Beware of "prohibited investments"
If you hold private company shares in your RRSP or RRIF, harsh new rules could catch you off guard and facing penalties as high as 100%.
The change, originally announced in the first 2011 federal budget but formally codified in draft legislation released last month, is part of the new antiavoidance rules for RRSPs. The rules use the term "prohibited investment" to describe an investment, typically consisting of common shares, in a company in which you or related persons own more than 10% of the shares.
Prior to this new change, it was possible to own private company shares in your RRSP even if you held more than 10% of the outstanding shares provided you and related persons didn't control the company and the cost of shares was below $25,000.
With this $25,000 limit now gone, many individuals who continue to own private company shares in their RRSPs are scrambling to get onside to avoid harsh new penalty taxes that could now apply.
For example, any income or capital gains earned after March 22, 2011 (the date of the original budget announcement) from a prohibited investment in an RRSP or RRIF is considered to be an advantage taxable at 100%.
This week, accounting giant KPMG issued a Tax Flash suggesting a couple of ways to avoid this harsh new tax by taking advantage of special transitional relief provisions available until December 31, 2021 but which require a special election.
Under the transitional rules, the advantage tax can be reduced from 100% to your normal marginal tax rate on any income or gains accruing from March 23, 2011 to December 31, 2021 provided the income or gain is withdrawn and paid to you within 90 days after the end of the year.
To take advantage of this, you must file a special election before July 2012 to have this transitional rate apply.
But, suggests KPMG, you may also wish to remove the prohibited investment out of your RRSP altogether. Of course if you simply withdraw it, the value of the private company shares being withdrawn would be immediately taxable as regular income.
Instead, consider removing the offending shares from your RRSP by "swapping" them for cash or other property with the same value, provided you to so before 2022. To do this, it's best to get an independent valuation of the fair market value of the private company shares you want to swap.
For example, let's say Elena paid $10,000 back in 1998 to purchase private company shares in which she owned more than 10% of the company. By March 22, 2011, they were worth $100,000.
Let's assume that a year from now when the shares are worth $120,000 Elena swaps them out for cash. With the election, the $20,000 increase in value can be taxed at her marginal tax rate instead of the 100% advantage tax rate which would have otherwise applied, provided the $20,000 is removed from her RRSP within 90 days after 2012.