Breaking down the government’s proposed IPP changes

The Department of Finance is moving ahead with its proposal from the 2019 federal budget to limit transfers of commuted values to individual pension plans (IPPs). It released the related draft legislation Wednesday.

The IPP definition was first introduced in 2011, when Finance sought to eliminate what it perceived as undue tax deferral that certain plans provided. The rules only applied to pension plans that met the definition. Now, Finance is again seeking to close down what it sees as an undue advantage. The proposal, if enacted, will only apply to plans meeting the definition.

When a client is no longer a member of a DB pension plan, it may be possible to transfer the full commuted value (CV) of the their accrued benefits on a tax-deferred basis. This is accomplished either by transferring the full commuted value (CV) to another DB plan sponsored by another employer, or by using the CV for the purchase of a copycat annuity.

Clients seeking to transfer the CV to a RRSP or similar registered plan are subject to a cap.  While Finance suggests that the the cap is “normally” 50%, our experience has been that it could be in the 30% range, especially when we are dealing with members of “rich” plans  who are entitled to unreduced benefits at a young age.

What did Finance propose?

Since transfers of CVs from DB plans to (locked-in) RRSPs and certain other defined contribution plans are subject to this cap, the taxes on the amount that cannot be transferred can be very significant. The 2019 budget said that Finance was concerned about “inappropriate planning” being undertaken to circumvent the cap.

The budget referred to situations in which IPPs were set up in newly incorporated private corporations that were controlled by individuals who had terminated employment with their former employers. By establishing the IPP, the individual was able to recognize the service with the previous employer and  thus transfer 100% of  their CV to the IPP. This eliminates the tax liability that typically would result because of the limitations on what can be transferred to a (locked-in) RRSP. Finance wants to curtail this behaviour, seeing it as an undue tax deferral.

Does the proposed measure shut down all commuted value (CV) transfers?

No. Transfers to locked-in RRSPs, copycat annuities and certain other plans are still permitted. Finance’s proposed measure only prevents CV transfers to IPPs. An IPP is defined as a plan with a DB provision that has three or fewer members in the year or any preceding year, and where at least one member is related to the employer sponsoring the plan.  (There is an anti-avoidance rule that will catch situations where a fourth member is added to the plan in order to avoid the application of this provision.)

Understanding whether the plan sponsor is related to the proposed plan member is key.

Case study 1

Alexander is employed at a large public utility with a generous pension plan. His commuted value (CV) is $2.5 million. He plans to terminate his employment since the plan provisions now provide him with an unreduced pension.

His employer still requires his services, so Alexander will set up NewCo (he will own all the shares) to provide consulting services to his previous employer. NewCo will sponsor a pension plan. Since Alexander is related to NewCo by virtue of his controlling the corporation, the pension plan is considered an IPP. Under the proposed rules, Alexander won’t be able to do a tax-free transfer of his CV to the new pension plan, since the public utility is not a participating employer in that plan.

The IPP can, however, recognize service starting with the current year. Terminating plan members will want to consider whether acquiring a copycat annuity with their CV is an appropriate alternate approach.

Case study 2

Josie’s employment at a large public company was terminated. The 52-year-old was offered a senior position at a privately owned corporation. Her base salary will be $150,000, and she will also be entitled to a significant bonus. She wants to work until at least age 60.

Josie will use her severance to purchase 20% of the common shares of her new employer. The new employer can sponsor a new pension plan. Since Josie will not be related to the new employer—her shares only make up 20% of the total shareholdings and she does not control the corporation —and the plan is therefore not an IPP, she will be able to transfer her entire CV to that plan. Thus, Josie will ultimately be able to draw a pension that recognizes her years of service at both the public company and the new employer.

Additional commentary

Readers who want further insight into CRA’s views on whether a plan member is related to a participating employer can review a technical interpretation that CRA released on this subject in 2017 (document number 2016-06655931I7.)

We find it interesting that Finance has proposed this measure. In many ways, the “unintended” tax deferral is of Finance’s own making. The method used for calculating the maximum transfer value was first proposed almost 35 years ago. The present value factors used in the calculation are artificially low.   Thus, plan members who choose to commute their pensions see a significant erosion of their capital because of the artificially large tax liability that arises on a transfer to a (locked-in) RRSP.

CRA will only register a pension plan where the “primary purpose” test is met. The tax regulations provide that the primary purpose of the plan must be “to provide periodic payments to individuals after retirement and until death in respect of their service as employees.”

Instead of leaving it to CRA to identify situations in which this is not the case, and where CRA would have refused plan registration, or would have deregistered the plan, Finance has chosen to simply prohibit certain transfers. We find it disconcerting that Alexander could transfer the CV to any registered pension plan that will accept the funds, provided that the plan is not an IPP.

Has the measure passed?

Many of the measures in the 2019 federal budget were contained in Bill C-97 that received royal assent in June. The IPP measure was not part of the legislation and is not yet law. Finance’s draft legislation said the amendments would apply to pensionable service that’s credited on or after March 19, 2019. The comment period for the legislation runs to Oct. 7.

The House of Commons is adjourned until Sept. 19 and is unlikely to return until after the Oct. 21 election. Thus, it is difficult to anticipate what progress this legislation will make.

How is CRA proceeding?

CRA is reviewing submissions made to the registered plans directorate and attempting to identity those that might be impacted by the proposals. It is stating that “benefits will still be permissible if the period of employment with the former employer was pensionable service under the defined benefit provision of the individual pension plan before March 19, 2019.”

What is problematic is that CRA’s criteria for determining whether the pensionable service had been set up prior to the cut-off date is not known. Is CRA expecting that a plan document (or plan amendment) proving this had been submitted prior to the cut-off date?  Or, is it sufficient that there be written documentation in place as at the cut-off date evidencing the employer’s commitment to provide such past service? We are seeking answers to these questions from the agency.

Summary

IPPs are a valuable retirement tool. Accountants and financial planners will want to identify clients for whom this strategy is appropriate. We will be monitoring the progress of the proposed changes and their potential impact.

It is also our hope that Finance will update the transfer rules so that members of DB plans who are commuting their pensions to (locked-in) RRSPs are not seeing their retirement capital eroded because of the out-of-date rules.

Lea Koiv, CPA, CMA, CA, CFP, TEP, is a tax, pension and retirement expert with Lea Koiv & Associates (info@leakoivassociates.ca). William C. Kennedy, FSA, FCIA, is senior vice-president at Lesniewski Moore Consulting Group.