RCA tax fundamentals

The 50% tax bracket is back. In case you missed it, Nova Scotia residents will be subject to a 50% tax rate on income over $150,000 when they file their returns for 2010. And if recent tax platform reversals in British Columbia and New Brunswick indicate the broader political mood, there could be company coming to that 50-plus party.

There’s something magical — and not in a good way — about the 50% threshold. The notion that the government gets more of your earnings than you do can be a powerful incentive to explore tax-planning options. Unfortunately for those of us who are straight-up employees, there are relatively few avenues to relief.

By contrast, business corporation owners and incorporated professionals have much greater latitude with which to organize their affairs strategically. One vehicle that may return to the planning radar due to its close association with the 50% bracket is the retirement compensation arrangement (RCA).

Though RCAs may lead to tax benefits, they are not inherently tax beneficial. In fact, the rules were created in 1986 to forestall what were perceived as abusive ‘top hat’ pensions, which aggressively supplemented beyond RPP limits. The RCA rules have not outlawed these supplemental executive retirement plans (SERPs), but are sufficiently onerous to make planners weigh the issues before heading down that road.

At first blush, it appears the employee’s personal marginal tax rate would have to be greater than 50% to consider an RCA. While that might be preferred, the RCA can be better viewed as a coordinated component of a broader plan comprising current compensation, creditor protection, business succession, retirement income and estate planning.

Still, the ultimate value of the RCA depends on good tax management, and that in turn relies upon tax-informed investment management.

(RTA) is like an interest-free loan to the government. While this may be unavoidable with respect to the initial deposit, carefully managing the RCA can limit further additions to the RTA that would otherwise arise out of realized earnings.

Sophisticated strategies go so far as including housing-exempt life insurance policies, or even shared interests in such vehicles, within the RCA. While such arrangements may have benefits, they may not be appropriate where the RCA is intended to operate principally — if not exclusively — as a pension supplement.

On a general operational level, then, what considerations should inform the investment management of an RCA?

The RCA should not be viewed in isolation from other investment and income sources. For the RCA, one may be inclined to choose assets designed or expected to generate unrealized gains; the drawback, however, is those gains will eventually be treated as regular income, despite the accompanying market risk.

It may be preferable to skew the owner or employee’s non-registered asset allocation toward such investments, to be eventually rewarded through preferred capital gains and dividend treatment in that tax environment.

As a corollary, that would mean that the RCA assets would lean toward fixed income.

The drawback here is that annual realized income forces payments over to the RTA. While this causes a drag in accumulation years, it may not matter as much once the drawdown phase has begun, as RCA payments to the employee will recover RTA deposits.

During the accumulation period, it may be useful to defer annual recognition while maintaining a conservative risk profile. This might be achieved by holding a structure like mutual fund corporation shares that carry underlying fixed income instruments.

Ultimately, whether prompted by tax developments or personal circumstances, the RCA discussion is worth having with appropriate entrepreneurs and professionals, and is probably best framed in that broad planning context.

Retirement Compensation Arrangement Rules

Public corporations were the primary providers of RCAs until 1998, when the CRA formally revised guidelines for Canadian Controlled Private Corporations so private corporations could establish RCAs. Corporations use RCAs to increase employee loyalty by allowing them to accumulate more tax-sheltered retirement savings.

The RCA rules are:

An employer may deduct contributions to a funded SERP, termed an RCA.

Out of the amount contributed to the RCA, 50% must go to a refundable tax account (RTA) with the CRA.

Earnings within the RCA are not entitled to the capital gains inclusion tax rate, or to preferred dividend gross-up and tax credit treatment.

As with contributions, 50% of realized RCA earnings must be paid to the RTA.

For each $2 paid out to the employee from the RCA, $1 is refunded by CRA from the RTA to the RCA; on wind-up, the whole RTA is refunded to the employee.

Payments from the RCA to the employee are regular income.

Doug Carroll, JD, LLM (Tax), CFP, TEP, is vice president of tax and estate planning at Invesco Trimark Ltd.