TFSA move targets savvy investors

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Finance Minister Jim Flaherty's crackdown on Tax Free Savings Accounts targets a small group of savvy investors and traders, who are taking advantage of loopholes and insufficient penalties to reap significant rewards, but will leave most Canadians unscathed.

Introduced at the start of this year, TFSAs allow people to save or invest $5,000 a year for any purpose - retirement, education or a rainy-day fund - without paying tax on any gains. The problem is that some sophisticated market players are using them as an active-trading tax avoidance scheme.

"For the average everyday Canadian who is putting $5,000 a year into a TFSA account, these changes will be of absolutely no interest," said Jamie Golombek, managing director tax and estate planning CIBC Private Wealth Management. "It is a group of highly sophisticated traders and investors who are exploiting the rules. It is not a lot of people, but the people who do it have huge opportunities for tax-free gains."

In an announcement released late Friday, the Finance Minister unveiled a series of changes designed to clamp down on "inappropriate transactions to draw excessive benefits." The changes, which kicked in on Saturday, aim to eliminate schemes that involve investors making deliberate over-contributions or unapproved investments because the tax-free gains exceed the penalties.

The first loophole Mr. Flaherty is trying to close is deliberate over-contribution, where people put money into their tax-free accounts in excess of the annual $5,000 limit. The old penalty for going over the limit was 1 per cent a month tax on the excess contribution. Under the new rules, people will also have to pay a 100 per cent levy on any gains or income they make with the excess contribution, effectively erasing any incentive to earn that money.

One theoretical situation involves an investor putting an extra $100,000 into a TFSA and buying a junior mining penny stock on bets it will be taken over. If the company does indeed get scooped up and the stock doubles, the investor would have to pay a penalty of $1,000 (the 1 per cent a month on the amount of the over-contribution) but would be left with a large gain that is then secure in a tax-free shelter. The new rules will mean that all of the investor's stock gains and/or income from the $100,000 excess contribution will go to the taxman.

"For the average person who invests a little more than $5,000, this is not a big deal. Again, this is targeting people making enormous amounts of over-contribution," Mr. Golombek said.

The government was also concerned about asset transfer transactions, where investors were trying to make gains in the value of their investments by transferring money from their RRSPs and other registered savings plans, which discourage early withdrawals with heavy taxes, to their TFSAs. From now on, TFSA amounts that are "reasonably attributable" to these kinds of transfers will face a tax of 100 per cent.

The last loophole Mr. Flaherty tackled relates to prohibited or non-qualified investments. It appears some investors were making these investments despite the existing penalties because the gains remained in the accounts even after the offending purchase was removed. Again, under the new rules, any gains on prohibited investments, such as shares of a company in which you own a significant interest, will be taxed at 100 per cent while any secondary income related to non-qualified investments, such as land or general partnership units, will be taxed at regular rates.

Mr. Golombek believes the amendments will cause investors to second-guess their questionable tax strategies.

"These new measures are punitive and have taken away the advantage that existed. It also may give any financial institutions ammunition to warn investors who are engaged in this kind of trading."

Finn Poschmann, vice-president of research at the C.D. Howe Institute, said TFSAs are still a good investment with strong appeal. "Like everything else, they do need regulations so that people do not take advantage of them."

He believes Canadians are finding TFSAs to be a attractive vehicle for savings and that, over time, Ottawa should consider raising the contribution limit for them.