CLIENTS WHO HAVE BEEN USING tax-free savings accounts (TFSAs) to shelter gains achieved from certain kinds of trading may face serious tax penalties, as the federal government moves to penalize some of these types of transactions.

Although the relatively new TFSA is intended to assist ordinary savers, it didn’t take long for some professional investors to find ways to shelter large trading gains in their TFSAs, which is contrary to the legislative purpose of these accounts.

These “inappropriate transactions,” as the Canada Revenue Agency (CRA) calls them, were prohibited by the CRA in 2009, the year TFSAs were launched. But the agency now has embarked on a review of TFSAs having large gains. According to CRA spokeswoman Mylene Croteau, the agency has “initiated a number of audits of TFSAs to ensure compliance with the Income Tax Act.”

If taxpayers are found to have breached the rules, Croteau says, those transgressors could be subject to a “tax on advantage” that could amount to 100% of the impugned gains.

The TFSA rules – and the latest enforcement efforts – are, Croteau says, “intended to prevent transactions designed to shift otherwise taxable income artificially into the shelter of the TFSA or to circumvent the TFSA contribution limits.”

Since 2009, Canadians over the age of 18 have been able to contribute $5,000 annually to their TFSAs. These contributions can be placed in qualified investments, including securities listed on designated stock exchanges, government and corporate bonds, investment funds, money market instruments and guaranteed investment certificates.

Theoretically, the value of a TFSA in 2012 should be equivalent to no more than $20,000 ($5,000 per year for four years), plus or minus any investment gains or losses.

However, some individuals apparently have been able to accumulate six-figure amounts in their TFSAs through what the CRA refers to as “tax planning schemes” or “aggressive tax planning.”

Says David Ablett, director of tax and retirement planning with Winnipeg-based Investors Group Inc.: “[These individuals] were able to manipulate the prices of securities by using [daily] swaps, which resulted in significant capital gains in their TFSAs – catching the attention of the CRA.”

Jamie Golombek, managing director of tax and estate planning with the private wealth-management division of Canadian Imperial Bank of Commerce in Toronto, says these types of swaps were used by mostly “professionals” in the first year following the launch of the TFSA but were then disallowed in October 2009.

More specifically, these transactions involve the non-arm’s-length transfer of securities between an investment account and a TFSA account, shifting value to or from the TFSA using daily trades in the same security.

A typical swap transaction, Golombek explains, takes advantage of wide differences between the bid and ask prices of a thinly traded security.

For example, the investor will swap, for cash, 100,000 shares of a security with a bid price of 10¢ and an ask price of 20¢ from a non-registered account to a TFSA, using the bid price. The value of the transaction is $10,000 (100,000 shares x 10¢). On the same day, the securities are swapped back into the investment account at the ask price of 20¢, for a value of $20,000 (100,000 shares x 20¢), allowing the “gain” of $10,000 to remain within the TFSA. In this example, the investor is able to move an additional $10,000 into the TFSA, as payment for the security.

@page_break@ Golombek says that in this type of transaction “investors [do] not make any real money” but are able to benefit by avoiding taxes by using their TFSAs.

Ablett adds that any gains made by additional contributions “can be withdrawn from the TFSA without being subject to taxes” – thus providing an additional benefit to the accountholder. He cautions that the CRA has indicated that it will be applying the “anti-avoidance” rule to inappropriate transactions of this nature.

Croteau says that the CRA has been sending out risk-assessment questionnaires to accountholders to identify TFSA accounts for audit based on the type of investments made, the nature of the transactions carried out and the amounts involved in of those transactions.

“Because different types of investments can be held in a TFSA,” Croteau says, “the questionnaire is a valuable tool to get details on what investments are held in a taxpayer’s TFSA.”

The audits will be looking not only at swap transactions but also at deliberate overcontributions, prohibited investments and non-qualified investments.

In the case of swap transactions, a Department of Finance memo dated Oct. 16, 2009, states that a 100% tax will apply to “transactions or events that would not have occurred in an open market in which parties deal with each other at arm’s length.”

With respect to deliberate overcontributions, a tax of 1% per month is applied on the highest amount of excess contributions for the month. The Department of Finance’s memo cautions that it is aware that in some cases, deliberate overcontributions are made with the intent of generating returns that will offset the tax on overcontributions. In such instances, the anti-avoidance rule may apply.

Prohibited and non-qualified investments may be subject to a tax equivalent to 50% of the fair market value of the property – or more, in certain circumstances. Prohibited investments include an interest or investment of 10% or more in entities in which the accountholder does not deal at arm’s length. Non-qualified investments include land (real estate) and general partnership units.

“As new audits commence,” Croteau says, “each taxpayer under audit will receive a questionnaire.”

Most of your clients who hold TFSAs, however, should not worry. Those who have realized large gains through strong investing choices, for instance, are not the target of the CRA audit.

“For the taxation year 2009,” Croteau says, “less than 1% of TFSA holders were audited for aggressive tax-planning activities.”

© 2012 Investment Executive. All rights reserved.