TFSA Tax: Canadian Tax Lawyer Guidance - Capital Gains Tax

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Introduction: Cryptocurrency in Your Tax Free Savings Account -A Tax Catastrophe Waiting to Happen?

Introduced in 2009, a tax-free savings account (or TFSA) allowsindividuals to earn investment income tax free. While you cannotclaim a deduction for your TFSA contributions, your earnings withinthe TFSA accumulate tax free. Moreover, you pay no tax when youwithdraw the profits that you racked up within your TFSA. In otherwords, as the name suggests, a tax-free savings account essentiallyallows you to grow your savings on a tax-free basis.

With cryptocurrencies like Bitcoin, Ethereum,Dogecoin, Dash, and XRP wrestling for acceptance in the mainstreamfinancial landscape, Canadians looking for investment opportunitiesmay view cryptocurrency as a way to induce greater returns. Thedevelopments in blockchain technology bring about anever-increasing range of opportunities, arrangements, andassets-smart contracts, cryptocurrency liquidity mining and yieldfarming, and non-fungible tokens (NFT), to name a few. AndCanadians might be curious about uniting these opportunities withthe tax advantages of a TFSA.

So, the question is: Can you contribute cryptocurrency and otherblockchain-based assets into your tax-free savings account? Or isthis a tax catastrophe waiting to happen?

To answer these questions, this article first discusses thebasic tax rules concerning tax-free savings accounts-in particular,the requirement that a TFSA contain only "qualifiedinvestments." The article then analyzes whether cryptocurrencyor other blockchain assets can qualify as TFSA investments. Thisarticle concludes by offering pro tax tips to Canadian taxpayersseeking to hold qualifying cryptocurrency investments in theirtax-free savings accounts.

Tax-Fee Savings Accounts, "Qualified Investments"& the TFSA Penalty Tax

A tax-free savings account can be set up by any individual whois at least 18 years of age and a Canadian tax resident. In otherwords, the TFSA holder must be an adult natural person (as opposedto a corporation or other entity). And if you're not a Canadiantax resident, you cannot open or contribute to a tax-free savingsaccount. For more information on determining your status as a taxresident, see our article "Tax Residence in Canada - AreSignificant Residential Ties Less Significant for Immigrants toCanada than for Emigrants from Canada?" A person's statusas a Canadian tax resident depends on several interrelated, complextax rules, and it may require a careful analysis of not onlyCanada's domestic tax law but also the tax rules in a taxtreaty between Canada and another country. Notably, tax residenceis distinct from residence for immigration purposes: You can be aCanadian tax resident even if you aren't a Canadian permanentresident or a Canadian citizen, and you can be a Canadian citizenor permanent resident yet fail to be a Canadian tax resident. Ourexperienced Canadian tax lawyers can provideyou with advice on your status as a tax resident in Canada and yourresulting Canadian tax liabilities.

The tax benefit of a tax-free savings account is that you pay notax on any interest, dividends, capital gains, or other income thataccumulates within your TFSA. (Unlike contributions to a registeredretirement savings plan or RRSP, contributions to a TFSA are nottax deductible and not taxable on withdrawal.)

Canada's Income Tax Act limits the amount that youmay contribute to your TFSA per year. The TFSA dollar limit isbased on inflation, and it has generally been about $5,000 to$6,000 per year since 2009 when Canada's Parliament introducedthe tax-free savings account. (The one exception is 2015 when theTFSA dollar limit was increased to $10,000 for that year alone.)For the 2021 tax year, the TFSA dollar limit is $6,000.

That said, the TFSA dollar limit is cumulative. This means thatthe TFSA dollar limit results in additional TFSA contribution roomeach year-even if you haven't opened a tax-free savingsaccount. To illustrate: If you have never contributed to a tax-freesavings account and have been eligible since the TFSA'sintroduction in 2009, your cumulative TFSA contribution room in2021 is $75,500. Moreover, if you withdraw funds from your tax-freesavings account, the amount of the withdrawal is added to your TFSAcontribution room for the following year.

So, your TFSA contribution room for the year is actually thetotal of the following three amounts: (1) your TFSA dollar limitfor that year, (2) the amount of any withdrawals from your TFSAduring the previous year, and (3) your unused TFSA contributionroom from previous years.

Excess contributions to your tax-free savings account result ina TFSA penalty tax. If, at any time during the year, you make aTFSA contribution that exceeds your TFSA contribution room, youincur an TFSA penalty tax on the excess amount at a rate of 1% permonth. You must also file a special tax return reporting the TFSApenalty tax (Form RC243, "Tax-Free Savings AccountReturn" and Form RC243-SCH-A, "Schedule A - Excess TFSAAmounts"), and you may suffer an additional penalty forfailing to file this return. The penalty tax is also subject tointerest at the prescribed rate.

A penalty tax also applies if the tax-free saving plan acquiresa non-qualified investment. If the TFSA acquires a non-qualifiedinvestment or if an existing TFSA investment becomes anon-qualified investment, then the TFSA holder suffers a TFSApenalty tax equal to 50% of the fair market value of thenon-qualified investment. In addition, the TFSA holder must pay taxon any income from the non-qualified investment or any capital gainfrom disposing of the non-qualified investment.

In other words, the TFSA's tax-preferred treatment onlyextends to the "qualified investments" within the TFSA.The Income Tax Act's definition of "qualifiedinvestments" captures all the following:

money, GICs, and other deposits;
most securities listed on a designated stock exchange, such asshares of corporations, warrants and options, and units ofexchange-traded funds, and real estate investment trusts;
mutual funds and segregated funds;
Canada Savings Bonds and provincial savings bonds;
debt obligations of a corporation listed on a designated stockexchange;
debt obligations that have an investment-grade rating; and
insured mortgages or hypothecs.

Hence, for Canadian taxpayers seeking to hold cryptocurrency,non-fungible tokens, or other blockchain-based assets in theirtax-free savings accounts, the key tax issue is whether theseassets constitute "qualifying investments."

Do Cryptocurrency, Non-Fungible Tokens, or Other BlockchainAssets Constitute "Qualified Investments" for a Tax-FreeSavings Account?

Cryptocurrencies and non-fungible tokens themselves aren't"qualified investments." As mentioned above, theIncome Tax Act's definition of "qualifiedinvestments" basically refers to two items: (i) money and (ii)securities that are listed on a designated stock exchange. The CRAholds the-legally correct-view that "digital currencies, suchas [B]itcoins, are not considered to be money issued by agovernment of a country and are not qualified investments"(see paragraph 1.12 of Canada Revenue Agency, Income Tax FolioS3-F10-C1, "Qualified Investments - RRSPs, RESPs, RRIFs, RDSPsand TFSAs," October 1, 2018). Likewise, no cryptocurrency orNFT is itself traded as a security on a stock exchange designatedas such by Canada's Minister of Finance. So, cryptocurrenciesand non-fungible tokens don't meet the Income TaxAct's definition of "qualified investments," andthey cannot be held in your TFSA.

Yet the investment market has seen a recent surge incryptocurrency-based ETFs (or exchange-traded funds), many of whichare traded on designated stock exchanges. So, whilecryptocurrencies themselves aren't "qualifiedinvestments," many of the publicly listed cryptocurrency ETFsare. As such, these cryptocurrency-based ETFs may qualify as a TFSAinvestment. In particular, the cryptocurrency-based ETF meets thedefinition of a "qualified investment" if the fundappears on a designated stock exchange, like the Toronto StockExchange (TSX), the New York Stock Exchange (NYSE), or any of theother Canadian or international stock exchanges that Canada'sMinister of Finance has designated for the purposes of Canada'sIncome Tax Act.

In summary, your TFSA cannot directly hold cryptocurrencies ornon-fungible tokens because these assets aren't themselves"qualified investments." Your TFSA can, however, containcryptocurrency-based ETFs or other cryptocurrency-based funds-butonly if the fund is listed on a designated stock exchange, such asthe Toronto Stock Exchange or the New York Stock Exchange.

Pro Tax Tips - Expert Canadian Tax Guidance from aCanadian Tax Lawyer: Relief from TFSA Penalty Tax Resulting fromNon-Qualified Cryptocurrency Investments & CRA Tax Audits forTFSAs Carrying on a Business

As mentioned above, cryptocurrencies and non-fungible tokensdon't meet the Income Tax Act's definition of"qualified investments," so they cannot be held in yourtax-free savings account. As a result, if your tax-free savingsaccount holds cryptocurrencies, non-fungible tokens, or any othernon-qualified investment, you will sustain a TFSA penalty tax equalto 50% of the fair market value of each non-qualified investment inyour tax-free savings account.

Subsection 207.06(2) gives the Canada Revenue Agency the powerto cancel some or all of the TFSA penalty tax resulting fromholding non-qualified investments-like cryptocurrencies ornon-fungible tokens-in your tax-free savings account. Inparticular, the Canada Revenue Agency may cancel the TFSA penaltytax if the CRA "considers it just and equitable to do sohaving regard to all the circ*mstances, including (a) whether the[TFSA penalty tax] arose as a consequence of a reasonable error;(b) the extent to which the transaction or series of transactionsthat gave rise to the [TFSA penalty tax] also gave rise to anothertax under [the Income Tax Act]; and (c) the extent towhich payments have been made from [the tax-free savingsaccount]."

Our experienced Canadian tax lawyers have assisted numerousclients with applications to cancel TFSA penalty taxes undersubsection 207.06(2). We can carefully plan and promptly prepareyour subsection 207.06(2) application. A properly preparedpenalty-tax-cancellation application not only increases the oddsthat the CRA will accept your application but also lays thegroundwork for a judicial-review application to the Federal Courtshould the CRA unfairly deny your application and refuse to cancelyour TFSA penalty taxes.

If your tax-free savings account carries on a business, thatincome is taxable under subsection 146.2(6) of Canada'sIncome Tax Act. In other words, while you pay no tax onany interest, dividends, or capital gain that accumulates withinyour TFSA, you will incur tax on any business income that'sgenerated within your TFSA. The problem is that many cryptocurrencytransactions straddle the line between capital transactions andtransactions resulting in business income. So, even if yourcryptocurrency-based assets qualify as investments that you mayhold in your TFSA, you may nevertheless attract tax liabilityshould the nature of your transactions suggest that you carried ona business by actively trading these assets within your tax-freesavings account. Canadian courts have churned out a large body ofcase law grappling with the ambiguity between investing, whichproduces a capital gain, and trading, which results in businessincome. Courts assess a wide range of factors when deciding whetherto characterize a transaction's gains or losses as on anaccount of capital or income.

Our Certified Specialist Canadian tax lawyer can provide adviceon how to address issues with your TFSA holdings and your TFSAtransactions. This expert tax guidance can prove invaluable inensuring that the CRA doesn't fault you for misrepresenting theinformation in your tax returns, and thereby minimizing yourexposure to tax liability and penalties.

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circ*mstances.

TFSA Tax: Canadian Tax Lawyer Guidance - Capital Gains Tax - Canada (2024)

Introduction: Cryptocurrency in Your Tax Free Savings Account -A Tax Catastrophe Waiting to Happen?

Tax-Fee Savings Accounts, "Qualified Investments"& the TFSA Penalty Tax

Do Cryptocurrency, Non-Fungible Tokens, or Other BlockchainAssets Constitute "Qualified Investments" for a Tax-FreeSavings Account?