Tax-Free Savings Account Changes

On January 1, 2009, the very popular tax-free savings account (TSFA) became available to Canadians who are 18 years of age or older. The TFSA allows individuals to make non-deductible contributions of up to $5,000 per year, and any income or capital gains realized in the account are not taxable and may be withdrawn from the account at any time without tax. Furthermore, if the account holder makes a withdrawal from the plan, he or she may return the funds to the TFSA in a subsequent taxation year to "top it up."

In order to prevent abuses of the TFSA, the existing legislation contains provisions to penalize individuals who make contributions in excess of the $5,000 annual limit. The penalty is levied on the amount of the overcontribution at the rate of 1% per month. 

In addition, there are restrictions as to the type of investments that a TFSA can purchase. In general, these restrictions parallel the rules for registered retirement savings accounts, which limit investments to shares and debt of publicly traded corporations and mutual funds, as well as Guaranteed Investment Certificates and term deposits. The legislation also prohibits investments in entities in which the account holder has a significant interest (10% or more), or with which he or she does not deal at arm's length - generally referred to as "prohibited investments." An individual who owns a TFSA that acquires a non-qualified or a "prohibited investment" is currently subject to a penalty of 50% of the fair market value of the property. This penalty is refundable if the investment is disposed of by the end of the year following the year in which the investment was acquired, except where the individual knew or ought to have known that the investment was ineligible. Furthermore, income and capital gains realized on "prohibited investments" are subject to a tax of 150% of the tax that would be payable by the TFSA were it not for its special tax-free status. This tax is payable by the individual. (The 50% mark up is a proxy for provincial tax payable, since the provinces do not have similar provisions.) Finally, a TFSA that earns income or capital gains from non-qualified investments (other than "prohibited investments") is itself subject to tax on that income.

Notwithstanding these rather onerous penalties, some tax planners devised creative schemes to use TFSAs to generate income and capital gains that exceed the penalties. These schemes generally resulted in assets remaining in the TFSA in excess of the prescribed annual limits. These assets then continued to earn income on a tax-free basis within the account, and could also be withdrawn later without tax.

As a result, on October 16, 2009, the Minister of Finance announced new provisions to restrict perceived abuses of TFSAs. Specifically, the following additional penalties will be charged:

1. Income and capital gains earned on overcontributions and on "prohibited investments" will be taxed in the individual's hands at the rate of 100% (i.e. the entire amount of the income).
2. The existing tax on income and capital gains from "prohibited investments" will be cancelled.
3. The tax payable by the TFSA on income and capital gains earned on non-qualified investments (other than "prohibited investments") will be extended to include income on that income, and so on, thus restricting tax-sheltering of this ancillary income in the future.
4. Withdrawals of amounts in respect of overcontributions, prohibited investments, non-qualified investments, and income earned on those amounts will not constitute "distributions" for TFSA purposes and, as a result, will not create additional TFSA contribution room (i.e. they cannot be considered in the "top up" calculation).

Finally, it seems that some individuals engaged in "swap" transactions, whereby assets are purchased and sold between a TFSA and another account, such as a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF). When structured properly, these "swaps" allowed transfers of value from the RRSP/RRIF to the TFSA without paying the tax that would otherwise be payable on an RRSP/RRIF withdrawal. The new provisions will impose a penalty of 100% of the TFSA amounts reasonably attributable to these types of asset transfer transactions.

The new provisions will be applicable to all transactions after the date of the announcement. Draft legislation has not yet been introduced. Contact your Collins Barrow advisor to find out more about how these new TFSA rules will affect you.

Judy Moore, CA, is a Tax Partner in the Toronto office of Collins Barrow.