CRA’s Anti Avoidance Rules for Preventing Unfair and Aggressive Use of a TFSA
While the above represent incidences that usually arise from not being fully knowledgeable of the tax rules around TFSAs, there are practices that some savvy investors sometimes engage in to take advantage of the tax-free status of the account.
These practices relate to having non-qualified and prohibited investments inside your TFSA as well as practices that one deliberately engages in in order to gain a tax advantage that would otherwise not occur.
Non Qualified and Prohibited Investments
What are non-qualified investments? Non-Qualified Investments refer to any property other than money, guaranteed investment certificates, government and corporate bonds, mutual funds, and securities listed on a designated stock exchange. The types of investments that qualify for TFSAs are generally similar to those that qualify for registered retirement savings plans.
Examples of non-qualified investments include land and units of ownership in a general partnership, as well as shares of a non-Canadian company that once traded on a designated stock exchange, but has since been de-listed.
A prohibited investment is property to which the TFSA holder is closely connected. It includes any of the following:
- A debt of the holder
- A debt or share of, or an interest in, a corporation, trust or partnership in which the holder has a significant interest–generally a 10% or greater interest
- A debt or share of, or any interest in, a corporation, trust or partnership with which the holder does not deal at arm’s length.
The policy intent of the prohibited investment rules is to prevent a stream of disproportionate returns into the plan, thereby circumventing contribution limits, or that facilitate an intentional devaluation of the investment in order to avoid a later income inclusion.
How much tax do you pay on non-qualified and prohibited investments?
If in a calendar year, a trust governed by a TFSA acquires property that was a non-qualified investment or a prohibited investment or if previously acquired property becomes non-qualified or prohibited, the holder of the trust is subject to a 50% tax on the value of the investment and on any income earned on the investment. The holder is required to file a special tax return and remit the tax.
When an investment ceases to be a non-qualified investment or prohibited investment while being held by the TFSA, the investment is deemed to have been disposed of immediately before that time for equal to its fair market value and re-acquired for the same amount at the same time. This ensures that only the portion of the capital gain or capital loss that accrues during the period in which the investment was non-qualified or prohibited is taken into account in determining the trust’s adjusted taxable income.
For example, Phil has a TFSA, which governs a trust that purchased $4,000 worth of shares of Red White and Blue, a company whose shares are listed on a designated stock exchange. The shares are later delisted and become a non-qualified investment. The shares are only worth $500 when they are delisted. These shares are deemed to have been disposed for $500 and re-acquired at this same $500 cost.
Several months later the trust sells the shares for $2,500, resulting in an overall loss in value on the shares of $1,500 ($4,000 – $2,500). However, the trustee would calculate the tax payable based on the capital gain of $2,000 ($2,500 – $500) that accrued during the period the shares were non-qualified.
Penalties for Tax Advantages
In addition to the broader anti-avoidance rules discussed above, the CRA has also implemented anti-avoidance penalties for practices that involve using a TFSA to gain a tax advantage.
These abusive tax-planning strategies include intentional over-contributions to a TFSA with the deliberate intention of generating a return sufficient to outweigh the cost of the regular TFSA over-contribution tax of 1% per month. Other examples include swap transactions that artificially transfer amounts that would otherwise be taxable into a TFSA and reallocating fund rebates in the TFSA in order to acquire the best tax advantage.
The consequences for these practices are extremely severe: If the CRA finds a taxpayer has received an advantage under his TFSA, that person must pay a tax equal to 100% of the fair market value (FMV) of the benefit. Basically, the benefit is fully confiscated.
Click here for part 3 of our TFSA series where we discuss how to use your TFSA for legitimate tax planning advantages.
Get the most out of your TFSA and avoid any costly mistakes by consulting with a qualified tax expert at Kalfa Law. We are here to ensure that your TFSA works for you both today and in the long term.
You work hard for your money. We work hard for you to keep it™.
-Shira Kalfa, BA, JD, Partner and Founder
© Kalfa Law 2019
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.