TFSA Proposed Amendments

The Tax-Free Savings Account (TFSA) has not even celebrated its first birthday, but the Department of Finance is already cracking down on TFSA abuses.

The TFSA, which debuted on January 1, 2009, allows each Canadian resident who is 18 years of age or older up to $5,000 annually of TFSA contribution room. While contributions to a TFSA are not tax-deductible, any investment income or gains earned inside a TFSA are 100% tax-free. TFSA withdrawals are also tax-free.

The Department of Finance has announced it is proposing amendments to the Income Tax Act to penalize those exploiting TFSAs to avoid paying tax. While the changes are punitive, they are not likely to affect the vast majority of Canadians who use their TFSAs to save for such things as a rainy day, their kids' education or retirement. The new rules are aimed at sophisticated investors, who are using TFSAs as trading accounts, to exploit what may have been perceived to be fairly modest penalties in exchange for gargantuan tax-free profits.

The proposed amendments target four main areas of concern:

Any income attributable to deliberate over-contributions beyond your TFSA contribution limit ($5,000 in 2009) will be taxed at 100%
Any income from prohibited investments held inside a TFSA, such as private company shares of which you own 10% or more, will also be subject to a 100% tax
Any income attributable to non-qualified investments held by a TFSA, such as land or general partnership units, will be taxable at regular income tax rates, including secondary income (i.e. income on income)
Swap transactions, in which shares or other property are transferred from an RRSP or non-registered account to a TFSA in exchange for cash or other property, will effectively be prohibited by taxing amounts attributable to these transactions at 100%

Finally, while TFSA withdrawals generally increase your TFSA contribution room the following taxation year, the proposed rules specify that any withdrawals of amounts in respect of deliberate over-contributions, prohibited investments, non-qualified investments or amounts attributable to swap transactions or of related investment income, will not create additional TFSA contribution room.

So what were sophisticated, savvy investors doing, and how is the government trying to prevent future abuses? Let's examine three scenarios:

Tom decides to over-contribute to his TFSA in 2009. While his contribution limit is only $5,000, he decides to invest an additional $100,000. His investment, in one million shares of a junior mining stock trading on the TSX Venture at 10 cents a share, is based on speculation that the stock will double within the next couple of weeks.

Tom is willing to pay the 1% per month penalty tax on the over-contributed amount, which equates to $1,000 the first month. Fortunately for Tom, the stock doubles and he immediately withdraws his $100,000 over-contribution. His TFSA has therefore realized a $100,000 gain, tax-free, and his cost was only the $1,000 penalty tax. Under the proposed rules, $100,000 of penalty tax will be payable, equal to the entire $100,000 gain, thus erasing the benefit of such a transaction.

Dick invests $5,000 of his TFSA in private company shares of which he is a significant shareholder (he owns more than 10%). These shares are a prohibited investment for a TFSA. The company subsequently declares a $1-million dividend on the shares held by the TFSA.

Currently, Dick would pay a one-time penalty tax equal to 150% of the normal tax that would have been payable on the $1 million dividend if earned outside the TFSA. The $1 million, however, could remain inside the TFSA and grow tax- free for life, resulting in "an unintended permanent increase in TFSA savings and contribution room." Under the proposed amendments, any income attributable to prohibited investments will be taxed back at 100% -- that is, $1 million of tax will be payable.

Harry swaps $5,000 of thinly traded shares that have a bid price of 10 cents, but an ask price of 30 cents, from his non-registered account to his TFSA for cash, using the 10 cents price. The shares are then swapped back for cash a few days later to Harry's non-registered account for 30 cents per share, allowing the $10,000 "gain" to remain inside the TFSA. Under the proposed rules, the entire gain on the swap transaction would be taxed back at 100%, causing Harry to forfeit his $10,000 profit

Disclaimer:

As with all planning strategies, you should seek the advice of a qualified financial advisor or tax advisor to discuss planning opportunities.

Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto. As a member of the CIBC Retail Markets team, Jamie works closely with advisors from CIBC Private Wealth Management, Wood Gundy, Imperial Service and other partners to support their high net worth clients and deliver integrated financial planning and comprehensive advisory solutions. Jamie writes a weekly column called "Tax Expert" in the National Post, which is also syndicated across various CanWest newspapers in Canada. In his spare time, Jamie teaches an MBA course in personal finance at the Schulich School of Business at York University in Toronto.