CRA clarifies tax treatment of settlement payments related to RRSPs, other plans

Clients who lost money in their RRSPs and later received a settlement from a lawsuit related to those losses now have more clarity about whether that payment will be taxed.

The Canada Revenue Agency (CRA) clarified its position on settlements from class-action lawsuits in relation to losses incurred in registered plans in its updated Income Tax Folio S3-F10-C3, Advantages – RRSPs, RESPs, RRIFs, RDSPs, and TFSAs, released May 10.

Settlement payments made directly to the associated registered plan “would not constitute a premium, gift or contribution to the plan,” the agency confirmed, and would not result in an income inclusion to the taxpayer controlling the plan.

As well, a settlement payment to a plan’s controlling individual would not be taxable if the amount was returned to the plan.

However, the folio now states that taxpayers may be taxed on settlement amounts if they receive the payment and don’t return the amount to the plan “within a reasonable time.” This period is “generally” defined as six months from when the payment was received or by the end of the tax year, whichever is later.

The CRA noted that if the plan associated with the settlement amount no longer exists or has matured, the payment could be made to another registered plan of the same type.

If someone keeps a settlement amount beyond the reasonable period, that person might be considered to have received a benefit under the plan and could face a tax bill, depending on the type of plan.

In the case of an RRSP or RRIF, a settlement payment amount would be included in the individual’s taxable income. However, with a TFSA, the individual would face no tax as TFSA distributions aren’t taxable.

In the case of an RESP, assuming the payment was made to the plan subscriber, the payment would be considered an accumulated income payment (AIP) and included in the subscriber’s income. The AIP could also face an additional penalty tax.

And in the case of an RDSP, the tax treatment of the settlement amount would depend on who received the payment.

If the payment was received by the RDSP beneficiary, regardless of whether they were also a planholder, the payment would be considered a disability assistance payment (DAP) and be included in the beneficiary’s income for the year.

If the payment was received by an RDSP holder who isn’t also the beneficiary, the payment would not be a DAP and would not be included in income. Instead, the payment would be regarded as a “registered plan strip” and thus would face a 100% tax as an “advantage.”

Registered plan strips are tax-avoidance schemes that seek to remove or devalue property of a registered plan, excluding TFSAs, without an income inclusion for the controlling individual or beneficiary. However, “the only time the advantage rule would apply [to settlement payments in respect of registered plans] is when a payment is received by an RDSP holder who is not a beneficiary,” said Wilmot George, vice-president of tax, retirement and estate planning with CI Investments Inc.

The updated advantages folio also features guidance on referral bonuses paid in connection with registered plans and illustrated income tax implications associated with so-called TFSA maximizer schemes, about which the CRA has previously issued warnings.

The changes to the folio are out for comment until June 24.

The CRA also released on May 10 an updated Income Tax Folio S3-F10-C1, Qualified Investments – RRSPs, RESPs, RRIFs, RDSPs, and TFSAs. This folio includes updated rules for determining liability for tax on business income earned from day-trading in a TFSA. The updated guidance reflects legislative changes first introduced in the 2019 federal budget. 

That folio’s changes are also out for comment until June 24.