Retirement Compensation Agreements

Retirement Compensation Agreements are very effective in the corporate setting and requires a team of professionals: a lawyer, accountant and financial advisor, and that’s where we come in at Wise Financial Group Inc. We can be reached toll free at 1-877-779-4731 or via email info@companybenefits.ca.

»Introduction

When the Department of Finance first introduced new rules governing Retirement Compensation Arrangements ("RCA") in 1986, adverse tax consequences associated with RCA's made taxpayers shy away from such arrangements. However, with registered retirement savings plan contribution limits frozen until recently, and the defined benefit limit capped at $1,722 per year (resulting in a maximum allowable pension of approximately $60,000 annually at retirement), many companies are offering executives supplemental retirement income plans to fill the pension gap high income executives could experience upon retirement. With proper planning, Retirement Compensation Arrangements can be very effective in fulfilling a company’s obligations to executives for supplemental retirement benefits. This tax topic will review the rules governing RCA's and discuss some alternatives to funding Retirement Compensation Arrangements.

»Definition of an RCA

An RCA is defined under subsection 248(1) of the Income Tax Act (the "Act") as a plan or arrangement under which an employer makes contributions to another person, called a custodian, to fund benefits payable to an employee on, after, or in contemplation of retirement of that employee. An RCA may also exist where benefits are to be paid to an employee upon termination of employment or as a consequence of any substantial change in the service rendered by an employee. There must be a contractual obligation for the employer to provide benefits to employees. If there is no contractual obligation, there will most likely not be an RCA.

The definition of Retirement Compensation Arrangements in subsection 248(1) of the Act specifically excludes a number of plans, including the following:

RRSP's, RPP's, DPSP's, and EPSP's;
A group sickness/accident insurance plan;
A salary deferral arrangement; and
A plan established to defer the salary of certain professional athletes.

Employer-owned life insurance is also excluded from the definition of an RCA under subsection 248(1). However, under subsection 207.6(2) of the Act, an arrangement involving life insurance will be deemed to be an RCA if the following conditions are met:

The employer is obligated to provide benefits to an employee on, after, or in contemplation of retirement, termination of employment, or a substantial change in the services rendered by the employee; and
The employer, former employer, or a person or partnership with whom the employer does not deal at arm’s length, acquires an interest in a life insurance policy that may reasonably be considered to be acquired to fund, in whole or in part, those benefits. Where an arrangement is deemed to be an RCA, the person or partnership who acquired the interest in the life insurance policy will be deemed to be the custodian of the plan and the interest in the policy will be property of the Retirement Compensation Arrangement.

An RCA will typically involve two agreements: an RCA Trust Agreement, and an RCA (or Employee) Agreement. The RCA Trust Agreement is between the employer and custodian (trustee) and sets out the powers, rights and obligations of the trustee. The RCA Agreement is between the employer and employee and outlines the benefits the employee is entitled to and the conditions (if any) the employee must fulfill. The agreement may cover items such as employer contributions, vesting of benefits, treatment at death and upon the sale of the company and events that trigger the termination of the Retirement Compensation Arrangement.

»Tax Treatment of RCA's

An inter vivo trust is created when an RCA is established and there are specific rules relating to the taxation of RCA trusts. An RCA trust is exempt from Part I tax according to paragraph 149(1) (q.1) of the Act, but is subject to tax under Part XI.3 (sections 207.5 to 207.7) of the Act. Any contributions made to the RCA trust will be subject to a 50% refundable tax. Furthermore, any income earned within the RCA will also be subject to the 50% refundable tax. Capital gains and dividends do not retain their preferential tax treatment in an RCA. Capital gains are 100% taxable (rather than 50%) and there is no gross-up or tax credit for dividends.

Contributions by the employer to the trust will be 100% deductible by the employer in the year the contributions are made and no taxable benefit will accrue to the employee. Employees can contribute to the RCA trust if such contributions are required by the terms of employment and the amount contributed does not exceed employer contributions in the year in respect of that particular employee. Such contributions will be deductible by the employee under paragraph 8(1) (m.2) of the Act. The refundable tax will accumulate until such time as distributions are made from the RCA trust. The tax will be refunded on the basis of $1 for every $2 of benefits paid to a plan member or the employer. While the Canada Customs and Revenue Agency (the "CCRA") maintains the refundable tax balance, no interest will be paid on the balance.

Payments out of the plan (to either the employee or employer) will be included in the recipient’s income in the year received. Payments from the plan may qualify as a retiring allowance and may, subject to prescribed limits, be transferred into an RRSP or RPP under paragraph 60(j.1) of the Act.

Where an arrangement which involves an employer owned life insurance policy is deemed to be a Retirement Compensation Arrangement, an amount equal to twice the premium payment will be treated as a contribution to the RCA. Any payment received under the policy (including a policy loan) and any refund of refundable tax will be treated as a payment from the RCA. The employer will be deemed to be the custodian of the plan.

When establishing an RCA, one must consider the salary deferral arrangement ("SDA") rules. The SDA rules are another set of anti-avoidance rules that were introduced in 1986 and take priority over the RCA rules. An arrangement will be considered an SDA if:

The taxpayer has a right at the end of the year to receive an amount after the year;
It is reasonable to consider that one of the main purposes of the arrangement is to postpone tax payable by the taxpayer; and
The tax that is postponed is in respect of salary for services rendered or an amount in lieu of salary.

If an arrangement is considered an SDA rather than an RCA, then the employer contributions to the trustee will be taxable to the employee immediately, even though the employee does not receive the funds. The employer’s contributions will continue to be deductible. If the arrangement is not replacing current earnings but rather, represents funding for retirement income, then the arrangement should be considered an RCA.

»Retirement Compensation Arrangement Funding Approaches

There are various alternatives available to fund an RCA. Three alternatives are: funding with taxable investments, funding with life insurance and funding using letters of credit. Each of these alternatives is discussed briefly below.

Funding with Taxable Investments

One method of funding an RCA is to use taxable investments to build a sinking fund capable of meeting future obligations. An employer contributes funds to an RCA trust and the net proceeds, after the 50% refundable tax is paid, are invested in taxable investments such as GIC's, mutual funds, or non-prescribed annuities. Such investments would be subject to the annual accrual rules, resulting in a 50% refundable tax paid on annual income. This method of funding is not very attractive because the CCRA receives 50% of all income earned in the RCA trust, in addition to the 50% refundable tax paid in respect of all contributions to the Retirement Compensation Arrangement. Since interest is not paid on the refundable tax balance held by the CCRA, the ability of the RCA trust to significantly grow in value is hindered.

Funding With Life Insurance

When an RCA is funded with a life insurance policy, the policy is subject to the same taxation rules as if the policy was outside of an RCA. The funds accumulating in an exempt life insurance policy are not subject to the refundable tax. Therefore, the funds are allowed to grow tax-sheltered.

Any policy gains on a full or partial disposition of the life insurance policy will be subject to the 50% refundable tax. Death benefits are received tax-free by the RCA trust, but subsequent distributions to either the employer or the beneficiary would be taxable in their hands. The employer corporation would also not be entitled to an increase in its capital dividend account ("CDA") on distribution of the death benefit from the RCA trust. In order to pay the retirement benefits, the trustee of the RCA trust can use policy withdrawals or use the policy as collateral for a bank loan. As noted above, policy withdrawals may cause a tax liability for the trust, but a subsequent distribution out of the Retirement Compensation Arrangement trust will generate a refund of the tax. In some cases, it may be more cost effective for the trust to leverage the insurance policy.

A variation of the leveraging idea is to have the employer and RCA trust enter into a split-dollar arrangement whereby the corporation and the RCA trust apply for and co-own the life insurance policy. The split dollar agreement specifies the cost to each party and the benefit each party receives. Normally, the corporation pays for and owns a level death benefit, and the RCA trust pays for and owns the balance (i.e. the cash value of the policy). The corporation will pay its share of the premium directly to the insurance company and pay twice the RCA’s portion: one half to the RCA, allowing the RCA to pay for its share of the premium to the insurance company; and, the other half withheld and paid to the CCRA, representing the 50% refundable tax on the contribution. Under such an arrangement, upon the death of the employee, the corporation and the RCA trust each receive their respective portion of the death benefit tax-free.

The corporation, if eligible, will also receive an increase in its CDA equal to the excess of the proceeds received by the corporation over the adjusted cost basis of the policy to the corporation. When using split dollar insurance policies, it is important to ensure that each party pays a reasonable portion of the premium for the benefit received.

Funding With Letters of Credit

A letter of credit ("LOC") is another method of funding an RCA. A letter of credit is essentially a promise by the bank to pay an obligation of the employer, if the employer cannot. LOC's can normally be arranged at a cost of 0.25% to 1.5% of the principal amount, depending on the amount and creditworthiness of the applicant.

Once the employer creates a Retirement Compensation Arrangement trust, the employer contributes funds sufficient to cover the cost of the trust obtaining the LOC (generally 2 times the fee charged by the bank). The RCA trust then uses the funds to arrange the LOC and remits the 50% refundable tax. The employer does not contribute the LOC to the RCA trust since the refundable tax will be based on the FMV of the LOC.

If the employer wanted to fund the RCA trust with $500,000, the employer would have to contribute $1,000,000 so that after the 50% refundable tax is paid, the RCA trust is left with the desired amount. However, if a LOC for $500,000 was obtained, the LOC fee at 1.5% would be $7,500. Thus, the employer would only have to contribute $15,000 to the Retirement Compensation Arrangement trust as opposed to $1,000,000.

Where the LOC is guaranteed by specific assets of the employer, the CCRA may consider the value of such assets as a contribution, in addition to the fee for the LOC. However, if specific assets are not set aside for the RCA, and can be used for other purposes or to satisfy other creditors, they would likely not be considered separate contributions to the RCA.

»Administering an Retirement Compensation Arrangement

There are a number of administrative requirements that need to be considered before proceeding with an RCA. CCRA has published a guide entitled Retirement Compensation Arrangement Guide which is full of useful information that explains what forms are required, what the responsibilities of the employer and the custodian are and what penalties can be imposed if the requirements are not followed. In some cases, the penalties can be significant; therefore, it is important that these matters are properly researched before an RCA is created.

»Accounting for Retirement Compensation Arrangements

Generally a corporation is required to follow generally accepted accounting principles (GAAP) as set out in the standards of The Canadian Institute of Chartered Accountants Handbook (the CICA Handbook). An employer may have an obligation to pay post retirement benefits to an employee and provide the employee with a supplementary executive retirement plan (SERP). The financial statements of the employer must reflect the SERP, whether it is funded or unfunded.

An RCA is a funded SERP. Accordingly, a Retirement Compensation Arrangement will impact the corporate income statement, balance sheet and the notes to the financial statement of the employer. This section will discuss the financial reporting for an RCA that is funded with life insurance. This section will not discuss the financial reporting for an RCA that is funded using the split-dollar approach.

»Authoritative Support

The CICA Handbook currently contains Section 3461 which deals with employee future benefits. This section is applicable for fiscal years beginning on or after January 1, 2000. An RCA is considered a pension obligation of the employer, and therefore, the employer must follow Section 3461 after January 1, 2000.

»Financial Reporting for the Employer

The employer’s objective in accounting for the cost of providing the promised retirement benefits is distinct from the objective of funding the obligation with an RCA. When accounting for the cost of providing retirement benefits, the objective is to recognize an expense and a liability in the reporting period in which the employee has provided service to the employer. However, in funding the retirement benefits with an RCA, the objective is to provide funds to discharge the promised obligation and provide security at the least cost (including tax considerations) to the employer. Accordingly, the amount contributed to the RCA is not necessarily the appropriate amount to be recognized as a pension expense.

»Pension Expense

Determination of the pension expense to be reflected on the income statement depends on the nature of the retirement plan: whether the plan is considered to be a defined benefit pension plan, a defined contribution pension plan or a settlement of the obligation through the purchase of a life insurance contract (as defined in Section 3461 of the Handbook). The classification of an RCA will depend on the economic substance of the arrangement established by its terms and conditions.

»Defined Benefit Plan

A defined benefit pension plan is an arrangement where either the benefits to be received by the employee or the method for determining those benefits are specified. A Retirement Compensation Arrangement is considered a defined benefit pension plan if the agreement between the employee and the RCA stipulates the payment to be made out of the RCA to the employee at retirement. If the assets in the RCA trust are not sufficient to provide the promised benefits, the employer must assume the obligation and make the payments to the retired employee. If an RCA is considered to be a defined benefit pension plan, the following components are included in the pension expense:

The cost of benefits attributed to the employee’s services rendered in the period (current service cost),
The interest cost on the accrued benefit obligation,
The expected return on plan assets,
The amortization of past service costs arising from plan initiation or amendment,
The amortization of the net actuarial gain or loss
Gains or losses on plan settlements or curtailments.

Generally an actuary calculates the pension expense for the employer based on best estimate assumptions. Section 3461 contains guidelines to help management determine the assumptions to be used in the calculations.

»Defined Contribution Plan

In contrast, a defined contribution pension plan is an arrangement where the contributions are specified in the agreement, rather than the amount of benefit the employee is to receive. An RCA is considered a defined contribution pension plan if the amount of contributions that the employer makes to the RCA trust is specified and the amount that the employee receives at retirement is based on the accumulated contributions, the accumulated growth within the life insurance policy and the balance of the refundable tax account. The RCA trust has the primary obligation for providing the benefits based on the contributions and the accumulations. For a defined contribution plan, the following components are included in the pension expense:

The contributions required to be made by the employer in the period,
The interest cost for the period on the estimated present value of any contributions required to be made by the employer in future periods that are related to employee services rendered during the current period
The amortization for the period of past service costs, and
A reduction for the interest income for the period on any unallocated plan surplus.

If an RCA is considered to be a defined contribution plan, generally the employer reports a pension expense equal to the contributions made to the RCA (generally twice the amount of the life insurance premium).

»Settlement through the Purchase of a Life Insurance Contract

Section 3461 specifically discusses plans that are funded through the use of "insurance contracts". Insurance contracts are defined in the Section as a policy in which an insurance enterprise assumes an unconditional legal obligation to provide specified benefits to specific individuals in return for a fixed consideration or premium. The definition indicates that an insurance contract involves the transfer of significant risk from the plan and the employer to the insurance enterprise.

The accounting treatment, for insurance contracts defined in this manner, is a settlement of the pension obligation. A settlement is a transaction in which the employer substantially discharges or settles the retirement obligation. A settlement results in the elimination of the employer’s obligation for the pension obligation. An RCA is considered to be funded through the use of an insurance contract (as defined in Section 3461) if an annuity contract is purchased, the annuity payments are made to the retired employee and the retirement obligation has been fulfilled with the purchase of the annuity.

»Prepaid Pension Asset or Pension Liability

The pension expense may differ from the amount of the contributions made to the Retirement Compensation Arrangement particularly if the plan is considered to be a defined benefit plan. The Handbook requires that the cumulative difference between the amounts expensed and the contributions to the RCA be reflected on the balance sheet as either a prepaid pension asset (where total contributions exceed cumulative expense) or as a pension liability (where cumulative expenses exceed total contributions).

»Assets of the RCA Trust

The assets in the RCA trust, including the life insurance policy and the balance of refundable tax, are treated as pension plan assets. Handbook Section 3461 defines plan assets as assets that have been segregated and restricted (usually in a trust or a separate legal entity) to provide for employees’ future benefits when both of the following conditions have been satisfied:

The assets of the separate entity are to be used only to settle the related accrued benefit obligation, are not available to the reporting entity's own creditors, and either cannot be returned to the reporting entity or can be returned to the reporting entity only if the remaining assets of the trust are sufficient to meet the plan's obligations.
To the extent that sufficient assets are in the separate entity, the reporting entity will have no obligation to pay the related employee future benefits directly. If these conditions are met by an RCA trust, the life insurance policy and refundable tax is not reflected on the employer’s balance sheet. The assets are reported on the balance sheet of the RCA trust.

»Deferred Income Tax Expense and Liability

A deferred income tax expense may also be recorded on the income statement of the employer corporation. A deferred income tax expense arises where accounting treatment does not match income tax treatment for expenses. For accounting purposes, the corporation will record a pension expense as discussed above. For income tax purposes, the corporation is entitled to deduct the actual amount contributed to the RCA (generally twice the amount of the life insurance premium).

Therefore for a defined contribution plan the accounting expense and the income tax deduction may be the same amount. However for a defined benefit plan, the accounting expense will not equal the income tax deduction and a deferred income tax expense will result. The cumulative difference will be reflected on the balance sheet in the deferred income tax liability.

»Notes to the Financial Statements

Section 3461 of the Handbook requires specific disclosure for each type of pension plan. For defined contribution plans, the employer should disclose a description of any significant change that affects the comparability of the expense for the current and prior years. For defined benefit plans, the employer’s disclosure should include: the total plan obligation as determined by the actuarial valuation, the value of the Retirement Compensation Arrangement trust assets, the resulting plan surplus or deficit, the amount of contribution by the employer, the amount of contributions made by the employee and the amount of benefits paid during the year.

»Conclusion

With the continued restrictions on pension benefits and the freeze on RRSP contributions, Retirement Compensation Arrangements are gaining popularity as a method of supplementing an executive’s retirement income. RCA's can be very effective vehicles to accomplish such goals, but proper planning and research should be undertaken to prevent adverse tax consequences.

Tax Topics are distributed on the understanding that Wise Financial Group Inc. is not engaged in rendering legal, accounting or other professional advice. If legal or other expert assistance is required, the services of a competent professional person should be sought.

Return to Top

CompanyBenefits.ca

Servicing: Toronto, London, Windsor, Hamilton, Mississauga, Ottawa, Waterloo, Kitchener

1-877-779-4731

Key People

Categories