Caution when counselling DB-to-IPP transfers

Employees with defined benefit pension plans commonly take their pension annuity upon retirement.

Another option is to commute the pension. That’s been especially enticing for the last decade while we have experienced historically low interest rates, which lead to larger commuted pension values than would occur in a higher interest rate environment (see Should your client consider a copycat annuity?).

When a pension is commuted, there are two main calculations to make: the lump-sum value, and how much of that may be transferred, tax-deferred, into a locked-in RRSP. The more generous the pension terms, the more the commuted value will exceed the tax-deferred transfer, with the excess taxable in the year of commutation.

Continued full tax sheltering

When facing a large tax bill—even though it derives from a fortuitously large commuted value—a departing employee may consider a third alternative, which is to transfer to another DB pension plan.

That may work if the employee is moving to a new workplace and not actually retiring. If the new employer has a DB plan that’s willing to accept the transfer, then the full value may remain tax-sheltered.

A variation on this is to transfer to an individual pension plan (IPP) if the departing employee owns a corporation where he or she is an employee. This must be a bona fide employment relationship that is carefully documented; if not, the entire amount could be taxable in the year of commutation.

When an IPP may not pass muster

An Ontario judgment released in August ordered that a lawsuit may proceed against advisors and their firms related to a faulty IPP setup. The case deals with whether a statement of claim issued in 2012 was within the two-year limitation window, and is instructive on how complicated these matters can be.

In 2008, the plaintiff had been employed by a large corporation for 27 years. A co-worker advised that she was going to “retire early” without any reduction in her pension, and offered to introduce the plaintiff to the advisors who had created the plan.

With the advisors’ counselling and assistance, the plaintiff formed a corporation and executed the documents to register an IPP with CRA. She left her employment and directed the transfer of her $683,115 commuted pension value to the IPP, which was completed soon after. CRA confirmed that the plan had been accepted for registration as of Sept. 1, 2008. This process is similar to filing a tax return: CRA confirms receipt but doesn’t say whether there are errors or whether you’ll be audited.

In 2009, when the IPP payments were lower than expected, the plaintiff sought the assistance of an accountant to deal with the corporate tax filings. She was advised that the IPP did not appear to meet the registration requirements and was “very likely to have its registration revoked by CRA.” The case doesn’t provide details as to why, but presumably the bona fide employment relationship wasn’t met.

Indeed, after some correspondence through legal counsel, CRA confirmed in September 2011 that the IPP did not comply with the registration regulations.

Ineligible as an IPP, the $683,115 commuted pension would generally be taxable in the year she attempted the transfer (2008), with the possibility of interest and late-filing penalties.

The judge ruled that only upon CRA’s 2011 official notice could the plaintiff be certain the IPP was non-compliant. The plaintiff’s statement of claim against the advisors, issued in 2012, was therefore in time.

The ruling also rested in part on the advisor defendants’ reassurances to the plaintiff. As late as a March 2011 letter, their “repeated advice casted doubts over the inadequacy of the IPP,” making it difficult for the plaintiff to be certain about its status, and in turn the basis to make a legal claim.

Whatever happens with this lawsuit, it’s a cautionary tale for IPPs and advisors. In a self-reporting tax system, filing on time is no assurance that what’s filed fulfills the technical requirements. Qualified tax advice is critical.

Doug Carroll, JD, LLM (Tax), CFP, TEP, is Practice Lead — Tax, Estate & Financial Planning at Meridian.

Doug Carroll

Tax & Estate

Doug Carroll, JD, LLM (Tax), CFP, TEP, is a tax and estate consultant in Toronto.