By Jamie Golombek and Debbie Pearl-Weinberg
If your clients pay fees for the investment management of their registered portfolio, be it an RRSP, RRIF, or TFSA, these fees are not tax deductible. That being said, many clients wonder whether such investment management fees should be paid from inside the registered plan or be paid using outside funds?
The issue has come up recently due to some additional scrutiny on the part of the Canada Revenue Agency (CRA) in recent years. While there are a variety of fees that may be associated with registered plans, such as annual administrative fees and commissions, it’s the investment management fees, which are typically charged as a percentage of assets under management, that have caught the attention of the CRA.
In 2016, the CRA commenced a review of the payment of fees for registered plan accounts, and specifically looked at the question as to whether the payment of fees by the RRSP or RRIF annuitant or TFSA holder outside of a registered plan gave rise to an “advantage” under the Income Tax Act.
The Advantage Rules
Where a prohibited advantage has been received in respect of a registered plan, a 100% penalty tax on the fair market value of the advantage applies. The CRA has described the rules as targeting “abusive tax arrangements that seek to artificially shift value into or out of a registered plan.”
There are a number of ways that an “advantage” can arise. One is where an increase in the value of a registered plan can be linked to a transaction that would not have occurred in a “normal commercial or investment context,” and a main purpose was to benefit from the tax-free status of the registered plan. The CRA reasoned that the payment of investment management fees from outside the registered plan resulted in an advantage since it would lead to an increase in value of the property in the registered plan. The financial services industry made various submissions to the CRA, explaining that this is not always the case, as we will see below.
The CRA subsequently referred the matter to the Department of Finance, which, in the fall of 2019, announced that they did not have policy concerns with the payment of investment management fees from outside of a registered plan, and that they were prepared to amend the law to ensure that the advantage rules would not apply. This announcement sparks a bigger question: Should investment management fees for registered plans be paid from inside the plan or using outside funds?
Inside Versus Outside
Intuitively, you might think that clients would always be better off paying fees using non-registered funds, as that leaves more money inside the plan to grow unencumbered by tax. That may be true for TFSAs, so that tax-free growth within the plan can be maximized; however, that’s not necessarily the case for other registered plans. That’s because when a fee is paid using funds outside the registered plan, after-tax dollars are used. When RRSP funds are used to pay the fees, these are pre-tax dollars. In essence, the CRA is sharing in part of the fee.
Assume a $100 fee is due on RRSP investments for a client in a 30% tax bracket.
By paying the $100 fee from outside the RRSP, the cost is simply the $100. By paying the fee from within the RRSP, the client would really be out $70. Why? With an RRSP, the government defers collecting tax on the funds invested in the RRSP until those funds are withdrawn. If the fee is paid inside the RRSP, the $100 is never withdrawn, so tax is never levied.
Given this, you may wonder why CRA initially thought that paying RRSP fees from non-registered funds would be beneficial and potentially result in an advantage, and thus, subject to the harsh 100% penalty tax.
While paying fees from inside an RRSP may yield some savings, as described above, less funds would be in the RRSP, which means less tax-deferred growth over time. There is a “break-even point,” where the benefit of paying the fees from inside the RRSP is outweighed by the additional tax-deferred RRSP growth that could have accumulated inside the plan. After this break-even point, it would have been better to have initially paid the fees from funds outside the RRSP, preserving the extra funds inside the registered plan. Factors that influence the break-even point include rate of return and tax rate. A more detailed analysis of the issue can be found in our report entitled “Inside out: Fees for registered plans.”
The Bottom Line
Ultimately, to have any benefit from paying fees outside an RRSP/RRIF, a client must stay invested beyond the break-even point, which can be several decades down the road. It’s nearly impossible to determine what a person’s break-even point would be because of uncertainty of future rates of return and tax rates. It is also uncertain that clients will stay invested long enough to reach the break-even point, much less go beyond it and realize that benefit.
As for whether fees should be paid from inside or out, with TFSAs, it seems pretty clear they should be paid from outside to maximize the tax-free growth inside the plan. For RRSPs and RRIFs, this is not an easy question to answer, as it will depend on investment time horizon, rates of return, and tax rates.
Jamie Golombek, CPA, CA, CFP, CLU, TEP, is managing director, tax and estate planning, with CIBC Private Wealth Management in Toronto. Debbie Pearl-Weinberg, LLB, is executive director, tax and estate planning, with CIBC Private Wealth Management in Toronto.