When Canada Revenue Agency (CRA) first announced in 2012 that it was launching an audit of tax-free savings accounts (TFSAs), it caused quite a stir. After all, the very name of the investment account implies that it’s beyond the reach of the taxman. The CRA, however, quickly justified its reasoning by claiming that the scope of the investigation will be limited only to individuals who are allegedly using their accounts to shelter business income generated from active trading.

However, many investors believe the CRA’s definition of business income is ambiguous. They also note that individuals who’ve realized significant gains in their TFSAs—through luck or skill—are likely to attract scrutiny even if their intentions were pure.

The Investment Industry Association of Canada, which represents securities dealers regulated by the Investment Industry Regulatory Organization of Canada, agrees, arguing that it’s not possible for TFSA trustees and issuers to determine if a TFSA has carried on a business.

Determining the TFSA’s Purpose

TFSAs were intended to promote investment in the economy while assisting Canadians in saving for the future. They’ve proven to be a very popular investment vehicle, reports the CRA, with more than 10.7 million Canadians having opened an account as of December 2013. The CRA, however, believes not all Canadians are using TFSAs as a savings tool, claiming a small subset is abusing the tax-free incentive to generate business income. The Income Tax Act indicates that if a TFSA carries on a business, it must be taxed on the income earned from that business. The CRA claims that an individual with a TFSA in which frequent and successful trading takes place is, in fact, carrying on a business of trading in securities. Therefore, gains from the sale of securities within a TFSA should be taxed as business income.

To find out whether a TFSA is engaged in active trading, the CRA applies the same factors used in tax case law to determine whether an individual’s or company’s gains or losses from dispositions of securities are on income or capital account. The process involves evaluating eight factors. Any combination of them can lead to an audit.

1. Frequency of transactions: There’s a history of extensive buying and selling of securities or of a quick turnover of properties in the account.
2. Period of ownership: Securities are usually owned only for a short time period.
3. Knowledge of securities markets: The taxpayer knows the securities markets.
4. Trading experience: Securities transactions form a part of a taxpayer’s ordinary business.
5. Time invested: The taxpayer spends much time studying the securities markets and investigating possible purchases.
6. Financing: Securities purchases are financed mainly by borrowing to invest or by another form of debt.
7. Advertising: The taxpayer has indicated he or she is willing to buy securities.
8. Nature of the securities: The securities are either non-dividend or speculative in nature.

In reality, the size of an individual’s TFSA is perhaps the most important indicator of whether or not the account is trading securities. It also happens to be very easy to measure. For example, if the current value of the account is much greater than the 2015 aggregate contribution limit of $41,000, and there have been many trades within a short period of time (factors 1 and 2), it’s likely the CRA will review the account.

The CRA may also point out that the extraordinary growth in the account shows that the individual directing the TFSA’s investments has a professional level of knowledge of the securities markets and must be spending a significant amount of time on the TFSA’s trading (factors 3 and 5).

Herein lies the core of the issue: TFSAs should not be permitted to compete on a tax-exempt basis with taxable businesses. This would constitute an unfair disadvantage to taxable businesses. But is it possible to distinguish between an active investor with a strong track record and an account being utilized as a business? The stakes are high. If a TFSA is carrying on a business, taxes will be imposed on the income earned by that TFSA (dividends, interest, and the full amount of gains net of losses, without the benefit of the normal 50 percent inclusion rate).

To date, total audits have been largely confined to a few large accounts. According to Philippe Brideau, assistant director of media relations and media monitoring with the CRA, “The CRA’s Aggressive Tax Planning program reviewed TFSAs with holdings several times greater than the contribution limit, and to date has selected fewer than 1% for audit because activity indicated use beyond the legislative intent.”

Causes and Effects

An unintended consequence of the CRA’s audit may ultimately be to inhibit active trading in TFSAs. After all, the intention of a TFSA is to earn a return through buying and selling securities.

An audit may also unfairly discriminate against investment professionals who are deemed to have “trading experience” and may devote (or appear to devote) substantial time to investing (factors 4 and 5).

It may also have significant implications for the investment industry. If the CRA issues an assessment, the trust company that held the TFSA during the assessment period is liable for that tax and obligated to cover any shortfall should assets within the TFSA be insufficient to cover the penalty taxes. This would pose significant problems, as it’s common for taxpayers to move their TFSA investments from one financial institution to another for a variety of reasons. As a result, by the time the financial institution receives an assessment from the CRA, the TFSA to which it pertains may reside with another institution. This will create much uncertainty and may induce the institution to use holdbacks and other limitations on the mobility of TFSAs.

Conclusion

In the near term, the CRA’s audit project remains controversial and continues to be challenged by investors and industry associations alike. Greater transparency from the CRA would certainly help alleviate investors’ fears, but in the interim, individuals with large TFSA balances should be wary.