Ensure they meet the primary purpose requirement
Individual pension plans (IPPs) have certainly taken off over the past few years as a vehicle of choice for owner-managers of private companies. An IPP is simply a defined benefit pension plan, typically set up for one person — the owner-manager of the business.
The main advantage of the IPP is that it can receive higher, tax-deductible (to the corporation) pension contributions for the benefit of the owner-manager than he or she could have made into a traditional RRSP. This, in turn, theoretically leads to a higher tax-deferred accumulation inside the IPP than could have been built up inside an RRSP.
But, be sure that IPPs are truly used for the purpose for which they are created. Two recent federal court cases, along with a recent Canada Revenue Agency (CRA) warning (see: Registered Plans Compliance Bulletin No. 5, dated June 12, 2008), have drawn attention to the inappropriate use of IPPs in some situations.
In particular, the CRA has been focusing on various promotions and schemes whereby retiring employees with large defined benefit plans are advised to set up a new corporation, establish an IPP for themselves and thus get easier access to otherwise locked-in funds. The main focus of the CRA’s bulletin was to remind Canadians that for all IPPs set up, the “primary purpose” requirement contained within the Income Tax Regulations (ITR) must be respected.
Primary Purpose Requirement
The CRA’s Registered Plans Directorate will only register a pension plan (including an IPP) when its “primary purpose” is to provide lifetime retirement benefits to individuals who are employees of the employer who sponsors the IPP.
In addition, the IPP’s sponsor must confirm in writing that the IPP was not set up primarily for the purpose of receiving a transfer of benefits from the owner-manager’s former employer’s pension. Furthermore, the owner/manager must certifty that the IPP was set up to provide “lifetime retirement benefits” to the IPP’s members for their service as employees with the current employer.
Should the CRA later determine that an IPP doesn’t meet this primary purpose requirement, the CRA will take the necessary steps to revoke the registration of the plan, which will be done retroactively to the IPP’s original effective date. As you can imagine, the tax consequences of doing so are quite harsh.
For example, if the transfer of funds from the other plan into the IPP took place during the “normal reassessment period” (i.e., within three years from the date of the original Notice of Assessment), any pension benefits transferred into the revoked IPP would be included in the owner-manager’s taxable income for that year. Arrears interest would also be payable, along with a potential penalty.
The Court Decisions
The CRA’s bulletin follows closely on the heels of two fairly recent Federal Court of Appeal tax decisions, each one involving the questionable use of IPPs.
The first case, Jordan Financial Limited on Behalf of The Pension Plan For Presidents Of Jordan Financial Limited v MNR (2007 FCA 263), dated back to December 2000 when the IPP was originally established.
Charles Ross was a police officer who, upon retirement, was entitled to an Ontario Municipal Employees Retirement System (OMERS) pension. Instead of taking the pension, Mr. Ross arranged for the commuted value thereof (over $750,000) to be transferred from OMERS to a newly created IPP that had been set up by Jordan Financial Limited (Jordan Financial). In the documents that were filed when the IPP was set up, Mr. Ross indicated that he expected annual earnings inside the corporation to be about $66,500 per year and that the IPP was not set up for the purpose of receiving transfers of funds from other pension plans.
In February 2003, the CRA began auditing the plan. The audit revealed that while Mr. Ross reported income from various sources, he had no employment earnings whatsoever from Jordan Financial, the IPP’s sponsor. Not surprisingly, Jordan Financial hadn’t made any current service contributions to the IPP since its inception.
The second case, 1346687 Ontario Inc. On Behalf Of The Pension Plan For Presidents Of 1346687 Ontario Inc. v MNR (2007 FCA 262), began a year earlier, in 1999.
Mrs. Susan Greenhalgh was a teacher for over 30 years prior to her retirement, at which time she was eligible for her pension from the Ontario Teachers’ Pension Plan Board. Instead of taking the pension, she chose to have the commuted value of nearly $565,000 transferred into a newly established IPP of a newly established Ontario numbered company (1346687 Ontario Inc.).
The IPP registration documents indicated that Mrs. Greenhalgh expected to receive about $65,000 of earnings from her new numbered company. In January 2003, the CRA began its audit, which revealed that while Mrs. Greenhalgh had income from various sources, she had received no employment income from the numbered company since it was established.
In both cases, the Federal Court of Appeal agreed with the CRA, finding that the primary purpose condition, discussed above, was not met. Accordingly, the IPPs were both deregistered with nasty tax consequences.