Photo of Robert WorthingtonBy Robert WorthingtonNovember 03 2015
Tax Law

Retirement Compensation Arrangements: A Valuable Tax Strategy for Executives Terminated from Employment

In the current downturn in the oil and gas industry, companies are restructuring their workforce. Layoffs are never pleasant for anyone involved. To add further insult to injury, increases to personal tax rates may erode a terminated employee’s take-home severance package to a greater degree than before in Alberta, especially for high-income professionals or executives. 

If the tax rates proposed in the new Liberal government’s campaign platform are enacted, the top marginal personal tax rate in Alberta will reach 48%, compared to 39% in 2014.

As tax lawyers, it is not our place to advocate for or against the fiscal policy of increased tax rates. What we can do, however, is throw a lifeline in the form of tax planning to ease the pain of a terminated executive’s heavy tax burden. 

One such tax planning option is to use a “retirement compensation arrangement” (RCA). An RCA can be a tax-efficient retirement plan, but it need not have anything to do with retirement. An RCA can also reduce the tax burden of a terminated employee by spreading out the income inclusions over time, as will be shown in an example below.

An RCA is a form of trust arrangement that has been in the Income Tax Act (Canada) since 1986.  RCAs are very flexible in that withdrawals from an RCA can be in varying amounts and timeframes after retirement or cessation of employment. This feature is quite different from an RRSP, where withdrawals must be made in minimum prescribed amounts and timeframes (after it is converted to a RRIF), without regard to a person’s financial needs.

From an employer’s perspective, the payments made to an RCA, including a lump-sum severance payment, is deductible in a similar manner as ordinary compensation paid to an employee. Accordingly, the employer is tax-neutral, while the employee may enjoy a tax deferral or even an ultimate tax savings.

Historically, we have typically only used RCAs in limited circumstances such as for professional athletes or employees in provinces with higher tax rates than Alberta. One of the reasons is that RCAs have a negative aspect: when the employer contributes to an RCA, a so-called refundable “tax” must be remitted to the CRA in an amount of 50% of the contribution. The 50% refundable tax is not a tax as such; rather, it is similar to posting security. One might ask, why pay the CRA in advance? Although it seems counter-intuitive that paying the CRA in advance actually saves tax, the RCA strategy might make a great deal of sense in today’s economic environment.

Take the example of an executive who receives a lump-sum termination payment of $500,000. If the payment is received in one lump sum, assuming an average tax rate of say, 40%, the retiring or terminated employee would be left with after-tax cash of $300,000. Now suppose the cash was instead contributed to an RCA, and the retired or terminated executive instead withdrew $100,000 per year from the RCA.  The average tax rate for each year would be approximately 26% in Alberta, assuming no other income. In that scenario, the RCA produces cash of approximately $370,000 after tax, or a savings of about $70,000, less legal and accounting costs.[1]

The following table shows how RCA withdrawals might work in this scenario.[2]

201620172018201920202021
Severance payment500,000-----
Refundable payment250,000-----
RCA Distributions(100,000)(100,000)(100,000)(100,000)(100,000)(100,000)
Recovery of refundable payment[3]50,00050,00050,00050,00050,00050,000
Average personal tax rate0%26%26%26%26%26%
Taxes payable-(26,000)(26,000)(26,000)(26,000)(26,000)
After tax cash-74,00074,00074,00074,00074,000
Aggregate after tax cash370,000

RCAs are a valuable tax planning strategy for senior employees who are laid off. The current high tax, low interest rate environment make them particularly favourable today. Additionally, most banks will allow individuals to borrow against the refundable tax account held by the CRA to fund investments and generate greater wealth. The beauty of an RCA is in its flexibility; cash can be withdrawn from an RCA over time, spreading out and reducing the tax liability accordingly.

Invitation for Discussion:

If you would like to discuss this blog in greater detail, or any other tax matter, please contact Robert Worthington or one of the other tax professionals in the Tax & Estate Planning group at Nerland Lindsey LLP.

Disclaimer:

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

[1] The RCA is required to have a “custodian”, which is essentially a trustee, and to file tax returns annually.
[2] The writer would like to thank Riaz Mohammed, CA of TaxClinic for providing the calculations in this blog.
[3] The refund is distributed to the RCA trust and can be withdrawn at a subsequent time.

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