In 2009, the federal government introduced the tax-free savings account ("TFSA") program as a means of promoting investment in the Canadian economy and assisting Canadians in saving for the future. Under the TFSA program, individuals over the age of 18 are entitled to contribute annually up to $10,000 (as increased by the proposed federal budget of April 21, 2015) to a TFSA (previously $5,500 for 2013 to 2014 and $5,000 for 2009 to 2012), up to an aggregate contribution limit of $41,000 for 2015 (including the proposed limit). Unlike registered retirement savings plans ("RRSPs"), contributions to a TFSA are not tax-deductible. However, investment returns within a TFSA are generally tax-free and both contributions and returns may be withdrawn from the TFSA tax-free.
The Canada Revenue Agency (the "CRA") is currently engaged in a large-scale audit project of TFSAs, focusing largely on investors who have achieved significant growth in their TFSAs. As a result of this audit project, the CRA has begun issuing a significant number of assessments proposing to: (1) tax income and gains within the TFSA on the basis that it was carrying on a business; or (2) deregister the TFSA on the basis that the TFSA borrowed money or property. Some of the audits are going as far back as the 2009 taxation year, as there is practically no time limit on issuing a TFSA assessment (as the required annual returns for TFSAs are typically not filed and, without a filing, the limitation period never starts).
TFSAS CARRYING ON A BUSINESS
The CRA is specifically targeting TFSAs engaged in active trading. The Income Tax Act (the "Act") provides that, if a TFSA carries on a business, it is taxable on the income earned from that business. The CRA says that a TFSA that successfully engages in frequent trading is carrying on a business of trading in securities, and therefore gains from the sale of securities by the TFSA should be taxed as business income.
To determine whether a TFSA is carrying on a business of trading in securities, the CRA applies factors that have been developed over the years in tax case law for determining whether an individual's or company's gains or losses from dispositions of securities are on income or capital account. The factors are:
- frequency of trading transactions;
- length of time the securities are owned;
- the taxpayer's level of knowledge and experience in the securities market;
- whether securities transactions form part of the taxpayer's ordinary business;
- the amount of time the taxpayer spends studying the securities markets and investigating potential purchases;
- whether securities purchases are financed by debt;
- whether the taxpayer has advertised that he or she is willing to purchase securities; and
- the nature of the securities, i.e., whether they are income producing or speculative.
The CRA views the size of the TFSA account as an important indicator of whether there is a business of trading. If the maximum contributions have been made from 2009 to 2015, the TFSA will have received $41,000 of contributions. If the current value of the TFSA is, for example, more than $150,000 and there have been a lot of securities trades with short hold periods, factors 1 and 2 will be triggered, and the CRA may also take the position that the extraordinary growth indicates that the person directing the TFSA's investments has a professional level of knowledge of the securities markets and must be spending a significant amount of time on the TFSA's trading (therefore satisfying factors 3 and 5).
Where it is determined that a TFSA is carrying on a business, taxes are imposed on the income earned by the TFSA. Income that is subject to tax within the TFSA includes dividends and interest and the full amount of gains net of losses (without the benefit of the normal 50% inclusion rate).
The Act also provides that the Minister may require that any "specified non-qualified investment income" (i.e., second and subsequent generation income earned on the income from a business carried on by the TFSA) be distributed to and taxed in the hands of the TFSA holder. If secondary income is not distributed within 90 days, a 100% tax is payable on the secondary income pursuant to the advantage rules under the Act. Notwithstanding the provisions of the Act, the CRA has adopted a particularly aggressive position with respect to required distributions where it has determined that a TFSA is carrying on a business. Specifically, the CRA will typically require the withdrawal of all value in the TFSA, except contributions.
It is arguable that the provisions of the Act respecting the taxation of TFSAs found to be carrying on a business were not intended to prohibit active trading within a TFSA. Rather, the purpose of these provisions is clear: TFSAs should not be permitted to compete on a tax-exempt basis with taxable businesses, as this would constitute an unfair disadvantage to taxable businesses. No unfair disadvantage results, however, from a TFSA trading frequently in marketable securities. Further, it is clear that Parliament intended that TFSAs earn income from marketable securities as investments, which invariably requires buying and selling them from time to time.
The Act also provides that if an RRSP carries on a business, the RRSP is taxable on the income from the business. As the RRSP rules predate those of the TFSAs, the carrying on of business exception for TFSAs was no doubt modeled on the similarly-worded RRSP rule. Yet the CRA has not, as far as we know, sought to tax the gains of RRSPs engaged in frequent trading as business income. This may be because withdrawals from an RRSP are ultimately taxable anyway, while withdrawals from a TFSA are not. However, the different tax treatment of withdrawals should not be relevant to the interpretation and application of virtually identical provisions in the RRSP and the TFSA rules.
There is some case law support for the conclusion that a person trading within an RRSP is not considered to be carrying on a business (Prochuk v. R., 2014 TCC 17; Deep v. R., 2006 TCC 315). However, there have not, to date, been any cases that comment on the meaning of "carrying on a business" with respect to a TFSA. Broader case law regarding the trading in securities as a business may support the CRA's argument in assessing TFSAs as carrying on a securities trading business.
TFSAS THAT ARE BORROWING FUNDS
The second main area of focus in the CRA's TFSA audit project is TFSAs with negative account balances. The Act prohibits a TFSA from borrowing money or property, with the penalty being loss of tax-free status. The CRA has stated that, where a TFSA has a negative account balance, the TFSA has borrowed funds with the result that the TFSA should be deregistered. Deregistration results in a loss of tax-exempt status and a deemed taxable disposition of the securities in the TFSA.
There are several reasons unrelated to financing as to why a TFSA may have a negative account balance. For example, a negative balance may be the result of a "settlement mismatch". This would occur where, prior to the settlement date for a purchase of securities, the TFSA places an order with its broker to sell securities in order to provide funds to cover the purchase, but the sale settles one or two days after the settlement date for the purchase. The result is that the TFSA account balance goes negative for a short period of time.
The CRA may be incorrect in its position that a negative TFSA account balance generally represents a liability on the part of the TFSA as a borrower to the broker as lender. Case law is clear that a lender/borrower relationship is a contractual relationship, whereby the lender agrees to loan money to the borrower and the borrower agrees to repay the loan. In the context of TFSAs, there is no loan agreement. Rather, because TFSA brokerage accounts are cash accounts (as opposed to margin accounts), lending and borrowing transactions are not permitted by the TFSA's account agreement.
Purchases of securities by a TFSA may occur in one of two ways. Most commonly, a broker may facilitate the sale of securities to the TFSA by someone else. In these cases, the broker acts as an agent for the TFSA in purchasing the securities. Where a debit position occurs as a result of such "agent transactions", it is arguable that the negative TFSA account balance does not represent a loan from the broker to the TFSA, but may indicate that the broker has incurred a cost, as an agent, on behalf of the TFSA and the TFSA is liable to reimburse the broker for this cost in accordance with the principles of agency law.
In other cases, a TFSA may purchase securities from a broker as principal. In these transactions, the broker is selling shares owned by the broker to the TFSA. This will occur, for example, where the broker has acquired shares directly in an initial public offering or new issue, and then resells the shares to the TFSA. Where a debit position occurs as a result of these transactions, the negative TFSA account balance does not represent a loan from the broker to the TFSA. Rather, the relationship is one of purchaser and vendor, and the debit position represents the unpaid purchase price owing by the TFSA to the broker.
In both kinds of transactions, a TFSA account may have a negative balance. However, the negative balance does not necessarily mean that the TFSA has borrowed funds from the broker. Accordingly, there would be no breach of the TFSA rules and no basis on which to deregister the TFSA.
PROBLEMS FOR THE FINANCIAL INDUSTRY
If the CRA issues a tax assessment to a TFSA on one of the bases described above, the trust company that held the TFSA account during the period assessed is liable for the tax if the assessment is upheld. This poses significant problems for the financial industry, as it is common practice for taxpayers to move their TFSA investments from one financial institution to another. As a result, by the time the financial institution receives an assessment from the CRA, the TFSA to which it relates may have been moved to another financial institution. This creates a high degree of uncertainty for the financial industry and may incentivize the use of holdbacks and other limitations on the mobility of TFSAs.
Originally published by Taxes & Wealth Management, May 2015.
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