A tax-free savings account (TFSA) is a useful tool for saving money for short-term and long-term goals. Canadians can contribute a certain amount yearly and have tax-free growth in their TFSAs. However, there are certain TFSA restrictions to prevent abuse and manipulation of the plan.
For example, day trading in a TFSA is prohibited. A recent court ruling has sent a clear message to investors who use their TFSAs for frequent trading: You may have to pay taxes on your profits.
In this ruling, the Tax Court of Canada determined that an investor, whose TFSA had ballooned from $15,000 to over $617,000 in just three years, had been guilty of day trading within his plan.
Investors should know how to avoid prohibited day trading in their TFSA accounts and the consequences of failing to do so.
Notably, TFSA rules allow for a range of investments, including cash, GICs, bonds, stocks, ETFs, and mutual funds, among others.
What’s Considered Day-Trading in a TFSA?
Unfortunately, there is no specific test in the Income Tax Act on what constitutes day trading, as this is a fact-specific determination. “CRA generally considers day trading to occur when there is a high volume of trades, with a relatively brief period between buying and selling individual stocks, often within a single day,” explains Matt F. Trotta, vice president, of tax, retirement and estate planning, at CI Global Asset Management, in Calgary, Alberta
The CRA reviews multiple factors to determine if an investor is conducting business, including trade frequency, securities traded, investor skill, time spent trading, and intention to resell for profit.
“Since TFSAs are generally intended to be tax-free, the appearance of a taxable business within a TFSA presents an opportunity for increased tax revenue that CRA will continue to target,” says Trotta.
While there is no definitive criteria or threshold to establish what investment activities constitute ‘regular investment activities’, “the CRA does categorize activities like foreign currency trading, option writing, and excessive stock trading as business activities,” says David J. Rotfleisch, a tax expert at Rotfleisch & Samulovitch Professional Corporation, in Toronto.
Day trading, he adds, is grouped into excessive stock trading activities due to how frequently investors trade stocks within their TFSA accounts.
It is expected that following the recent Ahamed v. the King case, the CRA may further increase its scrutiny of TFSA accounts.
What Constitutes a "Qualified Investment" in a TFSA?
A qualified investment within a Tax-Free Savings Account (TFSA) is generally the same as those permitted in a Registered Retirement Savings Plan (RRSP).
As described in the Income Tax Act and its Regulations, they comprise money, GICs and other deposits, most securities listed on a designated stock exchange, mutual funds and segregated funds, bond, debt obligations of an exchange-listed corporation and those that have that have an investment grade rating, and others.
Based on the CRA’s definition of qualified investment, trading stocks is normally accepted. However, “the issue here is the risk of day traders being characterized as carrying on a business for trading in their TFSA accounts,” says Rotfleisch.
Additionally, some financial institutions that administer TFSAs may have internal policies that further limit the types of qualified investments that may be held by the plans they administer.
Where this becomes relevant for day trading is that “the frequent trading of many speculative securities that would otherwise be qualified investments can be an indication of running a day trading business,” Trotta notes.
As well, from a tax perspective, there are prohibited investments – such as investments in debt or shares of a company in which the investor owns at least a 10% stake or more -- that could attract severe tax penalties if found in an investor’s TFSA.
The Line Between Legit Investing and Day Trading
The goal of investing is to make gains, preferably large gains. This applies to TFSA as any other savings vehicle. For the investors holding investments over a longer time horizon, there is nothing to worry about. “Where it becomes unreasonable and worrisome is when [investment] strategies are assessed hourly, daily, or even weekly, and there is significant trading activity,” asserts Trotta.
As TFSAs are intended to be relatively passive in nature, one should be particularly mindful of the frequency of trades being made in these accounts. “While any large gain or large rate of growth may raise an eyebrow with CRA, the extent of activity is quite important, particularly if speculative securities form a significant part of one’s TFSA portfolio,” says Trotta.
The key yardstick, thus, should be how much time, effort, and skill one is expending to grow their portfolio, rather than mere growth of funds.
“In my view, investors should not be worried merely because they have qualified investments for a TFSA that have grown rapidly,” Trotta assures.
Rotfleisch complains that because TFSAs are uniquely designed to allow Canadians to increase their savings by earning tax-free investment income, punishing those who trade in TFSAs is an erroneous mistake in tax policy. “There should be no prohibition against trading stocks or participating in any qualified investment,” he argues.
“The investors already bear the heightened risks of losing their entire TFSA contribution by trading stocks, in contrast to those who choose more conservative and safer investments.”
Worse, the current law is more likely to hurt young investors than stop experienced traders from misusing the system, he adds.
Financial institutions should do more to alert investors the risks of their active participation in TFSA investments. “Quite often, they have failed to properly inform the investors,” Rotfleisch alleges.
If an investor plans to actively trade stocks in their TFSA, it is prudent to consult an experienced tax lawyer prior to any major or frequent transactions to understand and mitigate potential risks.
The Consequences of Crossing the Line
If a person is found to be running a day trading business through a TFSA, the main consequence will be the loss of the tax-free character of the TFSA. “All income and gains would be taxed as business income (which is taxed higher than at capital gains rates), along with potential interest and penalties if that income is added to a previous year’s tax return in a subsequent year,” Trotta warns.
There could be additional cost penalties as part of an unsuccessful litigation over and above the costs of representation through disputes and litigation processes.
“If CRA audits or reassesses a taxpayer, it’s likely they have gathered enough evidence to justify their position against the taxpayer,” says Trotta.
Even if CRA is ultimately proven incorrect during the audit process or at Tax Court, “it may be a costly and preventable dispute that a taxpayer could have prevented by obtaining advice in advance,” says Trotta.
