Department of Finance Squashes Aggressive TFSA Planning

By Evelyn Jacks, President, The Knowledge Bureau

On October 16, 2009, the Department of Finance moved to close several loopholes for TFSA investors including the prohibition of swap transactions between various investment accounts and the earning of income from prohibited and non-qualifying investments. The new rules, which will come into effect after October 16, 2009, contain four main components:

• Shifts in Value in Swap Transactions. Asset transfer or "swapî transactions between registered or non-registered accounts and Tax Free Savings Accounts, will no longer be possible after this date. That is, transfers between accounts of the same taxpayer or that of the taxpayer and an individual with whom the taxpayer does not deal at arm's length will be prohibited. This will squash any shift value from, for example, an RRSP to a TFSA without paying tax, first.

• Income from Intentional Overcontribution. Income earned within a TFSA due to an intentional overcontribution will be subject to a tax of 100%. Should a taxpayer have made an overcontribution in error, prompt rectification is required to avoid the penalty; such actions will be seen positively by the Minister, who will have the discretion to waive interest and penalties in those cases.

• Income from Investment in Non-qualifying and Prohibited Investments. In addition, should the taxpayer invest in non-qualifying investments (land and general partnership units, for example) or prohibited investments ( such as shares of the capital stock of a corporation in which the holder has a significant (10% or greater) interest and investments in entities with which the holder does not deal at arm's length), any income reasonably attributable to those prohibited investments will be considered an "advantage" and taxed at 100%.

• No New TFSA Room. The proposed amendments will also include rules to ensure that the withdrawal of amounts in respect of deliberate overcontributions, prohibited investments, non-qualified investments, asset transfer transactions and income related to those amounts do not constitute distributions for TFSA purposes and therefore will not create additional TFSA contribution room.

A brief review of TFSA Planning Rules:

1. What is a TFSA?

Unused contribution room can be carried forward on an indefinite carry forward basis. You can take money out, in other words, spend it on whatever you want, and then put it back in when you can because the TFSA contribution room has been preserved.

3. What happens when I make an overcontribution?

Taxpayers cannot contribute more than their available TFSA contribution room in a given year, even if they make withdrawals from the account during the year. If they do, a penalty tax of 1% of the highest excess amount in the month, for each month you are in an overcontribution position is charged. Discrepancies in contribution room limit or excess contributions, must be reported to the TFSA issuer.

In addition, after October 16, any income earned resulting from an overcontribution, or a contribution to a prohibited or non-qualifying investment will be taxed at 100%.

4. What income sources should be earned from the TFSA account?

That largely depends on age and sources of other income. Those sources of income subject to the marginal highest tax rates (such as interest) or dividends, which artificially inflate net income, thereby decreasing social benefits payments, should perhaps be earned within a TFSA. But if you are looking for real growth, the TFSA should contain a diversified set of investments, including equities.

Note that losses from investments earned within a TFSA are not deductible from capital gains held outside the account.

5. What are eligible investments for a TFSA?

The same eligible investments as allowed within an RRSP apply to the TFSA. A special rule will prohibit a TFSA from making an investment in any entity with which the account holder does not deal at arm's length.

Unlike the RRSP, contributions to a TSFA do not result in an income tax deduction and withdrawals from a TFSA are not reported as income nor included in income for any income-tested benefits, such as the Canada Child Tax Benefit or Goods and Services Tax Credit.

6. Do the Attribution Rules affect investments within the TFSA?

There is no attribution rule attached to the new TFSA, allowing adults, including parents and grandparents to transfer $5000 per year to each adult child in the familyófor the rest of their lives. In addition, one spouse may transfer property to the TFSA of the other spouse without incurring attribution.

7. Can the TFSA be used for retirement planning?