Retirement Compensation Arrangement (RCA)

Most business owners and professionals are often left in a state of shock when they see the small percentage of post retirement income provided by their Registered Retirement Savings Plans (RSP). RSPs are based on the premise that an annual contribution of 18 % of earnings will provide an individual with an adequate retirement pension. However, for higher income earners earning more than $100,000 per year, this often leaves them with pension benefits that are significantly lower than the acceptable 50 to 70 % of pre-retirement income. Fortunately, the Income Tax Act provides a way to end pension discrimination of business owners and professionals by the use of a retirement planning solution called a Retirement Compensation Arrangement (RCA).

Why RCA’s?
RCA’s are sometimes referred to as “super-sized pension plans” because there are no set limits on the amounts that can be contributed into the plan, provided that those amounts are “reasonable,” making them the uppermost level of retirement product currently available in Canada. RCA’s are intended to provide supplemental pension benefits for business owners and senior executives who wish to maintain their standard of living into retirement. They are also utilized to provide pension benefits to an employee or group of employees in situations where a company does not have a registered pension plan in place.

Refundable Tax Account (RTA)
When an employer makes a contribution to an RCA, 50% of the contribution is deposited with the custodian of the RCA Trust to be invested into an investment account, and the other 50% is deposited with the Canada Revenue Agency (CRA) as a refundable tax. In addition, 50% of all dividends, realized capital gains, and interest income less expenses earned in the investment account, must be remitted to the refundable tax account on an annual basis. That is, Canadian dividends and capital gains do not receive preferential tax treatment in an RCA like they do in a personal non-registered investment account or regular trust account. When benefits are paid to the beneficiary of an RCA, $1 for every $2 paid out of the RCA Trust is refunded to the custodian through the refundable tax account.

Taxation of an RCA
Contributions to an RCA are 100% tax deductible to the employer. There is no limit to the amount of contributions an employer can make to an RCA, provided that the amounts are “reasonable” and not excessive relative to the targeted retirement compensation being provided. To prevent an RCA from being deemed by the CRA as a salary deferral arrangement most employers retain an actuarial firm or insurance company to conduct an actuarial valuation. The CRA also allows tax deductible contributions by the employee, provided that those contributions do not exceed those of the employer and there is an employment agreement in place outlining the required participation of the employee in the RCA.

All distributions out of an RCA Trust to a beneficiary are fully taxable. When an employee, or former employee, receives payments from an RCA Trust, the income is treated the same as pension income and is taxed accordingly.

RCA Investments
In contrast to retirement pension plans, there are no investment rules or restrictions for RCA’s. RCA assets can be invested in mutual or pooled funds, stocks, bonds, T-bills, guaranteed investment certificates, and life insurance policies.

Insured RCA’s
Since the fund value of an exempt life insurance policy accumulates on a tax deferred basis, this makes it an attractive investment for an RCA. One of the key advantages of utilizing an exempt policy is that the investment income earned within the policy is tax exempt, and thus not subject to the 50% refundable tax. As such, the investment compounds at pre tax rates.

As a result, if the employee is a few years away from retirement, the accumulation within the life insurance policy may outperform alternative investment vehicles earning similar returns, resulting in the employer having to make fewer contributions to achieve the same results.

The tax effectiveness of this strategy is, however, reduced when the funds are withdrawn from the life insurance policy. A partial withdrawal will result in a partial disposition for tax purposes. The resulting policy gain is included in the income of the RCA Trust and is subject to the 50% refundable tax liability. Also, death proceeds from the insurance policy would be paid into the RCA tax free, but would be taxable in the hands of the recipient (the beneficiary of the RCA or the deceased’s spouse). In effect, this strategy converts what would otherwise be tax-free income (insurance proceeds) into taxable income (distribution from an RCA).

A partial solution to the above-noted quandary would be to utilize leveraging techniques to access the accumulated values within the life insurance policy. For example: the RCA Trust purchases a life insurance policy on the life of the executive. The insurance policy is funded using the contributions made to the RCA Trust. At the time of the employee’s retirement, the RCA Trust funds the retirement benefits from a combination of bank loans (using the life insurance policy as collateral to obtain the loans) and the refundable tax account.

Leveraging RCA's
As evidenced above, there are many ways to leverage an RCA within a life insurance policy. Another common technique allows an employer to make tax-deductible contributions to an RCA Trust, while borrowing back a significant portion of the contribution to reinvest back into the corporation. The process is as follows:

The employer, through his corporation, makes a tax deductible contribution to an RCA Trust.

The RCA Trust remits 50% of the contribution to the CRA as refundable tax, and purchases an exempt life insurance policy with the other 50%.

The RCA Trust arranges, with a financial institution, to secure a loan using the total value of the refundable tax account and the cash values of the life insurance policy as collateral. The collateral assignment of a policy is not a disposition for tax purposes.

The RCA Trust lends the money to the corporation.

Annuities
When the custodian of an RCA Trust buys an annuity contract for the beneficiary of an RCA, the CRA views the amount paid to purchase the annuity as a taxable distribution out of the RCA Trust to the beneficiary. The full amount is taxable in the year the custodian buys the contract, and the custodian has to issue a T4A-RCA slip showing the amount of the distribution and of the income tax deducted.

Advantages of an RCA
An RCA provides the following advantages:

• The amounts that can be contributed to an RCA is not limited by current CRA maximums for RSPs or Registered Pension Plans, nor does it affect employer or employee contributions to such plans, provided that the contributions are “reasonable.”
• Employer or employee contributions to an RCA do not affect RSPs or Registered Pension Plans contribution limits.
• A contribution to an RCA provides an immediate deduction to an employer at current tax rates, and is not taxable to the employee until the employee receives the benefit in future years, when the employee is in a lower tax bracket.
• An RCA provides flexible investment options due to the fact that it has no investment restrictions.
• Upon death, proceeds from an RCA are not subject to probate fees.
• The refundable tax account is an asset of the RCA Trust, and thus could be used as leverage to secure a loan.
• Unless pledged as collateral for a loan, or fraudulently conveyed, RCA’s are creditor proof.

Disadvantages of an RCA
An RCA provides the following disadvantages:

• The refundable tax rate of 50% results in a prepayment of tax for most provinces of approximately 3.5%. Since Alberta has the lowest personal top marginal tax rate of any other province in Canada, the prepayment is approximately 11%. In Newfoundland, the prepayment rate is as low as 1.4%. Consequently, the prepayment of tax makes RCA’s more attractive to Newfoundland residents than to Alberta residents.
• The refundable tax account is a non-interest bearing account.
• There are initial set up fees, ongoing management fees, and compensation paid to the custodian for administering the RCA Trust.
• The custodian has to file a T3-RCA tax return each year, even if there has been no activity in the RCA Trust in the year.

Non-Resident Tax Treatment
Withdrawals from an RCA by a non-resident beneficiary are subject to a 25% Canadian non-resident withholding tax. This Canadian non-resident withholding tax may be lower if the beneficiary is resident in a country that has a tax treaty with Canada. The tax treatment of RCA income and RCA withdrawals in the beneficiary’s country of residence depends on their local tax rules.

Prior to the implementation of The American Jobs Creation Act of 2004, when an individual, subject to U.S. taxation, received a distribution from a nonqualified deferred compensation plan (i.e. an RCA), he or she could exclude the portion of the distribution that related to the original contributions (plus related earnings) from his or her U.S. taxable income. It was not a requirement that these contributions be taxed in the U.S., but was sufficient that these contributions would have been includible in U.S. taxable income had the individual been a U.S. taxpayer at the time the contributions were made. As a result, the individual would only be subject to a 25% Canadian non-resident withholding tax on the RCA distribution.

Currently, The American Jobs Creation Act of 2004 considerably limits the ability of Canadians who have moved to the U.S. and are subject to U.S. taxes, to exclude the original contributions to an RCA from U.S. taxable income when they receive distributions as U.S. taxpayers. Chapter three of the Act states, “…overall, the Act significantly restricts nonqualified deferred compensation plans. Under the Act, amounts deferred under a nonqualified deferred compensation plan are includible in income at the time of deferral, or later…” This change, which applies to distributions received on or after October 22nd, 2004, will have a significant impact on a Canadian who retires in the United States.

RCA vs. Individual Pension Plans (IPPs)
An IPP is a registered, defined benefit plan sponsored by an employer. Like an RCA, contributions by an employer to an IPP are tax deductible for the employer. However, while RCA’s supplement RSPs, IPPs replace them. The IPP is used as an alternative to an RSP as they offer higher deductible contributions than RSPs; the contributions increase in age, whereas the maximum RSP contributions are set, and the assets of an IPP are creditor proof.