Pension Plan Taxation in Canada: Easing the Tax Burden

Over the course of the next twenty years, approximately 7 million Canadians will retire[1]. A considerable portion will be retiring with the (now rare) benefit of a pension plan; some with defined benefit plans, others with annuities purchased with the funds they receive from a defined contribution plan. Many will be spending much more time in retirement than anticipated by those designing the pension plans[2]. The sustainability of those plans, however, faces an uncertain future, as exemplified by the bankruptcy or insolvency proceedings concerning Indalex, Nortel and most recently, and for the second time, U.S. Steel Canada (Previously Stelco).

Numerous measures have been considered for the purposes of promoting a stable and sustainable future for pension plans, with concern for both the retirees as well as the sponsors. These have included considering a shift to target benefit plans that provide for the reduction of benefits or the increase in contributions should the Plan underperform[3], mandatory provincial plans to supplement retirement income[4], or expanding the Canada Pension Plan.

However, less consideration has been given to the impact on pension plan sustainability by the framework for taxation of pension plans and their respective beneficiaries. This lack of attention is particularly pronounced in exploring the tax burdens upon retirees and plan sponsors[5]. As such, this article considers a specific means of lowering the tax burden, thereby promoting plan sustainability through lower tax incidence.

Current System of Taxing Pensions in Canada

The current system for taxing pension plans is referred to as an “EET” system: exempt, exempt, taxable. This is the system generally used across most jurisdictions for taxing pension plans and retirement savings vehicles, whereas a “TEE” (taxable, exempt, exempt) system is often used to tax other savings vehicles, such as Tax Free Savings Accounts (“TFSA’s”)[6].

The respective digits in “EET” refer to the three stages of a pension plan: contribution, accumulation and withdrawal. At the contribution phase, consistent with the tax policy objectives of deducting savings from the tax base in order to encourage saving for retirement[7], a deduction is provided for the amount contributed to a registered pension plan (“RPP”).

The employee is not considered to receive a taxable benefit[8] and receives a deduction for the amount they may have contributed as well[9], as in the case of a Jointly-Sponsored Pension Plan (“JSPP”). The employer also receives a deduction for the amounts that are contributed[10].

The funds are then generally placed in trust for the benefit of the plan members. The pension fund invests and accumulates income from various sources; trading in securities, investment in infrastructure and real estate, interest income and numerous other means.

Generally, a pension fund acts as any large scale investment vehicle, albeit with a crucial added caveat; the added fiduciary duties owed to its membership. The general investment mandate of a pension plan, then, is a much more risk averse approach; government bonds with a low rate of return but stability over time, rather than risky securities and speculative joint ventures.

The income the pension fund earns at this time is also not taxable, as pension funds generally rely on tax-exempt vehicles under Division H of Part I of the Income Tax Act[11] (“ITA”). This is most often a pension trust[12], pension investment corporation[13] or a Master Trust[14] in some instances. The amounts earned by a pension plan are often quite sizeable, especially when one considers large scale public multi-employer plans, such as Teachers, OMERS or HOOPP[15]. This growth stage is the second “E” in the EET system.

Thus, pension plans have a considerable tax advantage; tax is not paid on sizeable amounts of investment income for a substantial length of time. The factor of 9, as is used to determine the upper limit of pension plan contributions under the ITA[16], further promotes horizontal equity between those who have pension plans that wish to contribute to individual retirement savings vehicles, such as RRSPs and those without a pension plan. This is the basis for the Pension Adjustment limit (“PA”), whereby a tax payers room to contribute to RRSPs is lessened by pension plan contributions.

Finally, the last stage is withdrawal; when the beneficiaries actually retire and begin to collect their pension. This is the “Taxable” part of the EET formula explained above. The retirees benefit from the income smoothing inherent in a pension plan: income that otherwise would have been taxed at higher rates is deferred and later included in the tax base at a time when income is presumably lower, thus bearing a lower marginal tax rate. Aside from that, and generally receiving a non-refundable tax credit[17], the retirees are taxed on the pension income as if such was regular income; at 100% inclusion, based on their marginal tax rate[18].

The Issue

While the above system of taxing pension plans and their beneficiaries provides a significant advantage in terms of tax deferral, it also results in a peculiar detriment to the beneficiaries. This occurs because the pension plans accumulation stage, being tax-free, has no need for certain deductions, credits and other advantageous tools provided in the ITA. It thus cannot use these “tools” to offset taxable income, as it has none.

To name a few examples, a pension fund has little need for deducting interest under paragraph 20(1)(c) of the ITA, there is no dividend gross up and credit system[19] for a pension fund receiving dividends, and neither does the fund derive any value from loss utilization through carrying non-capital and net capital losses forward or back in order to offset income or capital gains[20].

Similarly, a pension fund has no use whatsoever for the lifetime capital gains deduction on QSBC shares[21], and, on that note, dispositions on capital account have no need, and thus no ability, to take advantage of the 50% inclusion rate for capital gains[22].

All of these things have little use for a pension fund because, quite simply, the fund does not face income taxes on its growth. Rather, it is the beneficiaries that ultimately pay taxes on the amounts invested in the pension fund, in the withdrawal or payout phase. And, while they do so with some credit and attention paid to their retiree status (such as the above mentioned credit in subsection 118(3) of the ITA), they generally pay income tax on the entire amount, at an inclusion rate of 100%.

Thus, the potential issue arises as illustrated in the following hypothetical example; a pension plan makes considerable dispositions on capital account. Suppose even, that 50% of its growth arises from the gains made in these dispositions. The remaining 50% is earned in interest from regular investment income.

The pension fund does not face capital gains taxation, using a tax exempt entity, and thus the 50% inclusion rate for capital gains has little meaning or use. If the pension fund were taxable, however, it would pay tax on only 75% of its income: 50% of the plans income being fully included by virtue of being regular investment income, and only 25% of the remaining half, by virtue of the capital gains rate[23].

However, when a retired plan member receives their monthly pension, the tax they pay would be calculated on roughly 100% of their income; the 50% capital gains rate does not flow-through. There is no means through which to account for the various deductions and credits an investment vehicle would otherwise have access to.

Thus, where a taxable investment vehicle would, ideally speaking, be able to pass on the economic benefits that result from the tax deductions and credits available to it, a pension fund has no such ability. And so retirees could well be argued to have received the benefit of long term tax deferral, in exchange for a potentially lower tax rate by virtue of receiving the flow-through benefit of the various deductions and credits that were spoken of.

Making Use of the Tax Benefits

One may then reason from the above point that, perhaps, if one could account for the lack of the ability for retirees to get access to the various deductions and provide a benefit in lieu or a flow-through of the deductions, the tax burden on retirees would be eased.

This could be done in numerous ways. For example, a plan could keep an annual account of capital dispositions, noting the amount of income that would be subject to the 50% inclusion rate, perhaps with regard to the percentage that that income is of all income. Active members that make contributions in that year could then receive a deferred deduction, on a pro-rata basis, that they could then make use of in retirement.

Alternatively, either active members or employers could receive a portion of the annual deductions or credits that the pension plan may have been entitled to (if it were a taxable entity), such that they may shelter or offset some of their current income or gains.

Finally, the amounts of the benefit that would have been received from the deductions or credits could be treated as a refundable tax credit, whereby either the employer or the plan member could potentially receive a tax refund, thereby offsetting their inability to make use of the deductions, credits and capital gains inclusion rate during the pay-out phase.

In any case, whichever way this would be implemented, both plan members and sponsors could take advantage of this benefit. Plan members could lower their taxes during retirement or during their active income stage. A lower tax burden upon payout could also result in an easier fulfillment of the pension promise for plan sponsors, whereby through proper tax planning in the investment stage employers could lower the promised amount with the retirees nevertheless getting the same benefit. This would be because the after tax dollars paid out to the retirees would constitute a higher percentage of their pension earnings. Alternatively, sponsors (and employees in a JSPP) could also reduce contribution levels, knowing that a higher amount will be available upon payout due to the presumably lower tax rates.

Pros and Cons

The above point, of course, is simply stated and entails a slew of considerations, pitfalls and counter arguments based on both practical considerations and the policy side of things.

First and foremost, pension plan members are already considered to receive a considerable benefit in the deferral of tax. Not only so, but they can also be generally considered to be fairly privileged in a time when pension plans, especially defined benefit, are becoming increasingly rare outside of the public sector[24].

Thus, one may wonder whether this extra added benefit would be equitable in a system that already favours this cohort. Considering the aforementioned measures in using a PA limit to level the field between those with and without pension plans, this would certainly go against that policy by again favouring those with a pension plan over those without.

Secondly, this would be incredibly difficult to implement. Pension plan membership is not static and is subject to transfers, service buy-backs, plan conversions, terminations, early retirement and plan wind-up. To account for deductions and credits for each and every plan member, throughout what is already a difficult and highly complex system may just be an administrative nightmare, if not nearly impossible.

Finally, the actual cost vs. benefit approach may not work out to be economically beneficial; the added costs of extra tax planning in what is already a heavily regulated industry simply might not work out to provide a monetary benefit. In other words, it may just cost more to implement this policy, than the actual monetary benefit received through the reduction of tax.

Conclusion

Pension plan members can be said to be subject to inequitable treatment through paying taxes on a full income inclusion basis, without the flow-through economic benefit of various deductions and credits that would normally be encountered had the funds been invested in another vehicle.

However, to actually implement a means to provide that flow-through may not be practical or even economically beneficial. The task would be immensely complex and require substantial changes to both the pension taxation scheme and the administration of pension plans in Canada.

Nevertheless, with pension plans, their members and the sponsoring employers facing an uncertain future, less and less of the population saving for retirement and more members living longer than plan design had initially anticipated[25], this is a subject worth considering for discussion and debate.

After all, if effective and properly implemented, this measure could assist in promoting sustainability of pension plans and their respective members through providing a higher amount of after-tax dollars to both.
 

About The Author

Hennadiy Kutsenko practices in both tax planning and dispute resolution as tax counsel at Barrett Tax Law. He is currently earning his Professional LLM in Taxation at Osgoode Hall and sits on both the Taxation and Pension & Benefits Sections Executive Committees with the Ontario Bar Association.