One of the best things about a tax-free savings account (TFSA) is that it’s not just for saving — it’s also forinvesting. Indeed, you can hold a variety of assets inside a TFSA including stocks, bonds, exchange-traded funds and mutual funds — and the income you earn on those investments is sheltered from tax. As such, TFSAs can be an especiallygood wealth-building option for incorporated physicians.
Buta recent court rulingthat Vancouver-based investment adviser Fareed Ahamed must pay income tax on nearly $600,000 of investment returns he made over four years day trading in a TFSA has left some Canadians asking: are stock earnings inside a TFSA tax-free or not?
The answer is yes if you follow the rules surrounding TFSA investments. Here’s a simple guide that will help you understand what the TFSA stock trading rules are, why Ahamed’s day trading activities ran afoul of those rules, and how you can avoid a tussle with the taxman.
When are TFSA stock trades taxable?
In most cases, the investment earnings that the average Canadian would make from trading stocks within a TFSA truly are tax-free. However, according to theIncome Tax Act, there are a couple of major exceptions. An account holder must pay tax on income within a TFSA when:
- the income is earned from non-qualified investments
- the income is earned from a business
We explain both of these scenarios in detail below.
What kind of stocks can you trade in a TFSA?
Only “qualified” investments can be held and traded in a TFSA. These include:
- cash, GICs and other deposits
- most securities listed on a designated stock exchange, such as shares of corporations, warrants and options, and units of exchange-traded funds and real estate investment trusts
- mutual funds and segregated funds
- Canada Savings Bonds and provincial savings bonds
- debt obligations of a corporation listed on a designated stock exchange
- debt obligations that have an investment grade rating
Generally,the financial institution that administers your TFSA is responsible for monitoring your account to screen out non-qualified or prohibited investments. These might include equities that are not listed on a designated stock exchange, foreign mutual funds, or anyasset that you’re closely connected to, such as shares of a company or a partnership in which you have at least a 10% interest.
If you hold non-qualified investments in your TFSA portfolio, you’ll have to pay a 50% tax on the value of the investment, as well as capital gains taxes on any income earned on the non-qualified investment.
Incidentally, all the securities Ahamed traded in his TFSA were qualified investments–mostly penny stocks listed on the TSX Venture Exchange–so this wasn’t how he violated the TFSA trading rules. Rather, the Tax Court of Canada ruled that his frequent TFSA day trading amounted to running a business.
When is TFSA stock trading considered a business?
The Canada Revenue Agency (CRA) determines whether an individual’s stock trading constitutes a business on a case-by-case basis. Some of the factors it considers include:
- Frequency of transactions:There is a history of extensive buying and selling of securities, such as day trading.
- Period of ownership:Securities are usually owned only for a short period of time.
- Knowledge of securities markets:The account holder has some experience in securities trading.
- Security transactions form a part of a taxpayer’s ordinary business.
- Time spent:Significant time is spent studying the securities markets and investigating potential purchases.
- The type of investment: Investments are generally speculative or a non-dividend type.
It’s important to note that the size of the investment account or the amount of financial gain isnota determining factor.
“If someone was lucky or astute enough to buy shares of Tesla at the equivalent of US$1.50, hold onto them, and sell at the peak of more than US$400, those capital gains are rightly tax-free. This is not the same as someone who actively buys and sells securities on a regular basis, as that is, in effect, running a business,” noted a Toronto-based tax lawyer and CPA in aGlobe and Mailopinion piece.“The issue is not the amount of profit but rather the method by which that profit was earned.”
So, while Ahamed’s hefty TFSA returns may have been what alerted the CRA to investigate further, that wasn’t the reason the tax court ruled that he was running a business and his investment earnings are taxable. Rather, as a licensed investment adviser who was day trading in speculative penny stocks and only holding them for brief periods, Ahamed meets a number of the above criteria. Nevertheless, he is appealing the tax court’s decision.
What about day trading in other registered accounts?
You don’t have to pay tax on business income earned on qualified investments inregistered retirement savings plans (RRSPs)orregistered retirement income funds(RRIFs), because different rules apply to these accounts. However, you do need to pay income tax at your marginal rate on any amounts you withdraw from an RRSP or RRIF during retirement, so you’re still eventually paying taxes on your investment profits.
How to avoid TFSA day trading penalties
Unless you’re moonlighting as a professional investment adviser–or day trading is taking up a significant chunk of your time–you probably don’t have to worry about paying taxes on your qualified TFSA stock trades.If you’re concerned, however, it’s best to speak to an accountant or other tax professional.
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.
