Holding exempt market products within registered plans is a more common occurrence among investors than one might suspect. Lauded as the less-restrictive companion to the public market, exempt market products are nevertheless subject to heavily nuanced, dynamic regulatory restrictions. With an appropriate strategy, these products may improve resilience to market fluctuations and offer a balanced portfolio within investors’ registered accounts.
While many investors understand the importance of working closely with a financial advisor to develop a suitable investment strategy, far less attention is often paid to another key player whose role is instrumental in the overall arrangement: the trustee or administrator of registered plan accounts. With industry knowledge, operational strength and administrative fortitude, trustees hold the ability to guide investors through the intricacies of rules governing the holdings within registered accounts, the so-called “qualified investments” under the applicable tax rules.
According to Jacqueline Taylor, Associate Vice President of Investment Services at Community Trust, finding the right trustee to administer registered accounts is an essential component to an investment strategy.
“The administration of these exempt market products requires different operational considerations and processes, compared to the processes involved in the administration of more traditional
securities,” explains Taylor. “Unfortunately, very few investors have a thorough understanding of what they need to look for when choosing a registered plan trustee to administer their alternative assets.”
Taylor suggests that there are several key questions investors should ask of their trustees prior to entrusting them with the registered accounts holding their investments.
“Of course, there are the typical logistics to weigh, such as the ease of onboarding, timelines and fees, and good customer service,” says Taylor, “but what many investors don’t know, is that there is a handful of other operational details that can vary widely from trustee to trustee. Making the right choice when it comes to these elements can help ensure that investor’s registered account is compliant for tax purposes.”
Consideration #1: Is the desired security a ‘qualified investment’ for tax purposes?
All investments held within registered accounts must be considered ‘qualified investments’ as defined under the Income Tax Act (Canada) and meet the requirements set out in the applicable tax regulations.
“The Income Tax Act is a formidable piece of legislation. For example, [the Act] specifies that the shares of a Mortgage Investment Corporation (MIC) are generally eligible to be held in a registered plan; however, the MIC must meet a substantial number of additional criteria1, including (but not limited to), being a Canadian corporation, having a minimum of 20 shareholders, and the investment of funds must be in real or immovable property situated in Canada,” offers Taylor.
This labyrinth of complex regulations can be enigmatic to even the savviest consumers. “Working with tax and investment advisors is always strongly recommended,” Taylor reminds investors. “However, it’s also essential to choose an administrator who understands these rules and can guide investors toward the right experts.”
“It’s important to note that assets that are considered qualified investments for some types of registered accounts may not be treated as qualified investments in the case of other registered accounts. For example, Small Business Investments are not eligible for holding within RDSPs. Similarly, in order for an investment in Small Business Limited Partnerships to be treated as a qualified investment, no partner of that entity may hold more than 30% of the units2,” she shares. “Tax specialists are typically well-equipped to navigate these restrictions, but for an average investor, this might be an overwhelming exercise,” says Taylor.
Consideration #2: Does the institution offer administration for the type of investment and registered plan requested by the investor?
In addition to the range of exempt market products that could be held within registered accounts, which include but are not limited to mortgage investments (i.e. syndicated mortgages or arm’s length mortgages), Mortgage Investment Corporations and inter vivos trusts, clients are also empowered to choose from a number of account types. These include RRSPs, RRIFs, RESPs, RDSPs and TFSAs.
“There’s certainly no shortage of investment options when it comes to the Private Capital Market. However, to take advantage of them, the investor needs to be working with the right financial advisor and intermediary.”
A common misconception, Taylor explains, is that all trustees offer a full suite of registered accounts in which investors can hold alternative investments.
“Many banks and trust companies generally provide administration only for more traditional holdings, such as securities of publicly traded companies, mutual funds and ETFs, or GICs. It’s very important to do thorough research before assuming that an institution—even an alternative one—will be willing to provide the service an investor is looking for.”
Consideration #3: How does the institution handle distributions and dividend payments on the investment?
Another important consideration, suggests Taylor, is how the trustee handles payments, as the logistics can heavily impact the tax treatment of the investment.
“If the investment pays distributions, the investor may receive them as cash or as a DRIP, (a dividend reinvestment plan),” explains Taylor. “Distributions to registered accounts must be received back to the plan, otherwise they would be considered a withdrawal and, depending on the plan type, may be subject to unfavourable tax treatment”.
Consideration #4: Does the institution have a process in place to monitor the eligibility of an investment as a ‘qualified investment’?
“Ensuring that an investment qualifies at the outset is only half the battle. As an investor, you will want your trustee to monitor market changes and check investments on an ongoing basis to ensure that they remain qualified. Working with a trustee who is equipped to do so can make a big difference to investors.”
Indeed, the stakes are high. In cases where (1) a registered plan acquires a non-qualified investment or (2) an existing investment becomes non-qualified, the plan holder will be subject to steep fees3 including a 50% tax on the fair market value of the invested amount.
Additionally, the income earned on that investment would become fully taxable at the investor’s personal tax rate.
Consideration #5: Is the trustee up to date with changes in the market?
“As a cog in the continually shifting market, the regulation of alternative investments is anything but static,” notes Taylor. “Investors can expect to see ongoing changes in the regulation of exempt market products, particularly in the wake of the new rules proposed by the Canadian Securities Administrators (CSA).”
Here, Taylor refers to the Proposed Amendments to two national instruments published by the CSA in March 2018. The result of this change is to (i) remove the prospectus and registration exemptions currently available for the distribution of syndicated mortgages in a number of the CSA jurisdictions, (ii) introduce additional requirements to the offering memorandum exemption which would apply when the exemption is used to distribute syndicated mortgages, and (iii) make the private issuer prospectus exemption unavailable for the distribution of syndicated mortgages.
The Private Capital Market is known for empowering investors to build highly customizable investment vehicles. Integrating exempt market products into an investment strategy can allow investors to carve out highly specialized assets through unique investment types, with the goal of building greater resiliency to market fluctuations. But when it comes to deploying these strategies within registered accounts, there is a set of important restrictions, the effect of which can have very real impacts on investors’ investment return.”
“For all the flexibility offered by alternative investing, it’s no Wild West when it comes to putting investments in a registered account”, Taylor reminds investors. “The restrictions at play can be complex and dynamic. Working closely with a financial advisor and, in turn, finding the right intermediary to administer those investments within registered accounts, can help investors through an intricate landscape.”
Jacqueline Taylor is the Associate Vice President of Investment Services at Community Trust. Community Trust is a privately held, federally regulated financial institution and is regulated by the Office of the Superintendent of Financial Institutions (OSFI), offering impartial administration and full trustee services to alternative investors, specializing in mortgage investments.