RRSPs are Not Tax-Free, Just Tax-Delayed

When the Canada Revenue Agency website flags a "tax-free" scheme as something to avoid, listen. If the words "tax-free" and Registered Retirement Saving Plan are combined in the same sales pitch, run for the hills.

The last time CRA posted such an overt caution, it related to the "buy low, donate high" art donation schemes, which involved taxpayers buying art at a low price and donating it to a registered charity using an inflated appraisal value so as to claim an aggressive tax credit.

CRA did its best to audit everyone who made such a claim and almost all claims were denied. Eventually, the tax law was changed to close down this practice after similar charitable giving tax shelters began to proliferate involving the donation of other types of property such as pharmaceuticals or educational software.

Schemes are now circulating that claim you can withdraw funds from your self-directed or locked-in RRSP without paying taxes. The ability to tap into this large pool of savings without paying taxes on the withdrawal appeals to many taxpayers.

You can recognize these schemes by their promotional claims such as "take advantage of your RRSP now. No tax to pay" or "I will loan you $5,000 to $250,000 over five years, if your RRSP is locked in."

In the scheme, the promoter will offer you shares in a private company or interest in a mortgage, often at highly inflated values, using your RRSP funds. After deducting sizeable commission fees of 15 to 20 percent, the promoter will loan you back about 60 percent of your investment at low or zero interest.

Although some shares in private corporations and mortgages qualify as RRSP investments, the characteristics of the securities offered under these schemes do not meet the test of qualified investments under the Income Tax Act. The result is that CRA will add the value of the shares to your taxable income and you could lose your retirement savings.

The same holds true, with even graver consequences, if the scheme requires you to use the RRSP as collateral for the loan, as is often the case. In this situation, the entire value of the RRSP is added to your taxable income.

Like many tax avoidance schemes, the selling process can be high-pressured and structured to look like a legitimate and Income Tax Act-qualified investment. In fact, they are not qualified and the sales pitch is a scam.

In a recent tax court case, a taxpayer appealed a CRA decision to add the total value of the RRSP she invested in such a scheme back into her taxable income for the year in question. She had spent $20,700 buying shares in the promoter's companies but received access to only about $13,400 of her RRSP money after the $3,200 in fees was deducted from the $16,600 loan received from the promoter. Nevertheless, she had to pay tax on the full $20,700 value of her RRSP.

The court was sympathetic to her, acknowledging she most likely was the innocent victim of a swindle. However, it sided with the CRA because its assessment was correct and the securities instrument the taxpayer had bought was not a qualified investment for RRSP purposes. So we know the swindle defence won't work. However, the final message isn't buyer beware; it is more like buyer avoid at all costs.

Although RRSPs allow you to accumulate wealth without immediate taxation, eventually you will owe taxes on the funds as you withdraw them from the plan.