In a February 2010 decision, the Federal Court of Appeal (FCA) allowed the appeal from the decision of the Tax Court Judge by the Minister of National Revenue and ruled that the transfer of funds remaining after the purchase of a non-indexed annuity to a registered retirement savings plan from a Defined Benefit (DB) Individual Pension Plan (IPP) resulted in an income inclusion for tax purposes.
Marvyn Yudelson was employed by Den Packaging from 1973 to 2001. He was the sole member of the Den Packaging Corporation Pension Plan.
When Yudelson retired, the accrued pension before indexation was determined to be $52,934.12. The plan was valued at $681,900. Ultimately the sum of $572,316.20 was required to purchase a non-indexed annuity.
The Plan was wound up on August 31, 2001, and the first annuity payment was issued on September 1, 2001. On September 5, 2001, the respondent transferred the remaining $108,886.04 into an RRSP to fund indexation payments.
The parties agree that the respondent could have acquired an indexed annuity contract, but did not do so because he did not like the return, as the indexation was capped at what the Plan’s assets could provide.
Decision of the Tax Court Judge
In allowing the appeal, the Tax Court Judge determined that the transfer was within the limits prescribed by subsection 8517(1) of the Income Tax Regulations (the Regulations) for the purpose of the rules regarding transfers from registered pension plans to RRSPs set out in paragraph 147.3(4)(c) of the Income Tax Act (the Act).
The Tax Court Judge held that subparagraph 8503(2)(a)(ii) of the Regulations clearly contemplates that the indexation provided for in section 9.2 of the Plan forms part of the lifetime retirement benefits (LRBs) and that subparagraph 8503(2)(a)(iii) of the Regulations allows for indexation benefits to be considered LRBs even in the absence of periodicity and equality of payments.
This finding led to the Tax Court Judge’s acceptance of the actuarial evidence that the amount of LRBs commuted as a result of the transfer to the RRSP of the indexation benefits was $19,565. Since the first payment under the annuity was made on September 1, and the funds were not transferred to the RRSP until September 5, the Tax Court Judge accepted the actuary’s calculations made pursuant to paragraph 8517(4)(a). The actuary arrived at this figure by subtracting the value of a non-indexed annuity from the value of an indexed annuity and converting the difference into LRBs.
This produced a value of $197,000, or $19,565 on an annualized basis. Since the Plan allowed the respondent up to $197,000 of indexation value, Mr. Thomson was of the opinion that the transfer of $108,886 fell well within the prescribed amount (reasons for judgment, at paragraph 7). The Tax Court Judge agreed.
Issues before the FCA
In a unanimous decision of the Federal Court of Appeal, Madame Justice Trudel noted that the analysis could be disaggregated into three sub-issues:
- Had the benefits “commenced to be paid?”
- Did the benefits transfer to the RRSP exceed the prescribed amount?
- Did the tax court Judge err in the valuation of the commuted LRBs?
Decision of the FCA
Justice Trudel found that that benefits had commenced to be paid and that the proper formula for the valuation of commuted LRBs is accordingly found in paragraph 8517(4)(a) of the Regulations. She noted, “The section 147.3 exception is therefore designed to allow individuals one — but only one — rollover. Accordingly, while paragraph 147.4(1)(g) deems amounts paid under an annuity not to have been paid under an RPP for the purpose of preventing double rollovers, it does not imply that benefits were not received.”
Furthermore, Trudel stated, “It is implicit within paragraph 8517(4)(a) that the calculation of commuted LRBs must be made at the time of the transfer. At the time of the transfer, there was obviously no way for the respondent to receive an indexation payment, since under subsection 9.1(a) of the Plan indexation payments only begin a year after retirement. Accordingly, at the time of retirement, the total value of LRBs owed to the respondent was $52,934.12—the annual non-indexed payment owed under the Plan. Since the respondent received $52,934.12 in 2001, there were no residual benefits remaining in the Plan that were payable to him for 2001. Therefore, the value of “A” in calculating the prescribed amount, that is the amount of individual’s LRBs commuted in connection with the transfer, is equal to 0, and the prescribed amount (A x B) is also equal to zero.”
As a result, she ruled that the Tax Court Judge erred in calculating the value of the commuted LRBs. “The value of the commuted LRBs in this case is nil. This is because future indexation payments are not applicable to the calculation of commuted LRBs under paragraph 8517(4)(a). The actuarial evidence adduced by the respondent was premised on this flawed understanding of the Regulations. Its acceptance by the Tax Court Judge therefore constitutes a palpable and overriding error.”
It is interesting, and not surprising, that the FCA overturned the Tax Court Judge and ruled that CRA permits only one rollover from an RPP at a specified point in time, before the commencement of payment of LRBs. If Yudelson had elected to buy an indexed annuity with the full amount his benefits was valued at ($681,900), no tax would have been payable until each periodic pension payment was received.
However, because the sum of $108,886 he had left after the purchase of a non-indexed annuity was not enough to fully index his benefits up to 4% of CPI, he chose to transfer that sum into an RRSP. One can only assume that his rationale was that by investing on his own and tax sheltering the investment income in an RRSP, he would end up with a greater sum of money to augment or “self-index” his non-indexed annuity.
Also, in theory at least, he would have retained ownership of any part of the amount not used to augment his non-indexed pension and subsequently converted into a registered retirement income fund (RRIF) by age 71. In contrast, he has lost control over the lump sum used to purchase the non-indexed annuity and subject to any guarantee period no part of that amount will be passed on to his beneficiaries or revert to his estate.
In addition, he has to pay tax at his incremental rate on $108,886, leaving him with a much smaller amount to invest for future indexing of his non-indexed annuity.
It is important for both IPP beneficiaries and their advisors to fully understand the ITA rules for taxation of registered plans and the transfer of commuted DB benefits to an RRSP. Otherwise, like in this case, the overall tax efficiency of the scheme could be undermined.