When you've been hanging around the financial services world as long as I have, you inevitably come to understand the many ways that people can make money. Some stories are as improbable as, say, an adult accidentally swallowing a toothbrush (it's rare but it happens; just ask British student Georgie Smith, now 21, who, to the best of my knowledge, is the latest person to do this).
Take, for example, the improbability that your tax-free savings account (TFSA) today might be worth many hundreds of thousands of dollars – perhaps even millions. The fact is, there are more Canadians in this boat than you might think. And the Canada Revenue Agency (CRA) isn't happy about it.
In my recent discussions with the CRA, it's clear that rumours of a tax-audit project focusing on TFSAs are true. The CRA seems to be focusing on TFSAs that have a very significant value. And perhaps this should be no surprise, because those dollars will one day be withdrawn tax-free. It's not clear what dollar value in a TFSA might create a red flag for the taxman.
A big area of concern for the CRA is where investors are actively trading – often called day trading – in their TFSAs. In these cases, when certain criteria are met, the CRA may come to the conclusion that an individual is actually carrying on a business when trading in securities – sometimes referred to as an "adventure in the nature of trade" – in which case the profit could be taxed as business income. The CRA's argument is that business income earned inside a TFSA should be taxable (unlike capital gains, which would be tax-free inside the plan). There have been no court cases yet on this issue, but I expect we'll see a case or two in the next couple of years.
The RRSP comparison
Let's think about registered retirement savings plans for a minute. RRSPs, to my knowledge, have never been attacked when a taxpayer is successfully day-trading in his account. And no wonder, because those assets are taxed when they're withdrawn. Why should the CRA take offence? In fact, the CRA will collect more tax if the taxpayer is successful in his or her RRSP investing.
So, to attack TFSAs is to suggest that profitable active trading is offensive only to the extent that the profit can be withdrawn tax-free. Perhaps the CRA has forgotten that, unlike RRSPs, there was no tax deduction available to the taxpayer when money was contributed to the TFSA. In fact, a TFSA doesn't leave a taxpayer better off than an RRSP if his marginal tax rate stays the same or falls between the time of the contribution and the time of withdrawal (see the table below for a comparison). This is true even if the rate of return in the plan is very high. So, why should the CRA take offence to active trading in a TFSA when they aren't concerned about it in RRSPs? It makes no sense mathematically.
The CRA's approach to this issue makes no sense. It seems that if you're trading actively inside your TFSA, and you're successful at it, the taxman will take offence. But what if you're not successful? Will the CRA then allow you to claim the losses that are inside your TFSA? The fact is, there are many more investors who make little or no money – or even lose money – at the day-trading game. If the CRA wants to go down this path of taxing profit realized inside a TFSA, then it had better be prepared to allow losses to be claimed on the flip side.
From my experience, there are many more Canadians who could arguably claim business losses from their trading activities than actually do. Most of these people simply report their losses as capital losses because they aren't aware of the issue and don't think about reporting any differently. You can bet that if the CRA starts to tax profits inside TFSAs, there will be a groundswell of information-sharing, these very same taxpayers will start thinking about the issue, and they'll become more diligent about documenting their arguments for claiming business losses rather than capital losses. Imagine the look on the finance minister's face when he learns that attacking TFSAs has actually resulted in a net revenue loss to the government.
It's also clear that the taxman has lost sight of the fact that investors who realize large profits also take on large risks. Forcing them to pay tax on profits when taking on more risk, while others who take on less risk receive tax-free growth inside their TFSAs, is nonsensical.
Globe app users click here for TFSA vs RRSP comparison table
Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.
TFSA vs RRSP Comparison
|Income before taxes||$1,000||$1,000|
|Income taxes (40%)||400||-|
|Amount of contribution||600||1,000|
|Value after 20 years (7% growth)||2,322||3,870|
|Income tax on withdrawal (40%)||-||1,548|
|After-tax cash in hand||$2,322||$2,322|