TFSA Background - TFSA Anti-Avoidance Rules: TFSA Advantage
Tax Free Savings Account (TFSA) plans are a tax efficient method of investment for individuals created by the government to encourage Canadians to save for retirement or other shorter-term goals.
The basic structure of an TFSA is that a financial institution (the issuer) holds investments (the TFSA) for an individual with whom the issuer has a contract or arrangement that meets certain requirements. The individual is called the "controlling individual" of the TFSA. The TFSA can then invest the contributions into various types of investments. The holder of a TFSA cannot carry on a business in his or her TFSA (e.g. a business actively trading securities) without facing adverse tax consequences. TFSAs are not allowed to own certain "non-qualifying" or "prohibited" investments. Cryptocurrencies cannot be held in a TFSA directly, although it is possible to hold them in a TFSA indirectly through an exchange traded fund or similar securities. The TFSA itself is exempt from income tax and withdrawals from a TFSA by the individual do not give rise to an income inclusion. This effectively means that an individual can use a TFSA to invest 'after tax' money and not pay tax on the investment income (e.g. capital gains, interest, dividends) earned on their investment. Unlike with a Registered Retirement Savings Plan (RRSP), there is no deduction available when a contribution is made to the TFSA nor any tax liability when funds are withdrawn.
Only Canadian tax resident individuals who have TFSA contribution room can make a contribution to a TFSA. Every individual who is both of age 18 or older and a tax resident of Canada at some point during a year will accumulate TFSA contribution room for that year. The government specifies a fixed TFSA dollar limit which is the amount by which contribution room increases for every qualifying individual. The TFSA dollar limit for 2021 is $6,000. Unused contribution room will be carried over into future years indefinitely. When an individual makes a withdrawal from his or her TFSA, the amount of the withdrawal will be added to his or her contribution room at the start of the next calendar year.
To maintain the integrity of the TFSA system, the Canadian Income Tax Act contains numerous anti-avoidance rules which can result in severe tax problems for taxpayers. This article focuses on the anti-avoidance rules regarding TFSA advantage.
Definition of TFSA Advantage - TFSA Anti-Avoidance Rules: TFSA Advantage
TFSA advantage is a broad concept which in intended to capture a variety of different ways in which a taxpayers could obtain some kind of unintended tax benefit from or using their TFSA in a manner considered abusive by parliament. Similarly, anti-avoidance rules apply to all forms of registered tax accounts. Many of these benefits are achieved by finding a way to shift value either into a TFSA while avoiding the contribution limit.
Benefits or Indebtedness Conditional on the TFSA
One form of TFSA advantage is any form of benefit, loan, or indebtedness conditional in any way on the existence of the TFSA. The CRA has given as an example of this kind of benefit a taxpayer who invests in a mutual fund that holds rental properties near a ski hill through a registered account which offers a 25% discount to investors. In CRA's view, the amount of the discount would be an advantage.
This category of TFSA advantages is subject to some explicit exceptions. These exceptions are mostly designed to exclude from the definition of an TFSA advantage types of benefits that would be available in normal transactions in the open market. These exceptions from this prong of the definition of advantage include:
- administrative or investment services provided in connection with the TFSA,
- a loan or other debt that reflects arm's-length terms and conditions (including the use of a TFSA as security for the debt);
- a distribution from the TFSA in satisfaction of all or part of the taxpayer's interest in the plan;
- a payment or allocation to the plan by the issuer, carrier, or promoter of the TFSA; and
- a promotional incentive under a program offered to a broad class of persons in a normal commercial or investment context and not established mainly for tax purposes.
A benefit that fits into one of these exceptions may nevertheless be an TFSA advantage if it fits into one of the other criteria for TFSA advantage discussed below.
Note that these exclusions mean that loans contingent on the existence of an TFSA do not necessarily count as an TFSA advantage. However, a significant degree of caution should be exercised when entering into such an agreement, particularly if the loan appears much more favourable than loans that do not involve an TFSA or if it is not being offered by a large financial institution which offers similar loans broadly to the public and an experienced Canadian tax lawyer should be consulted prior to entering into any such agreement.
Increasing the Value of Property held in Connection with the TFSA
Another form of TFSA advantage is a benefit that is an increase in the total fair market value of the property held in connection with an TFSA if it is reasonable to consider the increase to be attributable to an improper source of the type described below.
Non-Commercial Transactions or Events Intended to Benefit from the TFSA Exemption
One type of improper source is any transaction or event (or series of events or transactions) that:
- would not have occurred in a normal arm's length commercial context involving knowledgeable, and prudent parties; and
- where one of the main purposes is to enable a person or partnership to benefit from the TFSA's exemption from income tax.
Determining whether a transaction or event fits with this definition requires a thorough evaluation of all the relevant facts by an expert Canadian tax lawyer. Some warning signs of a not commercially reasonable transactions are:
- property was purchased not at fair market value or in circumstances where it its value is difficult to determine,
- the transaction involves an investment the terms of which provide the parties a mechanism to stream disproportionate returns into the TFSA, or
- the transactions involve a much higher return on investment than would be expected given the risks involved.
Another type of improper source of increasing the value of the TFSA property is a payment received as, on account or in leu of, or in satisfaction of, a payment:
- for services provided by the controlling individual of the TFSA or someone not at arm's length with the controlling individual, or
- of interest, dividend, rent, royalty, proceeds of disposition, or other return on investment in respect of property (other than property held with respect to the TFSA) held by the controlling individual or someone not at arm's length with from the controlling individual.
The idea behind this source is to prevent the use of arrangements that shift otherwise taxable amounts into an TFSA.
Another category of improper source of increase in the value of TFSA property is increasing the value of TFSA through a swap transaction. A swap transaction is a transfer of property between the TFSA and its controlling individual or a person with whom the controlling individual is not dealing at arm's length. CRA's view is that a swap transaction that takes place at fair market value does not prevent subsequent increases in value of the TFSA attributable to the swap transaction giving rise to advantage.
There are a number of explicit exceptions from the definition of swap transaction which include:
- an TFSA withdrawal (i.e. a payment out of the TFSA in part or whole satisfaction of the controlling individual's interest in the TFSA),
- an TFSA contribution,
- a transfers of property between the TFSA and another TFSA of the same individual, and
- the sale of non-qualified or prohibited investment by the TFSA to the plan's controlling individual.
Specified Non-Qualified Investment Income
Another improper source of the increase in the value of TFSA property relates to specified non-qualified investment income. Specified non-qualified investment income is income or a capital gain that is reasonably attributable, directly or indirectly, to an amount in respect of which regular income tax was payable by the TFSA or another registered plan belonging to the same individual. This normally results from an TFSA generating taxable income (e.g. by the TFSA carrying on a business or holding a non-qualified investment), and then investing that income.
The Canada Revenue Agency can issue a notice to the controlling individual of an TFSA to cause the TFSA to pay out its specified non-qualified investment income. If the controlling individual does not accomplish this within ninety days of receiving the notice, then the specified non-qualified investment income remaining in the plan will be advantage.
Investment Income or Gains from Improper Sources
Another type of TFSA advantage is income or capital gains that is reasonably attributable, directly or indirectly, to:
- a prohibited investment held in the TFSA or another registered plan held by the same individual, or
- a deliberate overcontribution to the TFSA.
Note that the above rules target taxpayers seeking to benefit from the TFSA exemption from income tax in ways that the government did not intend.
Tax on TFSA Advantage - TFSA Anti-Avoidance Rules: TFSA Advantage
If during the course of a calendar year, an advantage with respect to an TFSA is received or receivable by the controlling individual of the TFSA, a trust governed by the TFSA, or a person not at arm's length from the controlling individual, then a tax is payable for that year.
By default, liability for the tax falls on the controlling individual of the TFSA. However, in the event that an TFSA advantage is extended by the issuer or carrier of the TFSA, or a person with whom the issuer or carrier is not at arm's length, then liability for the tax falls on the issuer or carrier of the TFSA and not the controlling individual of the TFSA.
Amount of the Tax
The amount of the tax on TFSA advantage is determined as follows:
- in the case that the advantage is a benefit, the tax is the fair market value of the benefit, and
- in the case that the advantage is a loan, the tax is the full amount of the loan.
In other words, the tax is equal to 100% of any TFSA advantage received or receivable.
Return and Payment of the Tax
The person liable to pay the tax on TFSA advantage in a calendar year is required to file a corresponding form RC339 tax return and pay the tax before July of the following calendar year. As with regular income tax, interest will accrue on a late payment and penalties may apply if a return is filed late or not filed at all.
Discretionary Relief from TFSA Advantage Tax - TFSA Anti-Avoidance Rules: TFSA Advantage
CRA has the discretion to waive or cancel part or all of a taxpayer's TFSA tax owing in circumstances where the Canada Revenue Agency determines that it would be just and equitable to do so. Some of the circumstances in which CRA may exercise its discretion are:
- when the tax arose as a consequence of a reasonable error,
- when the transactions that gave rise to the TFSA advantage tax also gave rise to another tax under the Income Tax Act,
- when payments have already been made from the TFSA.
To request that TFSA advantage tax be waived or cancelled, the taxpayer's experienced Canadian tax lawyer must submit a written application to the CRA's Pension Workflow Team located at either the Sudbury Tax Centre or the Winnipeg Tax Centre depending on the location of the taxpayer's residential address. The application should describe in detail the circumstances giving rise to the advantage tax and why it would be just and equitable for the advantage tax to be waived or cancelled.
Note that the CRA's taxpayer relief and voluntary disclosures programs which offer penalty and interest relief in some circumstances cannot be appealed to in order for the TFSA advantage tax itself to be waived or cancelled because it is a tax and not a penalty. It is possible however to get relief under those programs from penalties or interest associated with the TFSA advantage tax.
Pro Tax Tips - TFSA Anti-Avoidance Rules: TFSA Advantage
The definition of TFSA advantage is quite comprehensive and the consequences of an advantage existing are severe. Taxpayers should be extremely weary of any plans proposed to them that allow them to get an unusual tax benefit from an TFSA and consult with an experienced Toronto tax lawyer prior to proceeding with the plan.
In the event that you think you may have received an TFSA advantage or if CRA has assessed you as such in a tax audit, it is highly recommended that you speak with an expert Canadian tax lawyer regarding whether any steps can be taken dispute whether there was an TFSA advantage or apply for discretionary relief.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.