TFSA Investors: You Have to Know the Fine Print

Investors and day traders beware: CRA is looking to collect $75 Million in taxes and penalties due to mistakes investors are making in their TFSAs. What’s at stake is the possible repayment of most of the investment, once penalties and interest are factored in. However, taxpayers may have more rights than may appear at first glance.

As a starting point, before making a TFSA contribution be sure that you qualify to make the investment in the first place. The account holder must be over 18 and a resident of Canada. If you cease to be a Canadian resident, you do qualify for full TFSA contribution room in the year you leave the country. However, if someone makes the contribution on your behalf after you leave, the investment is offside. You cannot exceed the current year’s contribution limit ($5500) when making your contribution and the cumulative dollar limit in the plan cannot exceed $52,000, plus earnings from qualifying investments, unless you are a successor holder of the TFSA balance from your deceased spouse.  

You also need to know that if you withdraw money from the plan, you have to wait until the new year to recontribute unless you have unused contribution room in the year of the withdrawal.

If you have already received a TFSA audit letter, it’s important to know that the audit process generally begins with the proposal of a penalty tax. The important thing to remember is that the proposed return is not a formal assessment of tax. Canadians do have the right to respond to the taxes CRA has calculated on the RC243-P Proposed Tax-Free Savings Account (TFSA) Return they will send you.

While you can’t file a Notice of Objection in response to a proposed TFSA return, you can either agree and pay the proposed amounts or you can disagree with an explanation and correction. For example, if you have indeed made an excess contribution, the correction is simply this: remove the overcontribution or prohibited or non-qualified investment and show proof that you have done so.

CRA also has the ability to waive any penalty tax and related interest if you can show there was a reasonable error in making the incorrect contributions and that you have taken steps to remove the excess as explained above. So, it’s important to be both proactive, timely and complete in your response. Help from a Tax Services Specialist is always a good idea in these cases.

Here’s why: Being offside in your investment choices can attract very expensive penalties. They are levied in two tiers: first, 50% of the fair market value (FMV) of the prohibited investment is charged. In addition, there is an “advantage tax” of 100% on the earnings! That tax applies to any iincome or capital gain from the prohibited investment, plus any income or capital gain derived from the reinvestment of those amounts. The dividend gross-up is disregarded for these purposes.

If you can show CRA that you have disposed of your non-qualified or prohibited investment, you may be entitled to a refund of taxes paid in two cases:

• If the property was disposed of before the end of the calendar year following the calendar year in which the tax arose; or
• The property ceases to be a non-qualified or prohibited investment before the end of the calendar year following the calendar year in which the tax arose.

You will also have to convince the CRA that you did not know that the property was or would become a non-qualified or prohibited investment to avoid the taxes. Therefore, if you are in the investment business, and should have known better, CRA will take a harder line.

This is where day traders could also be caught in an unfortunate circumstance. CRA’s Folio S3-F10-C1 and C2 explains prohibited and qualifying investments for registered accounts, including TFSAs, but poorly. There are some twists and turns that can certainly make it difficult to understand CRA’s assessing policies. The rules can be misleading, as some have unfortunately found out, because CRA does not assess prohibited and qualifying investments “collectively” but rather, it appears, “individually.”

Next week, we’ll look at how easy it is for day traders in particular to get caught in over contributions to their TFSA.

Evelyn Jacks is President of Knowledge Bureau, a national educational institute that provides an academic path to continuing professional development for tax and financial advisors.

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