The Basics of Tax-Free Savings Accounts
Tax-Free Savings Accounts or TFSAs are a popular investment vehicle for Canadians. A taxpayer can contribute to his or her TFSA with after-tax income. Income is earned in the TFSA tax-free, and the taxpayer can withdraw the assets and any profits from the TFSA at any time tax-free. There are exceptions to the tax-free nature of the TFSA though. Improperly using your TFSA or using your TFSA as a vehicle to earn business income can lead to unexpected taxes on your TFSA.
Over-Contribution TFSA Penalty
Perhaps the most common pitfall for taxpayers with regards to their TFSAs is ensuring they do not over-contribute. Each year, Canadian resident taxpayers over the age of 18 who have a Social Insurance Number receive additional contribution room for their TFSAs. In 2020, taxpayers received $6,000 of contribution room each. If a taxpayer does not use any or all of his or her contribution room in a given year, that unused contribution room is added to the contribution room available for the following year. In other words all unused contribution room is carried forward.
A taxpayer's contribution room for the following year will also increase by the amount of withdrawals in the current year. It is important that taxpayers take note of that timing. If Ronald has $6,000 in contribution room for 2020, and withdraws $1,000 from his TFSA in 2020, he will over-contribute to his TFSA by contributing $7,000 in 2020. The extra $1,000 in TFSA contribution room from Ronald's withdrawal will not be available to him to use until 2021. A taxpayer will also not receive extra contribution room where the withdrawal is made pursuant to a qualifying transfer to another TFSA held by the taxpayer, their current or former spouse or common law partner, or the withdrawal is a specified distribution. Specified distributions are distributions related to an advantage, specified non-qualified investment income, income taxable in a TFSA trust or income on excess or non-resident contributions.
If a taxpayer contributes more to his or her TFSA than the available contribution room for that year, the taxpayer has made an excess contribution and over-contributed to his or her TFSA. A taxpayer does not over-contribute where the transfer is a qualifying transfer to another TFSA held by the taxpayer or their current or former spouse or common law partner. When a taxpayer has an excess contribution, a 1% per month tax penalty will be applied on the over-contributed amount even if the amount is only in the taxpayer's TFSA for a few days during the month. A pro tax tip for taxpayers with over-contributions is to remove the over-contributed amount immediately to avoid the tax penalty.
Taxpayers can apply to the Canada Revenue Agency for relief of this tax penalty if they have removed the excess contribution and any income reasonably attributable to the excess contribution without delay. The taxpayer must also prove the over-contribution was the result of reasonable error. Taxpayers who wish to object to the over-contribution/excess contribution tax penalty should speak to one of our expert Canadian tax lawyers.
Business Income Earned in TFSA
The TFSA is intended as an investment vehicle. Nonetheless, some taxpayers operate a securities trading business using their TFSAs to attempt to take advantage of the tax-free nature of those earnings. Taxpayers who are found to be conducting business within their TFSAs will have the income earned from their TFSAs taxed as business income. Not only does their TFSA lose its tax-free nature, income from business is taxed at the full rate not at the reduced 50% capital gains tax rate.
Whether a particular taxpayer is conducting business, which may also be known as an "adventure or concern in the nature of trade" with regards to his or her TFSA is based on a series of factors. These factors include frequency of transactions, knowledge and experience in relevant markets or areas, and the nature of the securities in his or her TFSA.
Taxpayers may be tax audited with regards to their TFSAs, or receive a reassessment for additional business income originating from their TFSAs. Our expert Canadian tax lawyers can represent you with regards to a tax audit, or can file a notice of objection to the reassessment. If you're unsure if your TFSA trading activities constitute a business, contact our experienced Canadian tax law firm. We can advise on whether you are conducting a business and assist with a voluntary disclosure of the income if necessary. The Canada Revenue Agency's voluntary disclosure program allows taxpayers to correct reporting errors without incurring penalties and/or .interest.
Prohibited and Non-Qualified TFSA Investments
Note that taxpayers are limited in the types of investments they can make in their TFSA. Prohibited investments include a debt of the TFSA holder, or a debt or interest in a corporation, trust, or partnership the TFSA holder has significant interest in or to which it is not arm's length. Non-qualified investments include, for example, participation in a general partnership. A previously qualified or non-prohibited investment may become non-qualified or prohibited due to change in circumstances.
Under section 207.04 of the Income Tax Act, where a TFSA acquires a prohibited or non-qualified investment or an investment held by the TFSA becomes prohibited or non-qualified investment, the controlling holder of the TFSA will be subject a tax equal to 50% of the fair market value of the investment. The fair market value is calculated and the tax is applied at the time the TFSA is considered to start holding the prohibited or non-qualified investment. For further clarity, for investments that become prohibited or non-qualified investment the tax only applies when the investment becomes prohibited or non-qualified.
The TFSA holder can recover this amount taxed if two conditions are met.
- He or she disposes of the offending investment by the end of the calendar year following the calendar year in which the tax arose and;
- The holder demonstrates it was not reasonable to believe he or she knew or ought to have known the investment was prohibited or non-qualified investment or would become prohibited or non-qualified investment.
Our experienced Canadian tax lawyers can assist with applications for this relief.
Non-Residents Contribution Tax
Individuals who are non-residents of Canada for tax purposes can continue to own TFSAs. However there is a tax trap. Contributing to a TFSA as a non-resident is inadvisable as the taxpayer will incur a penalty for these contributions. Similar to the over-contribution/excess contribution penalty, this tax penalty is 1% a month on any amount contributed to a TFSA by the non-resident. The tax penalty will continue to apply until the amount contributed is withdrawn.
Also similar to the over-contribution/excess contribution penalty, a taxpayer can apply for relief from this tax penalty. The taxpayer must remove the contributed amount and any income reasonably attributable to the contributed amount as soon as he or she is able. The taxpayer must also demonstrate the contribution was due to reasonable error. Our expert Canadian tax lawyers can assist with filing applications for relief of this penalty.
Two Further Notes for Non-Residents with TFSAs
Non-Residents should be aware of two additional tax impacts of holding a TFSA.
Firstly, the taxpayer will receive the entire contribution room for the year he or she emigrates from Canada, the contribution room is not prorated. However, the taxpayer will not receive any further contribution room in future years until he or she becomes a resident of Canada again. This change in the contribution room rules makes it much easier for non-resident taxpayers to incur the over-contribution penalty.
Secondly, your new country of residence may apply different tax rules to your TFSA than Canada would. For example, income or withdrawals from your TFSA may be taxable by your new country of residence. Non-residents should also confirm whether their new country of residence requires reporting of foreign held assets similar to Canada's T1135.
TFSA Penalty or Tax?
Throughout this article, we have used the term "penalty" when referring to amounts payable on over-contributions and non-resident contributions to TFSAs. Using the term penalty is common, but not accurate. According to the Income Tax Act, the 1% monthly amount assessed on TFSA over-contributions and non-resident contributions is a "tax". This distinction between tax and penalty can be important. For example, penalties are only assessed on tax and Taxpayer Relief Applications apply only to penalties and interest, not the underlying tax. Another distinction is the Voluntary Disclosure Program cannot be used to obtain relief from the 1% monthly amount assessed on TFSA over-contributions and non-resident contributions.
Pro Tax Tips: Notice of Objection for TFSAs
A notice of objection is an application filed by a taxpayer, or their representative, to appeal the Canada Revenue Agency's assessment of the taxpayer's taxes. They must be filed within 90 days of the notice of assessment being issued, or 90 days plus a year with an approved extension of time request. The notice of objection can be used to dispute assessments of over-contribution penalty, non-resident contribution tax and an assessment for business income. For over-contribution penalty, non-resident contribution tax and tax arising from prohibited and non-qualified investments, the taxpayer can also file an application for a waiver of the tax. Taxpayers should consult with our experienced Canadian tax lawyers to devise the appropriate strategy for dispute in their tax circumstances.