The Canada Revenue Agency offered a chilling take on tax-free savings account overcontributions at this week’s annual conference of the Society of Trust and Estate Practitioners (STEP) Canada while answering member questions during a virtual roundtable session.
But before sharing that response, let’s get up to speed on TFSA rules. In 2021, any resident of Canada who is 18 or over can contribute $6,000 to their TFSA for the current calendar year. Depending on your age, your limit for 2021 could be as high as $75,500 if you’ve never made a TFSA contribution before, since unused room automatically carries forward from one calendar to the next. Investors can also recontribute any TFSA withdrawals back into their TFSA beginning the calendar year following the year of withdrawal.
Given all that, it’s no wonder some get tripped up by their TFSA contribution limit and face the dreaded overcontribution penalty tax, which is equal to one per cent per month for each month you’re accidentally over the limit. You can request the CRA to waive or cancel the tax, which it has the power to do, if it can be established that the tax arose “as a consequence of a reasonable error” and the overcontribution is withdrawn from the TFSA “without delay.”
What is a ‘reasonable’ error?
In a recently published technical interpretation, the CRA provided taxpayers with some helpful guidance on the meaning of “reasonable error” and when it would consider cancelling a TFSA (or registered retirement savings plan) overcontribution penalty.
The CRA said it can waive the penalty tax on excess TFSA or RRSP contributions if the taxpayer can satisfactorily establish that the excess contributions subject to tax are the result of a reasonable error. In the case of excess RRSP contributions, it must also be shown that reasonable steps have been or are being taken to eliminate the excess, while in the case of excess TFSA contributions, one or more distributions are made without delay to eliminate the excess.
If more than one particular event has caused the excess contribution, each event will be separately considered. Waiver requests must be submitted in writing and be accompanied by all supporting documentation.
The term “reasonable error” is not defined in the Income Tax Act, but the CRA uses certain “internal general guidelines” to assess applications for waiving the tax on excess TFSA and RRSP contributions. The guidelines are reviewed on an ongoing basis and are adapted to the evidence submitted by the taxpayer in a specific situation.
The end result is that “each situation must be considered on a case-by-case basis in light of all the facts, circumstances and relevant documentation in relation to the particular situation.”
The CRA further explained that, according to its guidelines, a reasonable error means that the overcontribution is “truly the result of an error and that the taxpayer did not intentionally overcontribute. For the error to be reasonable, it must also be considered by an objective person … to be more likely to occur rather than less likely to occur based on the circumstances of the taxpayer.”
Ignorance of the law is not accepted as a reasonable error. The CRA cited a 2019 federal court of appeal case involving an RRSP overcontribution penalty, which stated that “(b)ecause the Canadian tax system is based on self-assessment, it is incumbent on taxpayers to take reasonable steps to comply with (the Income Tax Act), including by seeking advice where necessary.” Accordingly, the CRA generally won’t accept the claim of ignorance of the law as a basis for granting a waiver.
The CRA also said that arguing a taxpayer relied on the advice of a third party, such as a financial institution, employer or financial adviser, won’t fly as an excuse to get out of the overcontribution tax.
Other factors the CRA takes into account include the taxpayer’s compliance history (particularly with respect to previous excess contributions), as well as whether the taxpayer has suffered physical or mental duress (caused by death, serious illness or accident in the immediate family, marital separation, loss of employment, and natural or manmade disasters) during the period for which relief is sought.
The CRA’s chilling take
At the STEP conference, the CRA was posed with the following scenario (humbly submitted, in advance, by this columnist and loosely based on a real-life situation.) A taxpayer moves to Canada in 2021 and opens a TFSA soon afterwards. Because he was previously a non-resident, the taxpayer’s TFSA contribution room for 2021 is only $6,000. Due to a misunderstanding of the rules, the taxpayer contributes $18,000 to his TFSA and invests it all in the shares of one company. Before he has a chance to withdraw the $12,000 overcontribution, the company goes bankrupt and the value of the TFSA goes to zero. How can the taxpayer stop the TFSA overcontribution tax or request a waiver of the tax if he can no longer withdraw the overcontribution? Does he need to wait two years for new TFSA contribution room to open up?
The CRA responded that the excess TFSA amount will only be reduced once new contribution room becomes available to the taxpayer over the next two years. “Unfortunately, in this situation, since the individual is not able to withdraw any amounts from their TFSA, the conditions in (the act) wouldn’t be met … so the (CRA) wouldn’t have the authority to waive or cancel any of the (penalty) tax,” the CRA official said.
Assuming the individual doesn’t make any additional contributions to his TFSA before 2024 and the TFSA dollar limit for each of 2022 and 2023 remains at $6,000, the excess TFSA amount would be reduced to $6,000 as of Jan. 1, 2022, and fully eliminated as of Jan. 1, 2023. The net result is that the individual would be liable for the one-per-cent monthly tax in 2021 and 2022. The individual could resume making contributions to their TFSA again in 2023.
This is a seemingly harsh result, with no opportunity for relief. In this case, you can always try seeking a remission order.