The Department of Finance's plan to crack down on tax-fee savings account (TFSA) abuses might well have been subtitled, "Games people play with their TFSAs."
The TFSA allows Canadians 18 years of age or older to contribute up to $5, 000 annually, sheltering all income or gains from tax for life. TFSA withdrawals are also tax-free. Not surprisingly, some have tried to exploit the TFSA and look for loopholes to avoid paying tax. Finance is attempting to close the loopholes with proposed changes to the Income Tax Act.
So, what were sophisticated, savvy investors doing and how is the government trying to prevent future abuses? Let's examine three scenarios:
* Tom decides to over-contribute to his TFSA in 2009. While his contribution limit is only $5,000, he decides to invest an additional $100,000 in one million shares of a junior mining stock trading on the TSX Venture at 10 cents a share, based on speculation that the stock will double within the next couple of weeks.
Tom is willing to pay the 1% per month penalty tax on the over-contributed amount, which equates to $1,000 the first month. Fortunately for Tom, the stock doubles and he immediately withdraws his $100,000 over-contribution. His TFSA has therefore realized a $100,000 gain, tax free, and his cost was only the $1, 000 penalty. Under the proposed rules, $100,000 of penalty tax will be payable, equal to the entire $100,000 gain, thus erasing the benefit of such a transaction.
* Dick invests $5,000 of his TFSA in private company shares of which he is a significant shareholder (he owns more than 10%). These shares are a prohibited investment for a TFSA. The company subsequently declares a $1-million dividend on the shares held by the TFSA.
Currently, Dick would pay a one-time penalty tax equal to 150% of the normal tax that would have been payable on the $1-million dividend if earned outside the TFSA. The $1-million, however, could remain inside the TFSA and grow tax- free for life, resulting in "an unintended permanent increase in TFSA savings and contribution room." Under the proposed amendments, any income attributable to prohibited investments will be taxed back at 100% -- that is, $1-million of tax will be payable.
* Harry swaps $5,000 of thinly traded shares that have a bid price of 10 cents but an ask price of 30 cents from his non-registered account to his TFSA for cash, using the 10 cents price. The shares are then swapped back for cash a few days later to Harry's non-registered account for 30 cents per share, allowing the $10,000 "gain" to remain inside the TFSA. Under the proposed rules, the entire gain on the swap transaction would be taxed back at 100%, causing Harry to forfeit his $10,000 profit.