Ed Bartucci, Financial Post · Jun. 20, 2011 | Last Updated: Jun. 21, 2011 12:53 PM ET
Like many entrepreneurs, you may have used your RRSP to invest in your private company to help you capitalize the company and defer tax on the future growth of the company, or you may be thinking of doing so.
However, changes reintroduced in the June 6 federal budget, billed as stopping aggressive tax planning such as “RRSP strips,” have surprisingly changed the landscape on allowing private company shares in registered retirement savings plans.
Because previously qualifying small business RRSP investments have now been swept into these strict new rules, you could face a costly tax bill if you have shares in your RRSP that suddenly no longer qualify.
You’ll need to start planning to mitigate the tax consequences of removing those shares from your RRSP before the 2013 deadline for doing so. In some cases you may have to act before the end of June 30, 2011 to avoid adverse tax consequences.
These new rules are effective as of March 22, when the federal budget was first announced. Before this date, the law generally allowed private company shares to be “qualified” investments for your RRSP if, at the time your RRSP acquired the shares, you (and others related to you) held less than 10% of the company’s shares. Even if you held more than 10% of the company’s shares, the shares could still be considered a qualified RRSP investment, provided you and related parties did not control the company and the original cost of the shares was less than $25,000.
Under the new rules, shares in companies in which you (and related parties) have an interest of 10% or more have become prohibited investments for your RRSP. A special tax of 50% of the fair market value of the investment will apply to you (not the RRSP) if your RRSP acquires such a prohibited investment or if an investment it already holds becomes prohibited. However, the 50% tax will not apply to prohibited investments that qualified under the old rules if your RRSP held them on March 22, 2011 and it disposes of them before 2013.
For example, say you used your RRSP to help finance the startup of an innovative business you founded 15 years ago with four unrelated partners. At that time, your RRSP acquired 20% of the company’s shares for $20,000. The company has been successful because of all the partners’ hard work and business acumen and your shares are now worth $1-million. However, because you own more than 10% of the company’s shares, they have suddenly become a prohibited investment for your RRSP. Unless you remove the shares from your RRSP before 2013, you will have to pay a tax of 50% of their value.
Normally, if you withdraw funds or assets from your RRSP, the value of the withdrawal is taxed as regular income. At a top marginal tax rate of about 46%, depending on your province, this is not an attractive option for getting your private company shares out of your RRSP.
To recognize this type of situation, the new rules allow you to swap the shares for cash or other property with the same value, but only until the end of 2012. This way, you won’t have to pay tax on an RRSP withdrawal. The value of your private company shares for this purpose will have to be supported by an appropriate valuation.
For many entrepreneurs, a swap could be easier said than done. In our example, if you and the other four founders of your successful business are using all the company’s profits and your personal borrowing capacity to fund the business’s expansion, it could be difficult for you to come up with more cash or other qualifying assets for the swap.
Further,unlessthelegislation provides more relief, it appears the new rules can also apply a 100% tax to any increase in your shares’ value after March 22. You can avoid this additional tax if you remove the shares from your RRSP but you must do so by he end of this month. You can’t avoid this additional tax even if you remove the shares from your RRSP before 2013 if you miss the June deadline and the shares increase in value after March 22.
Clearly, if you have private company shares in your RRSP that have become prohibited investments under the new rules, you need to act as quickly as possible to mitigate the tax consequences. We hope the draft legislation to enact these rules will provide more relief for entrepreneurs in this situation, but it’s possible they could become law without significant changes.
Even if private company shares in your RRSP are still eligible investments under the new rules, or if you’re thinking about making such an investment in your RRSP, you will need to continually monitor the shares to ensure you don’t fall afoul of the strict new requirements.
– Ed Bartucci is leader of KPMG Enterprise’s tax practice in Canada.