TFSA Anti-Avoidance Rules: Prohibited And Non-Qualified Investments – Canadian Income Tax - Tax Authorities - Tax (2024)

TFSA BACKGROUND – TFSA ANTI-AVOIDANCE RULES: PROHIBITEDAND NON-QUALIFIED INVESTMENTS

Tax Free Savings Account (TFSA) plans are a tax efficient methodof investment for individuals created by the government toencourage Canadians to save for retirement or other shorter-termgoals.

The basic structure of aTFSAis that a financial institution (theissuer) holds investments in a special account (the TFSA) for anindividual with whom the issuer has a contract or arrangement thatmeet certain requirements. The individual is called the"controlling individual" of the TFSA. The TFSA can theninvest the contributions into various types of investments. Theholder of a TFSA cannot carry on a business in his or her TFSA(e.g. a business actively trading securities or running a marijuanastore) without facing adverse tax consequences. TFSAs are notallowed to own certain "non-qualified" or"prohibited" investments. Cryptocurrencies cannot be heldin a TFSA directly, although it is possible to hold them in a TFSAindirectly through anexchange traded fund [IT1]or similar securities. The TFSA itself is exemptfrom income tax and withdrawals from a TFSA by the individual donot give rise to an income inclusion. This effectively means thatan individual can use a TFSA to invest 'after tax' moneyand not pay tax on the investment income (e.g. capital gains,interest, dividends) earned on the investment. Unlike with aRegistered Retirement Savings Plan (RRSP), there is no deductionavailable when a contribution is made to the TFSA nor any taxliability when funds are withdrawn.

Only Canadian tax resident individuals who have TFSAcontribution room can make a contribution to a TFSA. Everyindividual who is both of age 18 or older and a tax resident ofCanada at some point during a year will accumulate TFSAcontribution room for that year. The government specifies a fixedTFSA dollar limit which is the amount by which contribution roomincreases for every qualified individual. The TFSA dollar limit for2022, as for recent years, is $6,000. Unused contributionroom will be carried over into future years indefinitely. When anindividual makes a withdrawal from his or her TFSA, the amount ofthe withdrawal will be added to his or her contribution room at thestart of the next calendar year.

To maintain the integrity of the TFSA system, theCanadianIncome Tax Actcontains numerousanti-avoidance rules which can result in severe tax problems fortaxpayers. This article focuses on the anti-avoidance rulesregarding prohibited and non-qualified investments.

Qualified and Non-Qualified Investments – TFSAAnti-Avoidance Rules: Prohibited and Non-QualifiedInvestments

Qualified investments are the types of investments that theGovernment of Canada intends for individuals to hold in theirTFSAs. TheIncome Tax Actprovides a list oftypes of qualified investments which include:

• Money and deposits with banks, trust companies, or creditunions;
• 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 fundcorporation;
• 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 acorporation incorporated in Canada that is not controlled bynon-resident persons and substantially all the fair market value ofthe corporation's assets are attributable to assets thatare:

• used principally in an active business carried on in Canada bythe 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 meetsthe criteria for being a prohibited investment as described belowthe investment will not be a qualified investment. As such,taxpayers should be very cautious when investing in privatecorporations through a TFSA and should always consult with anexpert Toronto tax lawyer before proceeding with theinvestment.

TheIncome Tax Act defines a non-qualifiedinvestment as any investment that is not a qualified investment.However, an investment that is not a qualified investment but alsomeets the criteria for prohibited investment status will beconsidered a prohibited investment only and deemed not to be anon-qualified investment. One example of a non-qualified investmentis shares in a private non-resident corporation.

PROHIBITED INVESTMENTS –TFSA ANTI-AVOIDANCE RULES:PROHIBITED AND NON-QUALIFIED INVESTMENTS

TheIncome Tax Actdefinition of prohibitedinvestment includes the following:

• a debt of the holder of the TFSA;
• a debt, share of, or an interest in, a corporation, trust orpartnership in which the holder of the TFSA has a significantinterest;
• a debt, share of, or an interest in a person or partnershipwith which the holder of the TFSA does not deal at arm'slength; or
• an interest in or right to acquire any of the aboveinvestments.

The term "a significant interest" generally refers tothe holder of the TFSA having at least a 10% interest in thecorporation, partnership, or trust. In making this assessment, theinterests held by persons who do not deal at arm's length withthe holder of the TFSA are also counted towards the 10%threshold.

TAX ON NON-QUALIFIED AND PROHIBITED INVESTMENTS–TFSA ANTI-AVOIDANCE RULES: PROHIBITED ANDNON-QUALIFIED INVESTMENTS

If during a calendar year, a TFSA acquires a non-qualified orprohibited investment, or if an existing investment held by theplan becomes a non-qualified or prohibited investment, then theholder of the TFSA is required to pay a special tax. The amount ofthe tax is 50% of the fair market value of the investment at thetime the event that led to the tax applying occurred.

The person liable to pay the tax on non-qualified or prohibitedinvestments in a calendar year is required to file a correspondingform RC339 tax return and pay the tax before July of the followingcalendar year. As with regular income tax, interest will accrue ona late payment and penalties may apply if a return is filed late ornot filed at all.

If the TFSA subsequently disposes of the non-qualified orprohibited investment then the holder of the TFSA becomes entitledto refund of the tax unless either:

• it is reasonable to consider the holder of the TFSA knew orought to have known at the time the relevant investment wasacquired by the TFSA that it was non-qualified or prohibited orthat it would become so, or
• the relevant investment was not disposed of by the TFSA beforethe end of the calendar year following the calendar year in whichthe tax arose, or any later time that the Canada Revenue Agencyconsiders reasonable in the circ*mstances.

INCOME EARNED ON NON-QUALIFIED AND PROHIBITED INVESTMENTS–TFSA ANTI-AVOIDANCE RULES: PROHIBITED ANDNON-QUALIFIED INVESTMENTS

Income earned by a TFSA from a non-qualified investment isconsidered taxable income for the TFSA which pays tax at the topmarginal rate. So for example if a TFSA holds shares in a privatenon-resident corporation which constitutes a non-qualifiedinvestment, then the TFSA will need to pay tax on the dividends itearns for holding the shares or the capital gain it realizes whenit eventually sells the shares. Income from a prohibited investmentconstitutes aTFSA advantage[IT2].

Subsequent generation income earned on taxable income earned bythe plan from a non-qualified investment or on income from aprohibited investment generally gives rise to a TFSA advantage. Forexample, if a TFSA reinvests dividend income from either anon-qualified investment or a prohibited investment, even into aqualified investment, then all the income generated by the newinvestment constitutes a TFSA advantage.

A special TFSA advantage tax is payable by the holder of a TFSAthat has given rise to a TFSA advantage during a calendar year. Theamount of the tax is 100% of the TFSA advantage for the calendaryear. The person liable to pay the tax on the TFSA advantage in acalendar year is required to file a corresponding form RC339 taxreturn and pay the tax before July of the following calendar year.As with regular income tax, interest will accrue on a late paymentand penalties may apply if a return is filed late or not filed atall.

DISCRETIONARY RELIEF –TFSA ANTI-AVOIDANCE RULES:PROHIBITED AND NON-QUALIFIED INVESTMENTS

CRA has the discretion to waive or cancel part or all of ataxpayer's TFSA advantage tax or tax on non-qualified orprohibited investments owing in circ*mstances where the CanadaRevenue Agency determines that it would be just and equitable to doso. Some of the circ*mstances in which CRA may exercise itsdiscretion are:

• when the tax arose as a consequence of a reasonable error,
• when the transactions that gave rise to the tax also gave riseto another tax under theIncome Tax Act,
• when payments have already been made from the TFSA.

To request that TFSA tax be waived or cancelled, thetaxpayer's experienced Canadian tax lawyer must submit awritten application to the CRA's Pension Workflow Team locatedat either the Sudbury Tax Centre or the Winnipeg Tax Centredepending on the location of the taxpayer's residentialaddress. The application should describe in detail thecirc*mstances giving rise to the tax and why it would be just andequitable for the tax to be waived or cancelled.

Note that the CRA's taxpayer relief and voluntarydisclosures programs which offer penalty and interest relief insome circ*mstances cannot be utilized in order for the TFSA taxitself to be waived or cancelled because it is a tax and not apenalty. It is possible however to get relief under those programsfrom penalties or interest associated with the TFSA tax.

FAQ

WHAT IS A TFSA?

A Tax Free Savings Account effectively allows individuals tocontribute funds to a special account, up to a contribution limit,and invest the funds with all of the capital gains and investmentincome from those investments not being subject to income tax. Thecontribution limit increases by a set amount each year that anindividual is over 18 years old and is a tax resident ofCanada.

WHAT IS A NON-QUALIFIED INVESTMENT?

A type of investment that is not intended to be allowed in aTFSA. The full details of what is qualified are complex, butgenerally investments in public companies, mutual funds, orgovernment debt are qualified investments, while privateinvestments are at risk of being non-qualified.

WHAT IS A PROHIBITED INVESTMENT?

A type of investment that is not intended to be allowed in aTFSA. The full details of what is prohibited are complex, butgenerally investments in a business where you own at least 10% ofthe business or investments where you are not at arm's lengthfrom the recipient of the investment are prohibited.