The CRA is cracking down on aggressive manipulation of TFSAs and all other registered plans

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As Canadians, we sure do love our TFSAs. The ability to earn tax-free investment income and gains for life, coupled with the flexibility to withdraw funds, tax-free, at any time and for any purpose and then recontribute the amounts withdrawn in a subsequent year, make these savings vehicles a favourite choice among millions of taxpayers.

But, unfortunately, it seems the temptation to manipulate the completely tax-free nature of TFSAs is too great for some, which is why there are several anti-avoidance rules in the Income Tax Act to prevent abuse and manipulation of all registered plans, including not only TFSAs, but also RRSPs, RRIFs, RESPs and RDSPs.

This past week, the Canada Revenue Agency published an extensive folio going through what’s known as the “advantage rules” for registered plans and providing numerous examples of how the anti-avoidance rules work and when they might apply, because if they do apply, the result is extremely harsh.

How harsh? Well, if you do find yourself offside, then you could face a 100 per cent penalty tax on the fair market value of any “advantage” that you receive that is related to a registered plan. The CRA does have the ability to waive all or part of the tax “in appropriate circumstances.” While originally the advantage rules applied only to TFSAs, they were extended to RRSPs and RRIFs in early 2011 and to RESPs and RDSPs in early 2017.

The advantage rules are part of a broader set of rules in the Tax Act that govern registered plans. For example, these plans can only invest in property that is a “qualified investment” (such as publicly traded stocks, bonds, mutual funds, GICs) and must not invest in property that is a “prohibited investment” (generally, private company shares or debt in which the plan holder has a significant interest).

In addition, however, registered plans must avoid investments or transactions that are structured so as to “artificially shift value into or out of the plan or result in certain other supplementary advantages.” According to the CRA, “These rules … represent overriding investment restrictions for registered plans intended to guard against abusive tax planning.”

The CRA further states that the rules are mainly intended to target abusive tax planning arrangements “that seek to artificially shift value into or out of a registered plan while avoiding” the typical contribution limits for registered plans, such as the current $5,500 TFSA annual dollar limit or the 2018 maximum RRSP deduction limit of $26,230 (or 18 per cent of the prior year’s earned income, if lower).

One example of an advantage is a deliberate over-contribution to a TFSA where an individual intentionally contributes more to her TFSA than her TFSA contribution limit with a view to generating a rate of return sufficient to outweigh the cost of the regular 1 per cent per month TFSA over-contribution tax.

Another situation that could give rise to an advantage is where an individual receives a benefit personally arising for his investment inside a registered plan. The CRA cites the somewhat unrealistic example of Daniel who buys units of a mutual fund in his RRSP that owns a number of rental properties at various ski resorts in Canada. As an investor in the fund, Daniel is entitled to rent any of the properties at a 25 per cent discount from the normal commercial rental rate. In January, Daniel rents one of the properties for two weeks for $750 per week, instead of the normal rate of $1,000 per week. The $500 discount constitutes a benefit that is conditional on the existence of Daniel’s RRSP and thus Daniel is therefore liable to pay advantage tax of $500.

An advantage also can include an increase in the total FMV of an investment held inside a registered plan which can be attributed to “a transaction or event … that would not have occurred in a normal commercial or investment context between arm’s-length parties acting prudently, knowledgeably and willingly, and one of the main purposes of which is to benefit from the tax-exempt status of the plan.’’

The CRA cites an example of an employer, a private company, that is looking to take advantage of the tax-free status of a TFSA. The private corporation issues a special class of non-voting preferred shares to the TFSAs of several key employees and sets both the subscription price and redemption value at $10 per share. Employees are required to have their shares redeemed when they leave the company.

Each year, the amount of dividends payable on the shares is determined at the discretion of the board of directors, but ranges between $50 and $150 per share per year, based on the financial performance of the corporation against pre-established performance benchmarks. In the CRA’s mind, this arrangement is “not commercially reasonable” and thus would give rise to an advantage as it would be reasonable to consider that the dividend payments were made “in substitution of the corporation paying bonuses or other remuneration to the employees.”

While the examples cited in the newly released bulletin are theoretical, a recent decision of the Tax Court, also out this week, involved a taxpayer who was reassessed nearly $125,000 in penalty tax applicable to the advantage the CRA says he received in connection with the transfer of private company shares to his TFSA.

The taxpayer went to court to challenge the constitutionality of the 100 per cent advantage tax on two grounds. The first was that a 100 per cent tax “fell within the provincial jurisdiction of property and civil rights … since the 100 per cent tax rate was a confiscation of property and was not necessary to the effective exercise of the federal taxation power as it overreached what was necessary to meet the aims of the section.”

The taxpayer’s second argument was that because the CRA has the discretion to reduce the 100 per cent advantage tax to zero, “Parliament … improperly delegated the rate-setting element of (tax) … to the (CRA) … in contravention of … the Constitution Act.”

Not surprisingly, the court disagreed concluding that the rule taxing the advantage at 100 per cent did not infringe on the right to make laws respecting property and civil rights on the basis that the section was “in pith and substance” taxation and “fell within a valid TFSA scheme of taxation within a valid (Tax Act).”

The judge, upholding the 100 per cent advantage tax, concluded, “The provisions are clear, were properly passed by Parliament into law … and are constitutionally valid.”