A Deep Dive: Retirement Compensation Arrangements (RCAs)

Prepared By: Mitchell A. Shields, CFP®, CLU®, TEP

If you’re a top-tier executive or a business owner, you might find that conventional retirement savings routes don’t quite measure up to your income replacement needs. With the 2025 contribution caps for RRSPs set at $32,490 and TFSAs expected to top off at a mere $7,000, how do you amass a nest egg to provide the level of income you’re accustomed to? Similarly, for employers looking to offer compelling retirement benefits to their key players, a traditional defined benefit pension plan like an Individual Pension Plan may not cut it.

Here’s a solution worth considering: a Supplemental Executive Retirement Plan (SERP), specifically in the form of a Retirement Compensation Arrangement (RCA). This alternative could be your ticket to a financially secure retirement that aligns with your lifestyle expectations.

A Retirement Compensation Arrangement (RCA) refers to a structured plan in which contributions are made by an employer, a former employer, or sometimes the employee themselves. These contributions are given to an entity, known as a custodian, to manage for the benefit of the plan member.

The custodian is responsible for holding these funds in trust with the goal of allocating them to the employee, a former employee, or another designated beneficiary. The disbursement of these funds generally happens under the following circumstances:
• Upon the retirement of an employee,
• If the employee is relieved from their employment,
• In the event of a significant alteration in the services provided by the employee. For instance, if a top-level corporate executive, after termination, is employed on a part-time basis to instruct a management course for new recruits, it may be perceived as a significant change in the services provided, thus falling under the definition of an RCA.

Why an RCA? – The Basics

The RCA allows an employer to provide a retirement benefit supplement to any existing or contemplated pension plans. An RCA also gives employers a competitive edge when recruiting for top talent. It provides potential material tax savings for an employee by deferring taxation that would otherwise be due on providing a bonus. Care must be taken however to ensure that the plan is not considered a Salary Deferral Arrangement (SDA), which we will address shortly.

An RCA plan is best suited for those who are in the top marginal tax rates, after maxing out their RRSPs or available pension plan contributions, due to the unique nature of the taxation of an RCA. Employer contributions to an RCA will not impact the employee’s RPP/RSP/IPP contribution room. In contrast, a contribution to an RPP/IPP could reduce what the CRA would consider ‘reasonable ’ to contribute to an RCA, reducing the amount that could be contributed to the plan.

Starting High Level

When an employer contributes to an RCA for an employee, the employer contributions to an RCA are subject to a refundable tax under part XI.3 of the Canadian Income Tax Act. This tax is equivalent to 50% of the contribution amount. To illustrate, for a contribution of $5,000, $2,500 is directed to the Canada Revenue Agency (CRA) and credited to a non-interest-bearing account called a Refundable Tax Account (RTA) that is administered by the CRA, while the remaining $2,500 goes to the RCA custodian. If the employer neglects to withhold this tax, the effective contribution doubles, resulting in potential excesses and penalties.

This contribution made by the employer, and any associated costs will be deductible for the employer, much like when paying salary, but will not attract payroll or healthcare taxes. It is possible that the CRA may deny the deduction for the business if the amounts are paid as a series of refunds and contributions For example, an employer contributes at year end then custodian refunds the amount back to the employer – The CRA will view this as a transaction that was solely for the corporate deduction, and they will deny said deduction.

This 50% withholding tax can result in an immediate tax savings for the employee over receiving this compensation personally, even before looking into the refundable nature of the tax when considering that top tier tax rates in most Canadian provinces is now above 50% as illustrated in the table below:

As you can see from the chart above, in some provinces there could be an immediate tax saving compared to a bonus of roughly 3%-4% when looking at the top marginal tax rate on income in those provinces. In addition to the 50% withholding tax on the initial contribution from the employer, when the funds held by the custodian are invested, there will be a continued 50% refundable tax charged on all income within the trust. For the purposes of the RCA, this will also include capital gains. An important point to consider is that dividends and capital gains realized within the RCA trust do not have preferential tax treatment. That means that for dividends, there will be no gross up or credits, and for capital gains, 100% of the gain will be included when accounting for the 50% withholding rate.

Contributions by an Employee

When establishing an RCA for an employee, it is possible to also allow or require the employee contribute to the RCA as well. This can be structured as a match of employer contributions or utilize another method of calculating contributions. These employee contributions may also be deductible to the employee under 8(1)(m.2) of the income tax act as long as the amount contributed in that year by employee is not more than the employer contribution.

Distributions to an Employee

The RCA provides additional flexibility for its members compared to other retirement plans such as pensions or Registered Retirement Savings Plans. With the RCA, there is no age-based requirement to start taking RCA income, and the funds could be left in the RCA right up to the death of the plan members, or started as soon as is deemed appropriate.

RCA Payments to the member offer better flexibility compared to a pension. Income can come out in a more discretionary manner as there is no obligation to take out funds on a consistent basis. For example, if a member took out funds last year, they are not obligated to do the same this year.

When the member receives a payment from the RCA, it will be added to their income in the year its received and taxed at a personal level as income. When this happens, a portion of the funds held with the CRA in the Refundable Tax Account will be refunded to the custodian managing the RCA. This will happen when the T3-RCA tax return which reports distributions to the employee from the RCA is completed. When RCA makes a distribution to its members, $1 is refunded from the RTA for every $2 paid to beneficiary. This means that all the refundable taxes will be refunded from the RTA by the time the plan is exhausted and collapsed.

In some cases, the RCA income can be split with a spouse, assuming it is structured in a way that it would be considered pension income . The ability to pension split the income requires that you are over the age of 65 and that the income is for a life annuity that is attributable to periods of employment for which benefits are also provided to the member under an RPP and provides benefits that supplement the benefits provided under an RPP.

Key Considerations for an Owner Manager

The Retirement Compensation Arrangement is not only suitable for employees of a business but can also be a great tool to be utilized by the owner of a business. For the owner of a business, the previously noted tax deferral benefits will all apply, and the RCA can be a great planning tool in addition to implementing other retirement plans such as an IPP. In addition to these benefits, specific to the owner of a business, the RCA contributions can reduce the value of the business which can be a valuable benefit when considering business sale, succession, or a potential departure from Canada.

When funding an RCA, any past years of service can be used when calculating a reasonable contribution. This could lead to a large contribution to be available year one when an RCA is set up after the executive or owner has worked in the business for some time . This could be additionally helpful when considering purifying a corporation of passive assets such as cash, when leading up to any of the above noted transitions.

Prohibited Investments

The funds retained with the custodian within the RCA plan can be invested diversly, similar to the eligible investments available within an RRSP. There are some key investments that are prohibited within the RCA that need to be considered. The two key investments that are prohibited within an RCA are:
• Debt of the member of the plan.
• Investments with which the member of the plan has significant interest (owns 10% or more or don’t deal at arms length).

When there are prohibited investments within the RCA, the Income Tax Act under 207.61(1) applies a tax on prohibited investments of 50% of the FMV of the property. This tax may be refunded if:
• Property is disposed of by the end of the calendar year after the tax arose.
• The property ceases to be prohibited before the end of the calendar year following the calendar year the taxes arose.
• If disposed of the same taxation year it was acquired, in which case remittance of tax is not required.

Across all three of these scenarios however, there will be no refund if it was reasonable to expect that the trustees should have known the investment was prohibited.

Additionally, any income earned on a prohibited investment while held in the RCA will be treated as ‘advantage’ and may be subject to 100% penalty tax . Under the Advantage Rules and Penalties – If an advantage occurs in an RCA, a penalty tax will be imposed by CRA payable by the annuitant equal to 100% of the benefit.

Life Insurance and Annuities

When considering that all income earned within the RCA, including capital gains and dividends, are taxed at 50%, some may look to utilize a tax-exempt life insurance policy as a primary investment vehicle, and this can provide a significant advantage over a traditional investment approach in some cases. Given that the policy is tax exempt, the funds retained within the insurance policy would not need to remit the 50% refundable tax to the RTA with the CRA when earned.

That said, care must be taken when incorporating insurance into an RCA structure as it may be seen as an advantage and attract additional penalties and tax. Given the nature of insurance, there may have never been an intent to benefit the member in a way that aligns with the spirit of a retirement plan. Additionally, If the custodian uses the RCA to purchase an annuity or some other life contracts, the CRA may consider the amount paid to purchase the contract as a distribution, and the premiums fully taxable to the beneficiary.

Utilizing insurance within the RCA should be done with care, by working with an actuary and tax professional who specialize in this area.

Purchasing insurance within an RCA, and other approaches such as using leverage, and split dollar policies is beyond the scope of this article and warrant one of their own.

Retiring Abroad

For individuals considering a retirement abroad, the RCA can significantly enhance such plans.

One primary concern when planning to terminate one’s residency in Canada revolves around the departure tax. This requires departing residents to remit taxes based on the fair market value of their Canadian-held assets. Essentially, this mechanism lets the Canadian government secure deferred taxes from previous years. Notably, the RCA is exempt from this and there won’t be any departure tax levied on the value of the RCA.

This wouldn’t be the case if the same amounts were channeled into the corporation because the value of such corporate shares would be subject to the departure tax.

As a non-resident, the tax you’d owe on RCA withdrawals would be Part XIII tax of 25% in Canada . This can be altered by a treaty existing between Canada and your chosen country of residence. Typically, you’d face a tax rate of 15%-25% in Canada. Subsequently, this pension income would need declaration in the foreign country. Often, people opt for countries boasting lower income tax rates compared to Canada. Making such a move can potentially lead to substantial tax savings.

Other Considerations of Note

‘Golden Handcuffs’:

When an employer is considering compensating top talent, an RCA can be a great way to apply some ‘golden handcuffs’. When structuring the plan, it is possible to apply vesting provisions around when the employee would be eligible for the RCA compensation. With that, it may provide financial incentive to keep top talent engaged, in lieu of equity-based compensation incentives.

Scientific Research and Experimental Development Credits (SR&ED)

For those Canadian Controlled Private Corporations who utilize the Scientific Research and Experimental Development Credits, there are requirements to keep the taxable capital of the corporation low to earn the enhanced credits. The expenditure limits start to decrease when taxable capital property for the previous year reaches $10,000,000 and becomes nil starting at $50,000,000. Owners may decide to bonus down their capital property to continue to earn enhanced limits, which for those provinces with top personal tax rates over 50%, may benefit from utilizing an RCA.

Executive Severance

An RCA can be a great option when considering executive severance compensation and is growing in familiarity and preference with employment lawyers in Canada. To provide an example, lets assume an executive in Ontario is being let go, with a severance payment of $500,000:
Option A – No RCA
• The payment amount is considered income in that year and subject to full taxation.
• Assuming the executive has already received income and is in the highest tax bracket, the tax rate on severance would be 53.53%, equal to $200,738 of tax owed.
• After‐tax amount would be $232,350.
Option B –RCA
• Executive retires and takes income solely from the RCA over the next 4 years at $125,000 per year.
• Average income tax rate reduced to an assumed 26.62% in Ontario on this income.
• After‐tax amount would be $366,900.

In this example, using an RCA provides an after‐tax increase in income of $134,550 compared to the traditional lump sum option.

Moving from one RCA to Another

If a situation arises where the existing RCA is to be moved to a new RCA plan, this can be done as a tax-free rollover as long as some key conditions are met. Under the Income Tax Act, section 207.6(7) covers a tax-free rollover if:
• A lump sum is transferred directly from one RCA to the next.
• Receiving plan does not have a non-resident custodian.
• Receiving plan is not a foreign plan (as defined 207.6(5)).
• For refundable tax to be transferred, representatives from both plans should have a signed letter of agreement.

In summary, don’t let traditional retirement options limit your financial future or that of your top executives. RCAs offer a flexible, efficient path to ensuring a comfortable retirement while retaining key talent in your organization. When conventional retirement planning tools seem mismatched to your earnings or ambitions, a Retirement Compensation Arrangement could very well be your game-changer. Consider consulting our team to explore how this can be tailored to your individual or corporate needs. After all, a well-planned retirement is the ultimate goal—both for individuals looking for peace of mind and organizations aiming to sustain their success.

Reference:

(1) https://teamlwc.com/deep-dive-into-individual-pension-plans/
(2) The Income Tax Act does not define what is considered a reasonable contribution to an RCA.
• CRA described in a 1998 Roundtable “a normal level of benefits would be the same benefit provided under a registered pension plan without regard to the revenue Canada maximum. This would be 2%x years of service x final five year average earnings or about 70% of pre-retirement income for an employee with 35 years of service”
• When looking to implement an RCA, a decision around what would be a reasonable funding limit would be determined with the assistance of an actuary.
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