10 June 2002 Internal T.I. 2002-0140577 - TRANSFER RPP SURPLUS TO AN RCA

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

1. Will subsection 56(2) apply to the payments in question?

2. Will the payments be employer contributions to an RCA

Position:

1. No.

2. No.

Reasons:

1. The payments do not satisfy the criteria established for 56(2) to apply.

2. 56(2) does not cause the amounts to be employer contributions. There is no use of the funds as security and the employer has no rights to use the amounts as security.

		June 10, 2002

Ms. Patricia Spice, A/Director	HEADQUARTERS
	Policy and Communications Division	W.C. Harding
	Registered Plans Directorate	957-8953

	Attention: Mike Godwin
	                 Manager
		2002-0140574

Subsection 56(2) and Distribution of a Pension Surplus to an Employer

This is in reply to your memorandum of May 13, 2002, regarding the characterization of payments made from a trust governed by a Registered Pension Plan (an "RPP") to a trust governed by a Retirement Compensation Arrangement (an "RCA").

Issue

The Registered Plans Directorate ("RPD") has been asked to approve a pension plan design whereby a pension and an RCA will be established and governed by the terms set out in a single document. RPD has been asked to only register the pension components that comprise a typical RPP. Once registered, surplus funds held by a trust governed by the RPP would then be made available to the trust governed by the RCA component to fund pension benefits provided under that component of the arrangement.

RPD has been developing conditions under which such an arrangement may be acceptable. One of these conditions is that a surplus distribution pursuant to subparagraph 8502(d)(vi) of the Income Tax Regulations (the "Regulations") made in order to fund benefits in excess of the limits permitted under the Income Tax Act (the "Act"), must be made as a factual payment of the surplus funds to the employer, who could then contribute them to the RCA trust. However, the consultants retained by the employer contend that the funds can be transferred directly from the trust governed by the RPP to the trust governed by the RCA, and that attribution to the employer under subsection 56(2) of the Act eliminates the necessity of factual receipt and distribution of the funds by the employer.

Our Comments

From a review of our files, it appears that we have not previously considered the application of subsection 56(2) of the Act to the payment of amounts out of an RPP in any similar circumstances. XXXXXXXXXX.

Background

It is our understanding that the employer provides pension benefits to some of its employees but that these benefits exceed the pension benefit limits currently set under the Act. Accordingly, the benefits are being funded through an existing RPP to the extent permitted under the Act and through an unfunded supplementary pension plan to the extent that the total benefits exceed the limits under the Act.

The RPP has accumulated an actuarial surplus and the Employer would like to use the surplus to fund the benefits currently provided under the supplementary plan. They propose to do this by establishing an RCA and transferring the RPP's surplus to it from time to time, to the extent necessary to fund the supplementary benefits. In addition, they propose to continue funding future supplementary benefits through the transfer of surplus as required from time to time (but within the limits established by RPD).

It is currently not possible to have surplus funds held in an RPP used to fund supplementary pension benefits provided under an RCA. To do so, would, in effect, result in the use of the tax sheltered RPP funding to fund benefits that are in excess of the limits the legislators intended to apply. On the other hand, but in general terms, and without considering certain of the Regulations applicable to RPPs, it is possible for an employer to execute the proposal by withdrawing the surplus funds from the pension plan, as necessary, including them in its income and then remitting them as deductible employer contributions to an RCA. However, because these steps would require the actual withdrawal of the surplus by the employer, approval would be required under the applicable (provincial) pension benefits standards legislation (the applicable "PBSA") and this approval would not likely be obtainable without the concurrence of all of the participating employees.

PBSA legislation generally applies to any funded provisions to provide pension benefits. Accordingly, the legislation generally applies to both RPPs and RCAs established for a single group of employees. Furthermore, the PBSA legislation generally treats an RPP and an RCA as a single plan if they are established and funded under one "document". Accordingly, it has been submitted that a transfer of funds from a trust governed by an RPP to a trust governed by an RCA will not be considered to be a withdrawal of funds under the PBSA provided both arrangements are established and administered as one plan for purposes of the PBSA. If this is correct, then approval under the applicable PBSA would not be required nor would the concurrence of all of the participating employees.

The problem then is to determine a manner in which a transfer of funds from the RPP to the RCA can be made which will not be a withdrawal of funds for PBSA purposes but will be a withdrawal of pension surplus and a contribution to an RCA for purposes of the Act.

The representative has drafted a single plan document, which he believes will establish (or amend) an RPP and establish a separate RCA. It has been suggested that this arrangement will be accepted by the provincial authorities as one plan. The representative has requested the RPD to register only that portion of the document that governs the RPP.

Analysis

While the PBSA may consider the transfer of the amount between trusts to not be a withdrawal of funds under the plan considered as a whole, we have expressed the view that a transfer of funds between a trust governed by an RPP to a trust governed by the RCA is a withdrawal of funds from the RPP and that it will not be an effective means to achieve the taxpayer's objectives unless the employer has, in fact, the right to withdraw the amount to be transferred and, therefore, has the right to cause the RPP trustee, acting as the agent of the employer, to make the transfer. We have indicated that, based on the representative's representations and our prior consideration of the use of surplus by employers and employees, it appears to us that the right to the surplus may only be established when approval to withdraw the amount has been obtained from the appropriate authorities.

In the alternative, the representative has suggested that subsection 56(2) of the Act would assist them in achieving the desired result. The current submission expands on these representations. In particular, the representative suggests:

? The Act can accommodate a deemed distribution in circumstances such as proposed through the application of subsection 56(2) of the Act;

? CCRA commentary on constructive receipt supports the proposition that the amount is an employer contribution; and

? CCRA commentary on pledging of security is an expansive view on what constitutes a contribution to an RCA and supports the proposition that the transfer of amounts from the RPP trust is an employer's contribution to an RCA.

1. Can the Act accommodate a deemed distribution in circumstances such as proposed?

a) It is not clear to us how the representative believes this provision will assist him. However, it appears to us that he is suggesting that a transfer can be made from the RPP trust to the RCA trust and that the inclusion of the amount transferred in the employer's income is sufficient to characterize the payment as an employer contribution.

Subsection 56(2) of the Act is not a deeming provision and does not deem an amount to be an amount received by a taxpayer. Accordingly, it cannot apply to deem or otherwise cause an amount transferred from an RPP trust to an RCA trust to be a payment made by the employer. The subsection merely provides that when an amount is paid by one person to another person and the conditions set out in the provision are satisfied, then the amount must be included in the income of the taxpayer to whom the provision is being applied. To clarify, the application of subsection 56(2) of the Act to the amounts transferred to the RCA trust may result in their inclusion in the income of the employer but does not deem the amounts to be paid out of the fund to the employer. Hence, the amounts cannot be considered to be contributions made by the employer to the RCA.

b) Furthermore, we are of the opinion that the conditions necessary for the application of subsection 56(2) of the Act cannot be satisfied by the employer unless the employer first obtains the approval under the PBSA for the withdrawal of the amounts.

As noted by the representative, the conditions for the application of subsection 56(2) have been discussed and examined in several court decisions. The Federal Court of Appeal describes the judicial history of the conditions in Kenneth James v. HMQ, 2001 DTC 5075. At paragraph 36 the court states:

"[36] It has long been established that there are four conditions for the application of subsection 56(2). The four conditions were stated in Murphy v. The Queen, 80 DTC 6314, [1980] C.T.C. 386 (F.C.T.D.) and Fraser Companies, Ltd. v. The Queen, 81 DTC 5051, [1981] C.T.C. 61 (F.C.T.D.) and were adopted by the Supreme Court of Canada in Neuman v. M.N.R., [1998] 1 S.C.R. 770, 98 DTC 6297, [1998] 3 C.T.C. 177 (at paragraph 32 of the decision of Mr. Justice Iacobucci):

(1) the payment must be to a person other than the reassessed taxpayer;

(2) the allocation must be at the direction or with the concurrence of the reassessed taxpayer;

(3) the payment must be for the benefit of the reassessed taxpayer or for the benefit of another person whom the reassessed taxpayer wished to benefit; and

(4) the payment would have been included in the reassessed taxpayer's income if it had been received by him or her."

In James at paragraphs 43 through 46 the courts also comment on the existence of a fifth condition:

"[43] The trial judge accepted the Crown's version of the facts. If those factual conclusions stand, there would seem to be no bar to the conclusion that subsection 56(2) was properly applied. However, counsel for Mr. James points to what he says is a fifth condition for the application of subsection 56(2). He says that the fifth condition is evidence that the actual recipient of the amounts in question (in this case Ms. Kirsten) would not be subject to tax on those amounts.

[44] The argument for the existence of a fifth condition is derived from obiter dicta in Winter v. Canada, [1991] 1 F.C. 585, 90 DTC 6681, [1991] 1 C.T.C. 113 (C.R.). In that case Mr. Winter, a shareholder and officer of a corporation, caused the corporation to sell property to his son-in-law at an undervalue. Mr. Winter was assessed under subsection 56(2) on the basis that he had caused a corporate appropriation to be directed to his son-in-law, and that the amount of the appropriation would be taxable in the hands of Mr. Winter under subsection 15(1) if he had received it. The son-in-law was also a shareholder of the corporation, and as he had received the alleged appropriation, it was argued that he should have been taxed on the resulting shareholder benefit under subsection 15(1), leaving no scope for the application of subsection 56(2) in a manner that would cause the same amount to be taxed in the hands of Mr. Winter.

[45] Mr. Justice Marceau, speaking for this Court in Winter, agreed with the logic of this argument, but found it had no application to the facts of the case because the son-in-law received the corporate appropriation in his capacity as son-in-law, not in his capacity as shareholder. From that it followed that there was no shareholder benefit that was taxable under subsection 15(1) in the hands of the son-in-law. In the course of his analysis on this point, Mr. Justice Marceau said this (emphasis added) (at page 594, F.C.):

'...I agree that the validity of an assessment under subsection 56(2) of the Act when the taxpayer had himself no entitlement to the payment made or the property transferred is subject to an implied condition, namely that the payee or transferee not be subject to tax on the benefit he received. The problem for the appellants, however, is that, in my judgment, this qualification does not come into play in this case.

[46] This reference to an "implied condition" simply recognizes that subsection 56(2) cannot apply to an amount that is properly taxable as income in the hands of the person who actually received it, because in that case the fourth condition cannot be met. Put another way, it is implicit in the fourth condition that the payment in question must be an amount that only the taxpayer, in this case Mr. James, is entitled to receive as income (see paragraph 53 of the decision of Mr. Justice Iacobucci in Neuman, cited above). When the comments of Mr. Justice Marceau are understood in this light, it is clear that there is no fifth condition to the application of subsection 56(2)."

The representative suggests that the four conditions set out by the courts have been met. However, before considering these representations, it may be beneficial to restate the summary of the Neuman decision (supra.) rendered by the Supreme Court of Canada:

"On April 29, 1981, the taxpayer incorporated Melru, an estate freezing and income splitting vehicle, in which he held one voting share. Distributions from Melru could be made selectively among the various classes of its shareholders. Pursuant to an agreement dated April 29, 1981, the taxpayer transferred his shares of an operating company into Melru in return for Class G shares, which were authorized to be issued to him on May 1, 1981. On the same date, 99 non-voting Class F shares of Melru were also authorized to be issued to R, the taxpayer's wife, for $1 per share. R was elected as the sole director of Melru on August 12, 1982. At a board of directors meeting held on September 8, 1982, R declared a dividend of $5,000 on the Class G shares, and another dividend of $14,800 on the Class F shares. R immediately loaned $14,800 to the taxpayer in return for a demand promissory note as security. She died in 1988 and the loan was not repaid. R made no contribution to Melru, nor did she assume any risks for the company. Relying on the indirect payment provisions of subsection 56(2) of the Act, the Minister included in the taxpayer's income for 1982 the said $14,800 paid to R in 1982. The taxpayer's appeal to the Tax Court of Canada was allowed (92 DTC 1652). The Crown's appeal to the Federal Court-Trial Division was dismissed (94 DTC 6094), but the Crown's further appeal to the Federal Court of Appeal was allowed (96 DTC 6464). The taxpayer appealed to the Supreme Court of Canada.

Held: The taxpayer's appeal was allowed. The appeal was limited to the interpretation and application of subsection 56(2) of the Act. It was not based on the general anti-avoidance rule ("GAAR") in section 245 of the Act, which came into force in September 13, 1988. However, at the heart of the appeal was the majority decision of the Supreme Court of Canada in The Queen v. McClurg. In the McClurg case, Dickson, C.J. concluded that, as a general rule, subsection 56(2) of the Act does not apply to dividend income since, until a dividend is declared, the profits belong to the corporation as retained earnings. The declaration of a dividend cannot be said, therefore, to be a diversion of a benefit which the taxpayer would have otherwise received. By way of obiter, however, Dickson, C.J. suggested that subsection 56(2) may apply where dividend income is distributed through the exercise of a discretionary power to a non-arm's length shareholder who has made no legitimate contribution to the company. The Federal Court of Appeal in the present case felt bound by this potential exception, since the only material difference between the facts in McClurg and the facts in this case was that R had not made any contribution to Melru. Subsection 56(2), however, cannot apply to dividend income, because, if the dividend is not paid to a shareholder, it remains with the corporation as retained earnings. Hence the reassessed taxpayer, as either a director or a shareholder of the corporation, has no entitlement to the money. In addition, Dickson, C.J. was of the view that, in the McClurg case, the dividend received by the taxpayer's wife, Wilma McClurg, did not constitute a benefit under subsection 56(2), since her contributions to the corporate enterprise could be described as a legitimate quid pro quo, and not simply as an attempt to avoid tax. This approach, however, ignores the fundamental nature of dividends, i.e., a payment which is related by way of entitlement to one's capital or share interest in the corporation, and not to any other consideration, such as the shareholder's level of contribution to the corporation, or the existence of a non-arm's length transaction. Accordingly, unless a reassessed taxpayer had a pre-existing entitlement to the dividend income, subsection 56(2) cannot operate to attribute the dividend income to him/her for tax purposes. For all of these reasons, the dividend paid to R was not required to be included in the taxpayer's income. The Minister was ordered to reassess accordingly.¹

The representative has expressed his view that the transfer of the amount from the RCA satisfies each of the conditions cited above. However, in our opinion, the representative has not properly considered the decision reached in Neuman as discussed in the above case summary. Foremost, in Neuman, the court agreed with the finding in McClurg that subsection 56(2) of the Act cannot generally apply to the payment of dividend income because if a dividend is not properly declared and paid to a shareholder, it remains with the corporation as retained earnings. Hence, the taxpayer has no entitlement to the dividend and it cannot be said that the payment to the third party was a diversion of the payment that would otherwise be received by (and taxable to) the taxpayer.

It has been established that under the Ontario PBSA legislation, if not under all PBSAs, surplus funds retained in a trust governed by an RPP remain the property of the trust and that neither the employer nor the beneficiaries have an entitlement to the funds until such time as an approval for a distribution has been obtained. Accordingly, following the logic applied in Neuman and McClurg, until the payment to the RCA is approved as a distribution or payment of funds made by the trustee of the RPP on behalf of the employer, it cannot be considered to be a payment of an amount nor as a diversion of an amount that would otherwise be received by the employer.^{2 3}

2. Does CCRA commentary on constructive receipt support the proposition that the amount is an employer contribution?

As noted above, it is generally conceded that neither the employer nor the employees have any right to surplus amounts until the appropriate authority approval for a distribution or allocation has been obtained. Constructive receipt cannot be applied if an absolute right to an amount does not exist.⁴

3. Is CCRA commentary on pledging of security an expansive view on what constitutes a contribution to an RCA and does it support the proposition that the transfer of amounts from the RPP trust is an employer's contribution to an RCA?

Given our commentary with respect to the representative's first two points, it would not seem necessary to comment on this point. However, we are of the opinion that the technical opinions and/or rulings cited by the representative are of no assistance to him given the facts of the present situation. In the case at hand, it is stated that an amount will be contributed to the RCA by the trustee of the RPP, either of its own accord or at the direction of the employer if the employer has a right to the amount. If the amount is in fact contributed, an "expansive" interpretation of the term contribution is not required nor of any application. If, in the alternative, an amount is not transferred to the RCA and the employer instead secures the obligations under the RCA with a charge against its right to the surplus held in the RPP, the positions cited by the representative might have application. However, unless the employer obtains a right to the surplus, as discussed above, we cannot see how the employer could use any portion of the surplus as security for the obligations of the RCA.

Roberta Albert, CA
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch

Enclosures:

Kenneth James v. HMQ, 2001 DTC 5075 (FCA)
Melville Neuman v. HMQ, 98 DTC 6297 (SCC)
HMQ v. Jim A. McClurg, 91 DTC 5001 (SCC)

Our Files: E9637406
E9641126
E9723506
E9813931

ENDNOTES

¹ See also McClurg v. HMQ, 91DTC 5001 (SSC) attached

² There is always the possibility that funds could be improperly expropriated from the fund. This issue was cursorily considered in the cases reviewed and we have not addressed the possibility here. However, it would seem to follow that expropriation will only occur where there is no existing rights to the amounts. Hence, it is difficult to see how subsection 56(2) could apply as explained above.

³ Several of the court's comments on the application of the preconditions to the application of subsection 56(2) of the Act could apply in the present case to deny the application of the provision in this situation. The Supreme Court in Neuman identified at paragraph 35 that subsection 56(2) strives to prevent tax avoidance through income splitting. The present case is clearly not a tax avoidance transaction. The courts have also noted that bona fide dividends paid to a third party are not considered to be subject to subsection 56(2) of the Act. It follows that 56(2) cannot apply to all transfers and payments out of an RPP simply because the employer concurs with their payment.

⁴ Supra, footnote 3

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