TFSA Background – TFSA Anti-Avoidance Rules: Prohibited and Non-Qualified Investments
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 a TFSA is that a financial institution (the issuer) holds investments in a special account (the TFSA) for an individual with whom the issuer has a contract or arrangement that meet 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 or running a marijuana store) without facing adverse tax consequences. TFSAs are not allowed to own certain “non-qualified” 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 [IT1] 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 the 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(RRSP), there is no deduction available when a contribution is made to the TFSA nor any tax liability when funds are withdrawn.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 qualified individual. The TFSA dollar limit for 2022, as for recent years, 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 prohibited and non-qualified investments.
Qualified and Non-Qualified Investments – TFSA Anti-Avoidance Rules: Prohibited and Non-Qualified Investments
Qualified investments are the types of investments that the Government of Canada intends for individuals to hold in their TFSAs. The Income Tax Act provides a list of types of qualified investments which include:
- Money and deposits with banks, trust companies, or credit unions;
- Securities listed on a designated stock exchange;
- Shares or debt of a public corporation;
- A unit of a mutual fund trust or share of a mutual fund corporation;
- Debt of the Government of Canada, a province, a municipality, or a Crown corporation;
- Gold and silver coins, bullion and certificates; and
- Shares of a specified small business corporation.
A specified small business corporation is generally a corporation incorporated in Canada that is not controlled by non-resident persons and substantially all the fair market value of the corporation’s assets are attributable to assets that are:
- used principally in an active business carried on in Canada by the corporation or a corporation related to it or
- shares or debt of connected small business corporations.
If an investment in a specified small business corporation meets the criteria for being a prohibited investment as described below the investment will not be a qualified investment. As such, taxpayers should be very cautious when investing in private corporations through a TFSA and should always consult with an expert Toronto tax lawyer before proceeding with the investment.
The Income Tax Act defines a non-qualified investment as any investment that is not a qualified investment. However, an investment that is not a qualified investment but also meets the criteria for prohibited investment status will be considered a prohibited investment only and deemed not to be a non-qualified investment. One example of a non-qualified investment is shares in a private non-resident corporation.
Prohibited Investments – TFSA Anti-Avoidance Rules: Prohibited and Non-Qualified Investments
The Income Tax Act definition of prohibited investment includes the following:
- a debt of the holder of the TFSA;
- a debt, share of, or an interest in, a corporation, trust or partnership in which the holder of the TFSA has a significant interest;
- a debt, share of, or an interest in a person or partnership with which the holder of the TFSA does not deal at arm’s length; or
- an interest in or right to acquire any of the above investments.
The term “a significant interest” generally refers to the holder of the TFSA having at least a 10% interest in the corporation, partnership, or trust. In making this assessment, the interests held by persons who do not deal at arm’s length with the holder of the TFSA are also counted towards the 10% threshold.
Tax on Non-Qualified and Prohibited Investments – TFSA Anti-Avoidance Rules: Prohibited and Non-Qualified Investments
If during a calendar year, a TFSA acquires a non-qualified or prohibited investment, or if an existing investment held by the plan becomes a non-qualified or prohibited investment, then the holder of the TFSA is required to pay a special tax. The amount of the tax is 50% of the fair market value of the investment at the time the event that led to the tax applying occurred.
The person liable to pay the tax on non-qualified or prohibited investments 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.
If the TFSA subsequently disposes of the non-qualified or prohibited investment then the holder of the TFSA becomes entitled to refund of the tax unless either:
- it is reasonable to consider the holder of the TFSA knew or ought to have known at the time the relevant investment was acquired by the TFSA that it was non-qualified or prohibited or that it would become so, or
- the relevant investment was not disposed of by the TFSA before the end of the calendar year following the calendar year in which the tax arose, or any later time that the Canada Revenue Agency considers reasonable in the circumstances.
Income Earned on Non-Qualified and Prohibited Investments – TFSA Anti-Avoidance Rules: Prohibited and Non-Qualified Investments
Income earned by a TFSA from a non-qualified investment is considered taxable income for the TFSA which pays tax at the top marginal rate. So for example if a TFSA holds shares in a private non-resident corporation which constitutes a non-qualified investment, then the TFSA will need to pay tax on the dividends it earns for holding the shares or the capital gain it realizes when it eventually sells the shares. Income from a prohibited investment constitutes a TFSA advantage[IT2] .
Subsequent generation income earned on taxable income earned by the plan from a non-qualified investment or on income from a prohibited investment generally gives rise to a TFSA advantage. For example, if a TFSA reinvests dividend income from either a non-qualified investment or a prohibited investment, even into a qualified investment, then all the income generated by the new investment constitutes a TFSA advantage.
A special TFSA advantage tax is payable by the holder of a TFSA that has given rise to a TFSA advantage during a calendar year. The amount of the tax is 100% of the TFSA advantage for the calendar year. The person liable to pay the tax on the 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 – TFSA Anti-Avoidance Rules: Prohibited and Non-Qualified Investments
CRA has the discretion to waive or cancel part or all of a taxpayer’s TFSA advantage tax or tax on non-qualified or prohibited investments 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 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 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 tax and why it would be just and equitable for the 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 utilized in order for the TFSA 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 tax.
The full definition of what constitutes a non-qualified or prohibited investment is quite comprehensive and the consequences of making a mistake are severe. Taxpayers should be extremely weary of making any investment in a TFSA if they are closely connected with the investment or if the investment is in a private business and consult with an experienced Toronto tax lawyer prior to proceeding with the plan.
In the event that you think you may have made a non-qualified or prohibited investment 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 a non-qualified or prohibited investment or apply for discretionary relief.
What is a TFSA?
A Tax Free Savings Account effectively allows individuals to contribute funds to a special account, up to a contribution limit, and invest the funds with all of the capital gains and investment income from those investments not being subject to income tax. The contribution limit increases by a set amount each year that an individual is over 18 years old and is a tax resident of Canada.
What is a Non-qualified Investment?
A type of investment that is not intended to be allowed in a TFSA. The full details of what is qualified are complex, but generally investments in public companies, mutual funds, or government debt are qualified investments, while private investments are at risk of being non-qualified.
What is a Prohibited Investment?
A type of investment that is not intended to be allowed in a TFSA. The full details of what is prohibited are complex, but generally investments in a business where you own at least 10% of the business or investments where you are not at arm’s length from the recipient of the investment are prohibited.