Introduction – TFSA and Saving for Retirement
For Canadians who are planning their retirement by investing their savings, the Tax-Free Savings Account (TFSA) has become an important supplement to the Registered Retirement Savings Plan (RRSP) since its introduction in 2009. In 2012, within only three years of its introduction, Canadians' total contribution towards their TFSAs exceeded their total contribution towards their RRSPs. However, for taxpayers to take full advantage of the benefits of the TFSA, they need to be mindful of the potential compliance pitfalls set out in the structure of the TFSA. One such pitfall is the non-residence TFSA contribution tax. For taxpayers who were assessed for a non-residence contribution, one of the possible remedies is the application of the TFSA Non-Residence Contribution Tax Cancellation with the CRA
Structure of the TFSA-Comparison with RRSP
Section 146.2 of the Income Tax Act allows Canadians over the age of 18 to invest in a TFSA from a licensed issuing institution. Compared to the RRSP, the taxpayer's TFSA contribution amount is not deductible against his or her income. Any gains generated from qualified investments through a TFSA account can be received tax-free by the account holder throughout his or her lifetime. Paragraph 149(1)(u.2) defines the qualified investment,, while subsection 207.01(1) sets out the definition of a non-qualified investment.
The TFSA has a maximum amount known as the TFSA contribution room, in which a taxpayer can contribute per year without incurring TFSA over-contribution penalties. With the notable exception of 2015, when the TFSA contribution room was $10,000, the TFSA contribution room has been indexed against inflation at $500 increments from its initial amount of $5,000. Currently, the TFSA contribution room is set at $5,500 for the 2018 and 2019 tax year. Furthermore, any unused contribution room from previous tax years can carry over to current and future tax years.
Schematically speaking, the tax on any gain from a TFSA account is "prepaid" in the sense that the initial contribution is paid after the taxpayer's total tax payable for the year and not deducted from the account holder's income at the time of contribution. Whereas the tax on any gain from an RRSP account is deferred by granting the plan holder a deduction of the contributed amount against his or her income in the year of contribution, and tax is levied on the eventual withdrawal. However, due to the different timing in which the tax is levied, TFSA has the greater savings potential for taxpayers on the common assumption that a person will move towards a higher tax bracket later in his or her life. Assuming that a taxpayer will move up at least one tax bracket from the time of contribution to the time of withdrawal, contributing to a TFSA will result in a taxpayer paying tax at a lower rate compared to contributing to an RRSP.
Non-Residence Contribution Tax
Any potential tax savings from holding a TFSA account can be undermined if a taxpayer fails to comply with the myriad of rules surrounding TFSA contributions. When a Canadian taxpaying resident becomes a non-resident by moving to another country, any contribution made by the taxpayer as a non-resident will be subject to a 1% per month tax on these contributions. The rationale of the rule is clear from the above discussion on the TFSA scheme. If a Canadian resident becomes a non-resident for even one year, he or she will not be liable for any income tax towards the CRA as a nonresident, which means that any contribution made towards a TFSA during that year will not be taxed upfront as Canadian income compared to Canadian resident TFSA contributors. But for the non-residence TFSA contribution tax, the account holder would have received the future gains on withdrawal of his or her non-residence year contribution completely tax-free. Additionally, but for the TFSA account, any income generated through a Canadian regular investment account held by a non-resident is fully taxable by the CRA.
This non-residence contribution tax, calculated on the full amount of the contribution, will apply for each month that any portion of the amount was contributed while a non-resident remains in the TFSA and will continue to apply until whichever of the following happens first:
- the contributions are withdrawn in full from the account and designated as a withdrawal of non-resident contributions; or
- the individual becomes a resident of Canada.
Non-Residence TFSA Contribution Tax Cancellation
Under section 207.02 of the Income Tax Act, the CRA has the discretion to cancel all or part of the taxes that become payable by an individual, because they made contributions to a TFSA when they were a non-resident of Canada. While the discretion is exercised based on all of the factors surrounding an individual account holder's personal circumstances, section 207.03 lays out two specific criteria for CRA when exercising this discretion:
(a) the individual establishes to the satisfaction of the Minister that the liability arose as a consequence of a reasonable error; and
(b) one or more distributions (withdrawing money out of the TFSA) are made without delay under a TFSA of which the individual is the holder, the total amount of which is not less than the total of
- the amount in respect of which the individual would otherwise be liable to pay the tax, and
- income (including a capital gain) that is reasonably attributable, directly or indirectly, to the amount described in subparagraph (i)
Paragraph (b) is worded in a seemingly complicated manner. In simple terms, paragraph (b) is asking for the TFSA account holder immediately to withdraw the amount contributed into the TFSA as a non-resident plus any gain that was generated by that amount. However, the determination of "without delay" can be a contextual determination based on the account holder's specific circumstances and the judgment of the CRA officer. If the account holder is still abroad when the non-residence contribution tax assessment is made and sent out by the CRA to the holder's Canadian address, considerable time can elapse between the date on which the CRA sent out the assessment and the date on which the account-holder actually becomes aware of the assessment.
Paragraph (a) contains even more vagueness and grants the CRA considerable leeway in what it may consider to be a reasonable error. While the CRA generally does not consider ignorance of the law to be a reasonable error for which a taxpayer can be granted relief from penalties and interest, the situation becomes different if the taxpayer relied on the advice of a tax or accounting professional in making the non-residence contribution to his or her TFSA account. The taxpayer's own background in tax and accounting will likely be an important factor in determining whether the error is reasonable.
Tax Tips – Retain Professional Advice to Navigate the TFSA Non-Residence Contribution Tax Cancellation Application
There is no guaranteed formula for a successful cancellation application for a TFSA non-residence contribution tax. However, it may be wise for a TFSA account-holder to retain the counsel of an experienced Canadian tax lawyer upon receiving an assessment for a non-residence contribution tax. The fact that the taxpayer retained a Canadian tax lawyer may become a positive factor towards fulfilling paragraph (b) of section 207.03, since it may support the inference that the taxpayer has withdrawn the contribution amount and gains without delay.
Furthermore, while not knowing the specific compliance requirement regarding the non-residence TFSA contribution tax is often a primary cause of non-compliance, an experienced Canadian tax lawyer may be able to find specific facts surrounding the account-holder that will lead favorably to the conclusion of a reasonable error in either facts or law. For example, for an account-holder who worked and resided a considerable amount of time in both Canada and abroad, an argument may be made that the account-holder made a reasonable error of law about his or her own tax-residency. The treaty and common law determination of tax residence is a complex determination of multiple factors with different weights attached to different factors. An experienced tax lawyer may be able to make the case that the taxpayer had a reasonable basis for concluding that he or she was still a Canadian resident based on the specific circumstances and maximize taxpayer's chance of being granted TFSA non-residence contribution tax cancellation.