When Tax-Free Savings Accounts Are No Longer Tax Free: The Canada Revenue Agency’s Aggressive Audit Campaign Against TFSAs Carrying On A Business—A Canadian Tax Lawyer’s Analysis
Introduction: Tax-Free Savings Accounts Audits
Introduced in 2009, the tax-free savings account allows individuals to set money aside tax free. While you cannot claim tax deductions for your TFSA contributions, the TFSA’s earnings are tax free even when withdrawn. If the tax-free savings account carries on a business, however, that income is taxable under subsection 146.2(6) of Canada’s Income Tax Act.
Recently, the Canada Revenue Agency has hung its hat on the business-income exclusion as the basis for an aggressive audit campaign. The CRA claims that it has identified over $75 million owing from inappropriate TFSA use. Of the $75 million, 20 percent comes from tax-free savings accounts that, according to CRA, carry on a business.
This article first discusses the factors that the Canada Revenue Agency uses to determine whether a TFSA carries on a business. Next, it compares the Agency’s approach to TFSAs with its contrary stance on registered retirement savings plans. Finally, this article offers several tips that may prove worthwhile to the concerned reader.
TSFAs Carrying On A Business: Frequent Traders With Large Balances Beware of Tax Audit
When auditing a tax-free savings account, the Canada Revenue Agency applies several factors to determine whether the account carries on a business and thus earns taxable income. These factors come from a long line of Canadian tax cases wrestling with the question of whether a gain or loss from selling securities should be on income account or capital account.
As a result, the following factors may cause the Canada Revenue Agency to conclude that your TFSA carries on a business:
- you conduct frequent securities transactions within your TFSA
- you quickly relinquish ownership of the securities in your TFSA
- you have knowledge of or experience in securities markets
- securities transactions form a part of your ordinary business or employment
- you spend ample time studying securities markets and potential purchases
- you use debt financing to purchase securities that you transfer to your TFSA
- you advertise your willingness to purchase securities
- the securities within your TFSA are speculative in nature or do not distribute dividends
In addition, the CRA insists that extraordinary growth within your tax-free savings account serves as an important indicator of business activity.
Some question, however, whether Parliament actually wished to bar frequent securities trading within a tax-free savings account. Although the Income Tax Act expressly renders taxable the business income of a TFSA, it seems that this caveat simply ensures that taxable businesses need not compete with tax-exempt TFSAs.
In addition, not only are publicly traded securities a permitted investment, but also the TFSA contribution-room formula seemingly anticipates fairly frequent trading activity. Indeed, this recent round of CRA tax audits were triggered by individuals amassing impressive TFSA balances without overstepping their contribution limits.
Inconsistent Treatment? Trading in An RRSP
Others simply find it puzzling that the Canada Revenue Agency seemingly adopts a contradictory position without explanation when it comes to registered retirement savings plans. Like a TFSA, a registered retirement savings plan is tax-assisted savings vehicle. Moreover, an RRSP permits the same investment holdings as those allowed in a TFSA. Yet, in Prochuck v the Queen (2014 TCC 17), the CRA and the Crown found themselves arguing that frequent trading within an RRSP does not amount to carrying on a business since an RRSP is “a unique tax-protected vehicle.”
In Prochuck, the taxpayer suffered a substantial loss on an investment outside his RRSP. He wished to characterize the loss as a fully deductible business loss. The CRA argued that the loss was only a one-half deductible capital loss. In response, the taxpayer pointed to the 512 trades that he made within his registered retirement savings plan during the taxation year at issue. The CRA and the Crown took the position that trading inside an RRSP cannot be considered a business. The Tax Court of Canada agreed. The court reasoned that the Income Tax Act “treats an individual who trades within his RRSP differently than a taxpayer who is in the business of trading.” In particular, while a taxpayer earning business income from trading must report all income on a yearly basis, a taxpayer trading within a registered retirement savings plan can move funds around inside of the RRSP without tax consequence and accumulate tax-free income on funds held in an RRSP. On this basis, the court concluded that “trading within an RRSP does not amount to carrying on the business of trading.” Interestingly, a tax-free savings account seemingly exhibits the same features that the Prochuck court found relevant when deciding that trading within an RRSP does not constitute a business.
But perhaps the CRA’s treatment of TFSAs finds justification from the fact that TFSA funds remain tax free even after the account holder withdraws.
Based on the methodology that the CRA employs, your status as an amateur investor does not guarantee your escaping a tax audit. That is, while professional investors trading within a TFSA seem a more likely target, amateur investors generating large balances with a frequent-trading strategy may find themselves subject to CRA tax snooping.
The difference between a tax-free savings account earning taxable business income and one earning non-taxable investment income turns on the specific facts of each case. Moreover, the courts have not yet been asked either to determine precisely when a TFSA “carries on a business” or whether Prochuck’s treatment of RRSPs should also apply to TFSAs.
If your exposure to a TFSA tax audit concerns you—or if you’re already the subject of a TFSA audit—consult one of our expert Canadian tax lawyers today.