be broadly defined as any benefit, loan or indebtedness that depends on the existence of the registered plan, subject to certain specified exceptions and inclusions, or any benefit that is attributable to a non-arm’s-length transaction that is intended to exploit the tax attributes of a registered plan. The 100% tax generally applies to the fair market value of the benefit or to the amount of the loan or indebtedness.

The CRA notes that “schemes that artificially attempt to shift value into a TFSA using transactions that are not commercially reasonable are caught by special advantage rules in the Income Tax Act.” This conclusion appears to be consistent with the wording of the Act, which generally provides that an advantage includes a benefit that is an increase in the fair market value of property in a registered plan (e.g. a TFSA) that is attributable to transactions that would not have occurred in a normal commercial or investment context between arm’s-length parties, and that have as one of their main purposes to take advantage of tax exemptions available to registered plans.⁵

The CRA lists various factors to consider in determining whether transactions have not occurred on commercially reasonable terms in paragraph 3.19 of Income Tax Folio S3-F10-C3, Advantages – RRSPs, RESPs, RRIFs, RDSPs and TFSAs. Among the factors considered, the CRA lists situations where “the rate of return on the investment is not commensurate with a reasonable return on investment capital given the degree of risk inherent in the investment”.

Since the CRA has concluded that the rate of interest on the second mortgage and the dividend rate on the second class of shares are not reasonable in the circumstances, the transactions cannot have occurred under normal commercial terms.

Thus, the resulting advantage tax under the scheme will result in a significant tax liability.

Deductibility of interest

The schemes operate on the basis that the interest expense on the loans is deductible because the loan is used to earn taxable investment income. The ability to deduct interest expense paid against the RRSP withdrawals is critical to the overall arrangement.

For an amount of interest to be deductible, one of the requirements under the Act is that the amount of interest must be reasonable in the circumstances.⁶ Since the CRA considers the rate on the second mortgage unreasonable, the investor will not be able to fully deduct the interest paid. Thus, the income inclusion from the RRSP withdrawals would not be fully offset by the interest paid, resulting in a tax liability

Next steps

The CRA continues to identify and shut down these schemes through increased audit activities and intelligence gathering. Investors and promoters may face serious consequences, including significant tax liabilities, penalties, court fines and possible jail time if they choose to participate in or promote these plans.

For investors who have already entered into a TFSA maximizer scheme, there are options available to mitigate the potential liabilities and reorganize the investments within each plan. For example, it may be possible to make a submission under the CRA’s Voluntary Disclosure Program; if the submission is accepted, the investor may have access to penalty relief and partial interest relief.

While reducing current and future tax liabilities is a common goal for many, it can also be a complex goal to achieve. The CRA has historically warned taxpayers that if a tax plan appears too good to be true, it likely is. Taxpayers should be wary of schemes offering a very high return for seemingly low risk, and also of schemes promoted by social media videos and word of mouth instead of by trusted advisors.

The CRA’s website provides guidance to help taxpayers identify tax schemes. It is prudent to speak to a reputable tax advisor to obtain the right advice before undertaking any tax planning arrangement.

Gael Melville, Vancouver, and Winnie Szeto, Toronto

Two recent cases from the Federal Court of Appeal (FCA) explored the conditions under which an organization can become a registered Canadian amateur athletic association (RCAAA) under the Income Tax Act (the Act). The courts haven’t considered these rules often, and it was interesting to see the Court reject the CRA’s reliance on its own internal guidance, which it found was not sufficiently rooted in the wording of the legislation.

The facts of the two cases were very similar, and ultimately the Court found in favour of both organizations, sending the registration requests back to the CRA for reconsideration.

What is an RCAAA?

Organizations that successfully apply for registration as an RCAAA are exempt from Canadian Part I income tax and can issue donation receipts to donors, allowing the donors to claim tax credits or deductions for donations to the organization.¹ To be eligible for registration, an organization must meet the definition of a Canadian amateur athletic association.²

That definition requires the organization to:

• Be created under any law in force in Canada
• Be resident in Canada
• Only pay its income to a club, society or association whose primary purpose and function is the promotion of amateur athletics in Canada
• Have the promotion of amateur athletics in Canada on a nationwide basis as its exclusive purpose and exclusive function and devote all its resources to that purpose and function

There are currently around 130 organizations on the CRA’s list of RCAAAs.

Facts of the cases

The facts of the cases were similar and each involved an entity — Organization 1 and Organization 2, respectively — that was a society incorporated under British Columbia’s former Society Act.

The two organizations had identical purposes, according to their constitutions, including “to develop, fund, promote and carry on activities, programs and facilities for the promotion of amateur athletics in Canada on a nationwide basis as [their] exclusive purpose and exclusive function.”

The principal difference between the cases was that Organization 1 intended to provide funding directly to athletes, while Organization 2 planned to help sports teams and clubs by paying for facilities, equipment and services directly.

In 2014, each organization applied to the CRA for registration as an RCAAA. Both received an initial letter from the CRA in March 2015 expressing concerns about their eligibility for registration. The organizations’ responses to their respective letters were unsuccessful in addressing the CRA’s concerns and each subsequently received a notice of refusal of registration in February 2016.

In the case of Organization 1, the CRA’s main concern was that the organization would be providing financial assistance to athletes. In the CRA’s view, only organizations that directly promoted amateur athletics in Canada could fulfill the requirements of exclusiveness of purpose and function under the Act, and that providing funding was not accepted as promoting amateur athletics. The CRA also believed Organization 1 had not shown it would operate on a nationwide basis since it was based in Vancouver and didn’t have enough capacity, based on its operating budget, to operate programs on a national level.

In the case of Organization 2, the CRA expressed similar concerns  — specifically, that the organization would not be directly promoting amateur athletics through its activities and that it didn’t have a sufficiently broad-based presence throughout Canada.

Both organizations filed notices of objection, and when the minister did not respond, each organization filed an appeal to the FCA.

FCA decisions

The FCA set out its reasoning for allowing the appeal in Organization 1’s written decision and referred to those reasons in Organization 2’s case, adding some extra commentary on certain points that related only to Organization 2’s case.

In particular, the Court in Organization 2’s case confirmed that there is no requirement for a Canadian amateur athletic association (CAAA) to be formed under federal law. The organization need only be formed under any law in force in Canada at the relevant time.

Issue 1: direct promotion of amateur athletics

The Organization 1 reasons dealt mainly with the first issue in the appeal, which was whether an organization’s activities must directly support the promotion of amateur athletics for it to become an RCAAA. The Court noted that the CRA’s discretion to refuse registration was limited and that it was required to determine whether an organization satisfied the definition of a CAAA under the Act. In making this determination, the CRA could not be bound by its own previous administrative guidance — in this case, a policy statement known as CPS-011 that was applicable until December 31, 2011.

The Court then considered whether the wording of the Act supported a requirement that organizations directly promote amateur athletics in Canada. The Court found there was no such requirement in the wording of the Act, and it highlighted how such a requirement would not fit with the CRA’s own interpretation of the acceptable purposes for RCAAAs.

The Court then made similar points in connection with two of the minister’s concerns regarding the purpose and function test, and whether the organization devoted all its resources to its purpose and function.

The Court noted that the registration process was not an audit of Organization 1. For example, whether or not a particular payment to an athlete satisfied the requirement that it promoted amateur athletics in Canada could only be determined once the facts surrounding the payment were known. At the time of registration, the CRA should be concerned only with whether proposed payments to athletes met the necessary function and purpose requirements in the Act.

Issue 2: nationwide basis requirement

The Court also considered whether Organization 1 had met the requirement of operating on a nationwide basis. Organization 1 had a presence only in Vancouver and the CRA was of the view that, based on its operating budget, it didn’t have capacity to operate programs on a national level.

The Court pointed out that the legislation requires only that an organization’s exclusive purposes and functions are the promotion of amateur athletics in Canada nationwide. An organization that has a physical presence only in one province could still be able to promote amateur athletics throughout Canada. However, if after registration the organization failed to carry on its activities on a nationwide basis, it could be subject to revocation of its registration.

Lessons learned

The takeaway from these cases is that the CRA must register an organization that meets the definition of a CAAA under the Act, unless the very limited exceptions in subsection 149.1(25) of the Act apply. In interpreting the definition of a CAAA, the CRA cannot treat its own guidance documents on acceptable purposes and functions as creating a binding and exclusive list of such purposes.

These cases provide a reminder that CRA administrative policy statements are not equivalent to law.

The cases also established that an organization does not need to directly promote amateur athletics in Canada to be eligible for registration. An organization that provides support more indirectly, in the form of funding, can be eligible as long as it meets the other requirements.

Tax Alerts – Canada

Tax Alert 2021 No. 25 – Bill C-208: changes to section 84.1 and section 55
On 29 June 2021, private member’s Bill C-208, An Act to amend the Income Tax Act (transfer of small business or family farm or fishing corporation), received Royal Assent.

Tax Alert 2021 No. 26 – Proposed changes to taxation of employee stock options now law
Significant changes to the taxation of employee stock options first proposed in 2019 received Royal Assent on 29 June 2021 and are now law.

Tax Alert 2021 No. 27 – SCC rules that CCAA charges take priority
On 28 July 2021, the Supreme Court of Canada (SCC) released its decision in The Queen v. Canada North Group Inc., 2021 SCC 30.

Tax Alert 2021 No. 28 – DIPs required to request information by 15 October
A Distributed Investment Plan (DIP), which as defined generally includes mutual fund trusts and certain partnerships, that is a selected listed financial institution is required to make a written request to obtain certain information from its investors by 15 October 2021.