Supplemental Pension Plans Secured with a Letter of Credit—Federal Budget 2023 Proposes Refundable Tax Relief

April 05, 2023

Written By Jordan Fremont and Anu Nijhawan

Retirement compensation arrangements (RCAs) are, in appropriate circumstances, a useful tool for employers to provide supplemental pension benefits to employees, but such arrangements come at a cost of refundable tax under the Income Tax Act (Canada) (the ITA). The 2023 Federal Budget (the Budget), released on March 29, 2023 (Budget Day), proposes to amend the ITA to exempt, from the refundable tax, fees or premiums to the extent paid for the purposes of securing or renewing a letter of credit or a surety bond for an RCA structured as supplement to a registered pension plan. This change is proposed to apply to fees or premiums paid after Budget Day. In addition, the budget proposes to allow employers to request the return of refundable taxes previously remitted in respect of such arrangements, at a rate equal to 50 percent of retirement benefits paid after 2023 from employer corporate revenues.

Draft legislation has yet to be introduced, but if implemented as proposed, the changes should help affected employers gain access to capital that has otherwise been effectively (and indefinitely) stranded in the form of refundable tax. The proposed changes would also ease the go-forward financial and administrative burden of maintaining a letter of credit or surety bond in respect of supplemental pension plan benefits.

Supplemental Pension Plans & The Refundable Tax Issue

A supplemental pension plan under which benefits are either funded or secured (with a letter of credit or surety bond issued by a financial institution), is recognized as falling within the broad ITA  definition for an RCA. Specifically, subject to certain stated exceptions, an RCA is a plan or arrangement where contributions are made by an employer or former employer to another person (a "custodian") in connection with benefits that are to be received or enjoyed by any person on, after or in contemplation of any substantial change in the services rendered by an employee (including a person holding an "office"), or the employee's retirement or loss of employment.

Where an RCA exists, refundable tax is imposed at a rate of 50 percent on contributions made to an RCA custodian, as well as on income and gains earned. The tax is generally refunded as amounts are paid out by the RCA custodian. For example, $100 in contributions to the RCA custodian would result in remitting $50 of refundable tax to the Canada Revenue Agency (CRA). Conversely, if the RCA custodian pays out benefits of $100 during a year, it would trigger a $50 tax refund.

To provide security to employees in respect of the payment of future supplemental pension benefits, employers may choose to fund an RCA, in which case contributions sufficient to pay benefits are paid to an RCA custodian), or can instead settle supplemental benefit obligations as they become due but secure that future payment obligation through a letter of credit or a surety bond. For funded supplemental pension plans, refundable tax will be returned to the employer as benefits are paid out by the RCA custodian. In contrast, supplemental pension plans that are secured with a letter of credit or surety bond can result in accumulating refundable tax that cannot be accessed through the normal operation of a plan. In the letter of credit or surety bond scenario, the employer will be required pay an annual fee or premium charged by the issuer, which fees or premiums will then be subject to the 50 percent refundable tax. Thus, if the annual fee for a letter of credit is $100,000, the employer must contribute $200,000 to the RCA custodian (with $100,000 of that amount to be paid to the financial institution to cover the fee and the other $100,000 will be remitted to the CRA for the refundable tax). As retirement benefits become due, the employer pays the benefits out of corporate revenues, but because there are no benefit payments made by the RCA custodian to trigger a 50 percent refund, the employer will be required to fund escalating refundable tax balances with no practical mechanism for recovery. From an employer perspective, this can make for an extremely tax-inefficient structure. Nonetheless, the structure is sometimes used as a means of providing benefit security but without creating the obligation to fully fund such liabilities.

What Next?

The Budget proposals are focused on providing refundable tax relief to RCAs that provide supplemental pension benefits, and will be welcome by employers that sponsor such an arrangement. Notably, left unaddressed by the Budget are other types of RCAs (not structured as supplemental pension arrangements) under which benefits are similarly secured by letters of credit or surety bonds. Such alternative RCA structures could include, for example, arrangements established to provide stand-alone (not supplemental) retirement benefits, arrangements that deliver retiring allowances or vehicles for providing funding or security for other termination of employment related (including change of control) entitlements. While the policy reason for treating other RCA structures differently is not clear, at present there is no basis upon which to expect that the scope of the proposed refundable tax relief will be expanded. A better understanding of intended scope, together with details on the refundable tax relief mechanics, will be revealed upon the introduction of supporting draft ITA amendments.

Members of the Bennett Jones Pension & Benefits and Tax groups would be pleased to discuss any questions respecting the Budget's RCA refundable tax related proposals, and in respect of anticipated consultations on supporting draft amendments to the ITA.

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