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Thirty percent rule update and tax policy review

30 percentThe federal government is reviewing one of the investment rules that applies to registered pension plan investments. The review is considering both the pension and tax policy rationale for the rule. While the repeal or relaxation of this rule would not impact the majority of Canadian registered pension plans in terms of their actual investments, any changes to income tax rules relating to pension plan investments could have much broader application. If you wish to make submissions to the federal government, they must be submitted by Sept. 16, 2016.


The so-called “30% Rule” restricts pension plans from investing plan moneys, directly or indirectly, in securities of a corporation to which are attached more than 30% of the votes that may be cast for the election of directors. Exceptions exist for investments in corporations that qualify as investment, real estate or resource corporations.

Ontario review

This rule has been subject to much criticism and debate. Ontario announced in 2015 that it would consider the elimination of this rule. In March 2016, Ontario invited submissions with respect to the utility of the rule. In its publication, Ontario suggested the rule might be eliminated or might be replaced with other disclosure or undertaking requirements where a pension fund acquires securities to which attach more than a prescribed threshold percentage of the votes that may be cast to elect directors. The Ontario submission period is now closed.

Federal government review

More recently, on June 3, 2016 the Department of Finance (Canada) announced that it is reviewing the utility of the 30% Rule, and whether it should be retained, relaxed or eliminated. The federal investment rules have previously been adopted by a number of provinces (Ontario included) and therefore changes to the federal investment rules could indirectly affect most Canadian registered pension plans.

From a pension policy perspective, the Department of Finance release asks a number of questions, which in essence relate to whether there is a continued rationale for the 30% Rule in light of the statutory requirements for prudent investing.

Tax policy considerations

Of particular interest is that the Department of Finance has indicated that there are tax policy considerations relating to the elimination or relaxation of the 30% Rule. While the repeal or relaxation of this rule would not impact the majority of Canadian registered pension plans in terms of their actual investments, any changes to income tax rules relating to pension plan investments could have much broader application. For example, many plans are co-investors in entities – corporations, partnerships and trusts – where either all or a majority of the investors are registered pension plans.

The primary concern noted is that when investing in active, as opposed to passive, investments, pension plans may be able to structure their investments so as to shift taxable income from the business entity (which would pay income taxes) to the pension plan (which would not pay income taxes). The result is to avoid federal and provincial corporate income taxes on income earned from these businesses. A secondary concern raised is whether the ability of larger pension plans to eliminate entity-level income tax in respect of controlled businesses adversely impacts on the fairness and efficiency of Canadian capital markets, and provides pension plans with an unfair competitive advantage as investors. A tertiary concern is whether the ability to minimize tax costs in respect of active versus passive investments could create a bias for pension plan investments toward active investments beyond what would otherwise be dictated by the relative merits of the investments.

Examples given by the Department of Finance include:

Earnings stripping via related-party debt – amounts paid as interest, unlike dividends paid, are generally tax deductible by the payor corporation. By contrast, neither interest nor dividends are taxable when received by a registered pension plan. Where a pension plan controls a corporation, funding the corporation disproportionately through interest-bearing loans from the pension plan can reduce or eliminate the controlled corporation’s taxable income

Private flow through entities – income generated by a flow-through entity such as a partnership or a private trust generally is taxed in the hands of the investor. By holding an active business through a flow-through entity, registered pension plans can eliminate income tax on the business as all income is taxable in the hands of the plan.

The Department of Finance release notes that most G-7 countries, other than Canada, have rules in place that either restrict corporate interest deductions in the case of interest paid to domestic tax-exempt and foreign investors, or that tax pension plans directly. This is accomplished in different ways, including through “thin capitalization rules” (limiting interest deductibility where the debt to equity ratio exceeds a prescribed threshhold), taxation of pension plan assets and investment income or (in the U.S.) through a tax on “unrelated business taxable income” (income generated by a tax-exempt entity by means of taxable activities).

The Department of Finance release raises the possibility of extending the “thin capitalization rules” under the Income Tax Act (Canada) to pension plan investments, and with respect to private flow-through entities, imposing an entity-level income tax on private flow through entities controlled by pension plans.

From a tax policy perspective, the Department of Finance release asks a number of questions intended to address the concerns raised.

Submissions are due no later than Sept. 16, 2016.

By Ash Gupta and Daniel R. Hayhurst, Gowling WLG

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