Investors: How to Stay Out of Audit Trouble with TFSAs

Marco Iampieri B.A., JD, M.B.A. with excerpts from EverGreen Explanatory Notes

The TFSA is an excellent savings vehicle for a variety of purposes including saving for large, long term purposes or providing an emergency fund.  But there are some restrictions about the type of assets that can be held in this plan, and how often you can trade them, something advisors and clients will want to chat about to avoid a tax audit problem.

Background.  The TFSA program began in 2009 as a way for Canadian resident adults who have a valid social insurance number to set money aside tax-free throughout their lifetime as a capital investment. Savings in the plan are funded with tax-paid dollars (that is, there is no deduction upon the contribution to the account) and the money accumulates tax free investment earnings.  That means, all withdrawals are tax free, too. 

Few Limitations.  There is no requirement to file a tax return or to have an “earned income” as is required when making RRSP contributions.  There is also no upper age limit (although there is a lower one:  the investor must be age 18).   However, there is a limit to the amount that can be contributed within a “lifetime contribution limit”:

Contribution Limit History

Withdrawing from a TFSA.  Best of all, you never lose the ability to recontribute to the value of the full withdrawal.   However the investor must beware of the proper calculation of TFSA Contribution room to account for those withdrawals. Essentially the recontribution cannot be made in the year of withdrawal. 

Penalties on Excess Contributions. When taxpayers make contributions over the allowed maximum  contribution room, they are subject to a 1% per month penalty until the amounts are removed. If taxpayers are willing to pay the penalty tax in order to keep the money in the plan, hoping to reap an even higher tax-free return on the excess contribution, 100% of the gains will be subject to tax when deliberate overcontributions occur after October 16th, 2009.

Further Restrictions.  The purpose of the TFSA is not to allow individuals to carry on business within the TFSA to shelter business income from tax liability.

There is a distinction between income on account of capital and business income under Canadian tax laws. Subsection 146.2(6) of the Income Tax Act, among other things, states that no Part I tax is payable by a trust that is governed by a TFSA on its taxable income for a taxation year, except that, if any time in the taxation year, it carries on one or more businesses or holds one or more properties that are non-qualified investments. If tax is payable by a trust that is governed by a TFSA, then the holder of the TFSA is jointly and severally liable with the trust to pay each amount payable under the Income Tax Act.

There is a distinction between income on account of capital and business income under Canadian tax laws. Subsection 146.2(6) of the Income Tax Act, among other things, states that no Part I tax is payable by a trust that is governed by a TFSA on its taxable income for a taxation year, except that, if any time in the taxation year, it carries on one or more businesses or holds one or more properties that are non-qualified investments. If tax is payable by a trust that is governed by a TFSA, then the holder of the TFSA is jointly and severally liable with the trust to pay each amount payable under the Income Tax Act.

But what constitutes carrying on a business with respect to the holder of a TFSA?  Important factors include the length of time regarding the security or securities at issue, the frequency of trading the security or securities at issue, the circumstances that prompted the sale of the security or securities, the motive of the TFSA holder before, during and after to the disposition of the security or securities.

Regarding the question of motive or intention, the test of motive or intention has been carried one step further by Canadian courts into what has generally been referred to as the “secondary intention” test. This has meant, in some cases, that even where it could be established that a taxpayer’s main intention was investment, a gain on the sale of the asset would be held as taxable as income if the court believed that, at the time of acquisition, the taxpayer had in mind the possibility of selling the asset if his investment project did not, for whatever reason, materialize. (Happy Valley Farms Ltd. v. Minister of National Revenue, 1986 CarswellNat 375 at para 16)

Important Takeaways: Be sure to track all transactions occurring within your TFSA. As mentioned above, the frequency of transactions is an important factor in determining whether a TFSA holder is appropriately utilizing the TFSA savings vehicle, thereby benefitting from the tax-free savings and withdrawals.

Ensure to double-check that all investments are ‘qualified investments’ for TFSA investment purposes prior to investment.

The voluntary disclosure program is available for Canadian taxpayers who are carrying on a business within their TFSA, and desire to inform the Canada Revenue Agency in order to benefit from penalty and interest relief.

EverGreen Explanatory Notes is the “ever ready” tax research library for advisors, to bring important tax and investment facts to light for more comprehensive conversations between advisors and their clients.

Additional educational resources:

The September 23 Virtual CE Summit will address the issue of Audit Defence: Managing Risk in Compiling Financial Statements, GST & Payroll.  Check out the comprehensive online agenda to learn more and enrol online today!