Pension Plan Investment in Canada: The 30 Per Cent Rule
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- News Release: Department of Finance Canada Launches Consultations on Federally Regulated Pension Plans
Closing date: Friday, September 16, 2016.
Who may respond: These consultations are open to anybody interested in participating.
Submissions of Comments
Written comments on the ongoing usefulness of the 30 per cent rule and considerations relating to its retention, relaxation or elimination should be sent before September 16, 2016, via email to: FIN.Pensions-Pensions.FIN@canada.ca.
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Pension Plan Investment in Canada: The 30 Per Cent Rule
Promoting the retirement income security of Canadians is an important goal of the Government of Canada. Canada has a sound retirement income system that is internationally recognized for its adequacy, affordability and sustainability. Private employment-related registered pension plans form an essential component of that system.
Over the past several years, the Government has taken concrete action to strengthen and modernize the legislative and regulatory framework for private pensions, including by implementing a number of changes to the Pensions Benefits Standards Act, 1985 (PBSA) and its regulations to increase pension plan member protection and promote plan sustainability.
The Government is seeking stakeholder input on the usefulness of the rule that restricts federally-regulated pension plans from holding more than 30 per cent of the voting shares of a company (the “30 per cent rule”).
This paper sets out background related to the history of the 30 per cent rule and recent developments relating to it. By preventing pension plans from acquiring controlling stakes in business corporations, the rule was intended to limit plans to a more passive role and to reduce the risk of exposure to business failure. The paper goes on to discuss prudential considerations and the implications of the rule for investment performance. The 30 per cent rule also has tax policy implications to the extent that it constrains a pension plan’s ability to acquire control of businesses. In particular, pension plan control of operating businesses may give rise to certain tax fairness and efficiency concerns. While not solely due to the 30 per cent rule, these issues may take on greater prominence if the rule were relaxed or eliminated.
In each of these areas, the paper sets out a number of questions for discussion on which interested parties are invited to reflect and provide comments. These questions are intended to stimulate discussion and are not intended to limit the range of considerations; stakeholders should feel free to comment on other relevant considerations.
The Government of Canada supports employment-related pension plans through prudential regulation and tax assistance. Pension plans offered in industries under federal jurisdiction (e.g., banking, transportation) as well as plans in the Yukon, Northwest Territories, and Nunavut are regulated by the Government of Canada under the Pension Benefits Standards Act, 1985 (PBSA) and Pooled Registered Pension Plans (PRPP Act). In addition, federally and provincially-regulated plans registered under the Income Tax Act (ITA) qualify for tax-deferred treatment, which is provided to assist Canadians to save for retirement.
The 30 Per Cent Rule
Among other investment rules, federally-regulated pension plans are restricted from holding more than 30 per cent of the voting shares to elect directors of a corporation (the 30 per cent rule). The principle underpinning this rule is that an investor holding such a percentage of shares is an active investor and that pension plans should be passive investors rather than managing the day-to-day operations of businesses in which they invest. The rule was also intended to reduce pension plans’ exposure to risk should a controlled business fail (e.g., incentives to retain investments in a failing business in the hope that its operations will turn around). The rule does not apply to pension plan investments in the securities of investment, real estate or resource corporations when certain conditions under the Pension Benefits Standards Regulations, 1985 (PBSR) are met.
As a result of a harmonization initiative in the early 2000s, most provincial pension legislation incorporates the federal investment rules and would be directly impacted by any federal change. Investment standards for the Canada Pension Plan Investment Board, the federal Public Service Pension Plan Investment Board, and the Caisse de dépôt de placement du Québec (the Caisse) also include a version of the rule.
Internationally, the majority of pension investments are not subject to an ownership concentration limit. According to the Organization for Economic Co-operation and Development, out of the seven member countries whose institutions hold 90 per cent of pension assets, Canada is the only country with an ownership concentration limit.1 As discussed later in the paper, however, most of these countries have tax rules that limit the deductibility of certain interest payments in the context of businesses controlled by pension plans and/or apply a tax directly on pension plans.
In recent years, increasing longevity has raised the cost of expected benefit payments for pension plans. At the same time, pension plans have seen increases in investible cash due to large contributions from baby boomers (currently 50-69 years old) in their peak earning years. Furthermore, low interest rates and volatility in global equity markets stemming from the global financial crisis of 2008 have diminished plans’ ability to generate returns from passive investments such as long-term bonds to match their liabilities. As a result, pension plans are increasingly seeking investments that can provide strong and steady returns over a medium term horizon.
Many pension plans have done so by increasing their holdings of investments in which they play an active role. It is estimated that in 2014, Canada’s six largest pension plans held at least $22.25 billion of active investments in Canadian entities outside of the real estate and resource sectors. According to the Pension Investment Association of Canada (PIAC), member pension plans reported in 2000 that only 1.5 per cent of their assets were invested in private corporations and infrastructure, which often involve a substantial ownership stake. In 2014, these investments (in and outside of Canada) accounted for approximately 13 per cent of pension plan assets.
In order to achieve these investment goals, large pension plans have been circumventing the 30 per cent rule through elaborate financial, legal, and organizational structures which effectively allow for control of a corporation with less than 30 per cent of the voting shares.2 In recent years, large pension plans have requested that the federal government repeal the rule. They argue that controlling stakes allow for improved investment returns and complain that working around the rule imposes significant administrative and legal costs as well as other difficulties. The 30 percent rule may create an additional barrier for a Canadian pension plan making investments in a foreign market in that the elaborate structures used to work around the rule could be perceived negatively by stakeholders in that foreign market. As a result, some pension plans and industry groups have called for the elimination of the 30 percent rule.
Several provincial expert panels on pension regulation have recommended repealing the rule on grounds of risk management, however they did not address tax implications. In June 2015, Québec enacted Bill 38, empowering the Caisse de dépôt et placement du Québec to manage and carry out infrastructure projects in the province and carving out its investments in infrastructure corporations from the 30 per cent rule.
In its 2015 Economic Outlook and Fiscal Review, Ontario announced that it intends to eliminate the 30 per cent rule. On March 14, 2016, Ontario released a description of the proposed regulation for consultation. Ontario-regulated plans accounted for 34 per cent of all Canadian registered pension plan assets at the end of 2013. Ontario had previously announced an intention to draft a regulation which would exempt plans from the rule for Ontario public infrastructure investments only.
Pension plan administrators are responsible for the investment function of their pension plan, taking into account the balance between risks and rewards. Under the PBSA, the prudent person standard requires the administrator to invest the assets of the pension plan in a manner that a reasonable and prudent person would apply in respect of a portfolio of investments of a pension plan. The demonstration of prudence is assessed principally by the process through which investment strategies are developed, adopted, implemented and monitored in relation to the plan portfolio as a whole. Federally-regulated pension plans are required to establish a written Statement of Investment Policies and Procedures. The Office of the Superintendent of Financial Institutions and the Canadian Association of Pension Supervisory Authorities has issued guidance regarding what must be included in the document. The Office of the Superintendent of Financial Institutions also has the discretion to ask pension plan administrators to provide documentation demonstrating how they adhere to the prudent person rule and other legal requirements.
The 30 per cent rule is narrowly defined, applying only to the shares of a corporation which carry the right to vote for directors. However, as long as pension plans do not invest more than 10 per cent of the book value of their plan in a single entity, they may obtain more than a 30 per cent equity stake in that entity if the excess shares do not carry voting rights. This creates a potential mismatch between ownership and voting entitlement, incenting pension plans to seek out complex governance structures to retain control of their investments.
Some stakeholders have argued that the ability of a shareholder (i.e., the pension plan) to vote to elect (and remove) directors is a critical corporate governance mechanism that acts to ensure the directors and the professional managers whom they oversee fulfill their duties and responsibilities in good faith and with a view to the best interests of the corporation and, in particular, its shareholders. They further express the view that the elimination of the 30 per cent rule would enhance oversight, accountability and transparency of public and private companies and allow for more effective risk management by pension plans.
- Does the philosophy that plan administrators should act as passive investors continue to be valid. If not, why?
- What are the benefits and risks of pension plans taking on a dual role of providing benefits to members and taking an active role in the operations of a business?
- Are the prudent person and other PBSA standards sufficient to offset potential risks involved in pension plans acquiring a controlling stake in a corporation?
- If a pension plan’s investment exceeds a certain threshold, should the plan be subject to additional requirements? If so, what should those requirements consist of and what would be the appropriate threshold?
In 2005, the Government moved to provide tax-deferred retirement plans, including pension plans, with greater flexibility to expand into new markets and achieve greater diversification of assets through the elimination of the Foreign Property Rule, which previously restricted ownership of foreign property (e.g., shares, units, and debt issued by non-resident entities) to 30 per cent of the plan’s assets. It has been argued that the elimination of the 30 per cent rule could achieve a similar outcome by providing pension plans with greater flexibility to increase their holdings in high-performance firms.
The elimination of the 30 per cent rule would in principle allow pension plans greater flexibility to identify, acquire and manage companies over which control could be exercised. However, some commentators challenge the notion that pension plans have limited options to invest in high-performance firms. They also state that the potential for increased returns in the absence of the 30 per cent rule should not be overstated, pointing to data which suggest that pension plans’ actively managed portfolios of public securities do not typically outperform passive benchmark portfolios. On the other hand, if pension plans had similar abilities as private equity funds to manage active investments, in theory they could avoid payment of management fees (explicit or implicit) associated with investing in a private equity firm and thereby potentially increase their return.
Pension plans are unique and important contributors to Canadian financial market efficiency. Precluding plans from making active investments in Canada could negatively affect capital market efficiency by reducing liquidity, the availability of patient capital, and capital for large-scale projects in which only large institutional investors are active. Also, by constraining an important class of Canadian investors, it could lead to increased foreign takeovers of Canadian businesses.
- Does the 30 per cent rule impede pension administrators from obtaining appropriate investment returns. If so, why?
- What are the costs, if any, that the 30 per cent rule imposes for pension plans seeking active investments?
- Does the 30 per cent rule create inequities between large and small pension plans? Conversely, could its removal do so. If so, why?
Tax Policy Considerations
Under the Income Tax Act (ITA), contributions (within prescribed limits) to Registered Pension Plans (RPPs)3, Registered Retirement Savings Plans (RRSPs) and Pooled Registered Pension Plans (PRPPs) are tax-deductible, investment income earned on the contributions is not taxed as it accrues in these plans, and payments/withdrawals are subject to regular personal income tax in the hands of the recipient. As a result, the ITA provides a significant tax deferral for savings in these plans. The deferral of tax provided on savings in RPPs, RRSPs, and PRPPs is intended to encourage and assist Canadians to save so that they may better achieve their retirement income objectives. In the case of RPPs, the non-taxation of income earned on investments is achieved by their treatment as tax-exempt entities.
Tax Implications of Pension Plans’ Business Acquisitions
It is likely that a relaxation or elimination of the 30 per cent rule would lead to higher levels of active investments by pension plans. While pension plans have an incentive to invest in tax-efficient instruments for both active and passive investments, their closer relationship with the management of the businesses in which they have a controlling interest provides tax planning opportunities for active investments that do not exist for their passive investments. For example, pension plans may in some circumstances be able to restructure their investments in these businesses so as to shift taxable income from the business entity to the pension plan. Since the pension plan is tax exempt, the result is to avoid federal and provincial corporate income taxes on income earned from these businesses. Several potential tax-planning structures could be used.
- Earnings stripping via related-party debt: To the extent that the acquisition plan involves investment by the pension plan in equity of the controlled corporation, the pension plan could replace a portion (potentially a large portion) of its equity with related-party debt. Since interest, unlike dividends, is tax deductible, the interest payments on the debt held by the pension plan could be structured so as to significantly reduce or eliminate the controlled corporation’s taxable income. However, the potential concern is not the use of high debt levels per se, such as that seen in typical leveraged buy-outs. Rather, the concern relates to the use of related party debt held by the pension plan that would effectively replace equity and bring the total debt of the corporation to a level that exceeds what would typically be seen under normal market conditions. Since the interest income on the debt is not taxable to the exempt pension plan, neither the pension plan nor the corporation would be taxed on the corporate earnings that are distributed in the form of interest payments. A simplified example is set out below.
Example 1: Earnings Stripping via Related-Party Debt
A taxable corporation, already fully leveraged through third-party debt, generates $10 million in net before-tax earnings annually. The corporation is subject to federal corporate income tax of 15 per cent on its $10 million in earnings, or $1.5 million. It also pays provincial corporate income tax at 10 per cent – a further $1 million. After payment of taxes, the balance – $7.5 million – is distributed to the shareholders as taxable dividends.
Assume, however, that a pension plan acquires all of the shares of the corporation. The pension plan could re-structure its investment to replace a significant portion of the corporation’s equity with related-party debt. Assume, for example, that the pension plan retains only a nominal equity interest and holds the rest of its investment in the form of debt (say $200 million) issued by the corporation paying a commercially reasonable rate of interest (assume 5 per cent is justifiable in the circumstances). The tax-deductible $10 million interest payment would fully offset the corporate earnings and eliminate the income tax liability of the corporation. As the pension plan would not be taxed on the interest received (in contrast to the case where interest is paid to a taxable investor), neither the pension plan nor the corporation would be taxed on the earnings generated by the corporation.
While this example sets out an extreme case where all the earnings of the corporation are distributed tax-free to the pension plan, the same policy issue arises if only a portion of the corporation’s earnings are distributed in this way.
- Private flow-through entities: A pension plan could also hold the business in a private flow-through entity such as a private trust or partnership. Since the income generated by these flow-through entities is generally taxed in the hands of the investor, it would not be subject to tax at any level where the investor is a pension plan. In 2006, in response to the proliferation of income trusts, an entity-level tax was introduced for publicly-traded Specified Investment Flow-Through (SIFT) entities (trusts and partnerships), which effectively mirrors corporate-level tax. This results in comparable entity-level taxation for all the major vehicles in which a publicly-traded business may be carried on. The SIFT tax, however, does not apply to trusts and partnerships which are not publicly traded.
Example 2: Private Flow-Through Entities
A pension plan purchases 50%4 of the units in a non-publicly listed limited partnership that operates an active business. The other 50% is held by a private equity firm. Assume the limited partnership earns $10 million in before-tax business earnings annually. For tax purposes, the $10 million would be attributed to the partners in proportion to their ownership stake. However, the $5 million of earnings attributed to the pension plan would not be subject to tax at any level given the pension plan’s tax-exempt status.
It may be noted with respect to both examples that, while the business earnings are not taxed initially, they will eventually be taxed when the pension plan distributes the earnings to its members as pension income, which is subject to personal level tax. However, the potential policy concern stems from the fact that this taxable distribution may not take place until many years after the income is earned, resulting in a very considerable deferral, not available to taxable businesses.
A taxable investor would typically not have the same incentive to undertake the strategies outlined above, since any income that is not taxed at the level of the business entity would be flowed through and taxed in the hands of the investor. The pension plan’s ability to eliminate current tax on business earnings raises potential questions about tax fairness in capital markets among different categories of investors. It could also create potential distortions in investment decisions that could affect economic efficiency and potentially cause tax revenue losses.
Fairness and Efficiency
Fairness and economic efficiency generally suggest that investors in capital markets and entities in operating business markets should compete on a level playing field. It is therefore important to consider whether the potential for pension plans (at least larger ones) to eliminate entity-level income tax in respect of businesses they control could provide a competitive advantage to them as investors (e.g., relative to taxable corporations, small pension plans and other retirement plans, foreign investors) and/or to the businesses that they control. This issue is relevant for reasons of tax fairness, market efficiency and government revenues. Some of the issues and questions that might be considered, which have been raised by commentators, are set out below. This paper does not purport to answer these questions, but raises them as potential issues for stakeholder comment and consideration.
- The (present value of) expected tax savings realizable by a pension plan due to the available tax-reduction strategies could enable it to pay a premium for the acquisition target. All other things equal, one might ask whether such a price premium could provide an advantage to pension plans relative to taxable investors in the market for corporate acquisitions.
- Small pension plans, while also tax-exempt, may not have the size, capacity or risk tolerance to be able to acquire controlling stakes in businesses. This raises the issue of whether they would be precluded from undertaking certain tax strategies potentially available to larger pension plans or may have to incur significant transaction costs (e.g., by working collectively through private equity firms) to employ similar strategies.
- Self-directed retirement savings plans like RRSPs are generally prohibited from having interests of 10% or higher in any business. In the absence of the 30 per cent rule, pension plans might be seen to have an unfair advantage over such other retirement savings plans and institutional investors.
- Foreign investors, including foreign pension plans and sovereign wealth funds, are subject to tax rules – known as thin-capitalization rules – which limit their ability to reduce a Canadian corporation’s taxable earnings through deductible interest payments on related-party debt. This raises the issue of whether similar limitations should apply to domestic pension plans.
- Pension plans could use tax strategies like those discussed earlier to make their entire return on capital from a controlled business effectively tax-deductible. This raises the issue of whether the resulting tax savings to a pension-controlled business on an ongoing basis could allow it to offer more competitive pricing than business competitors, facilitating the corporation’s expansion at the expense of businesses owned by taxable Canadian investors and foreign investors.
Another issue for consideration is whether the greater ability of pension plans to minimize tax costs in respect of active investments relative to passive investments could create a bias in pension plan investment in business toward active investments beyond what would otherwise be dictated by the respective merits of the investments.
Potential Tax Measures
As discussed earlier, the 30 per cent rule has not prevented Canadian pension plans from acquiring effective control positions in Canadian businesses. Canadian pension plans have also for many years explicitly been permitted for tax and regulatory purposes to directly hold and benefit from a tax exemption in respect of certain real estate and resource corporations. Nonetheless, the relaxation or elimination of the 30 per cent rule would enhance pension plans’ ability to acquire controlling stakes in businesses. To the extent fairness and efficiency issues like those noted above are real concerns, such a step could exacerbate them. In that case, potential tax measures could be contemplated with a view to mitigating some of these fairness and efficiency issues. Potential tax rules would presumably apply to both federally and provincially regulated pension plans, since it is their tax exempt status as RPPs that gives rise to the tax planning opportunities discussed.
Most G-7 countries (other than Canada) either have rules in place that restrict corporate interest deductions in the case of domestic tax-exempt and foreign investors, or tax pension plans directly. Approaches include limits on interest deductions by corporations, e.g., by thin capitalization or earnings-based rules (France, Germany, Italy and the U.S.), and taxes on pension plans’ assets (Japan) and investment income (Italy). Further, the U.S. imposes a tax on the “unrelated business income” of tax-exempt entities. The G20/OECD project on base erosion and profit shifting (BEPS) has recommendations for rules to limit net interest deductions that could be applied to both domestic and multinational groups.
In Canada, a number of potential types of tax measures could be contemplated to address tax fairness and efficiency issues associated with pension plan control of Canadian businesses entities.
For instance, the ability of pension plans to replace equity with tax-deductible debt in the corporations in which they hold significant interests could be limited by extending to debts owing to pension plans the thin capitalization rules that currently apply to debts owing to certain non-residents. These rules disallow the deductibility of an entity’s interest expense to the extent the amount of debt owing to a specified non-resident (a non-resident who holds a significant interest in the entity) exceeds 1.5 times the corporation’s equity.
To address the potential use of partnerships and trusts, the Government could consider extending the entity-level SIFT tax regime, which currently applies only to publicly-traded flow-through entities, to private flow-through entities controlled by pension plans.
- Are any of the tax policy concerns relating to the ability of tax-exempt pension plans to acquire controlling positions in taxable corporations (e.g., potential strategies to eliminate corporate-level taxation, which could provide an advantage to the plans or the businesses they control) material in nature?
- How does the potential relaxation or elimination of the 30 per cent rule impact any concerns described in respect of the previous question?
- Should the Government consider implementing tax measures (e.g., thin capitalization restrictions, application of the SIFT tax to pension-controlled trusts and partnerships) to limit the ability of pension plans to undertake tax planning strategies to reduce or eliminate entity-level income tax on business earnings? Are there other potential tax measures that the Government should consider in this regard? What considerations should be taken into account in the assessment of such potential measures?
1 Those seven member countries are: Australia, Canada, Japan, Netherlands, Switzerland, United Kingdom and United States.
Sources: “Pension Markets In Focus,” OECD (2014). “Annual Survey of Investment Regulation of Pension Funds,” OECD (2014).
2 For example, these rules can be circumvented by using convertible debt which can be rolled into voting or non-voting shares, or a plan can appoint a nominee to vote according to the pension plan’s directions..
3 The Canada Pension Plan (CPP) and Quebec Pension Plan (QPP) are not technically RPPs but are subject to a similar tax regime.
4 The pension plan must ensure its liability as a partner remains limited (i.e., it cannot be a general partner) in order to maintain its RPP status under the ITA.