Is Your TSFA Ripe for an Audit

A recent BMO survey revealed that Canadians contributed about $1000 less to their TFSAs in 2016 than they did the year before. The reason? They simply couldn’t afford to save as much – 43% said they didn’t have enough money, while 36% needed the money for other things. About 15% of the people polled didn’t contribute to their TFSA at all.

The amount a taxpayer can contribute per year is limited. In 2015, the limit was $10,000, but in 2016 it was only $5,500. However, the unused portion is carried over, so you can go over the annual limit if you didn’t max out in previous years.

Average amounts contributed:

  • Atlantic Provinces: $4312

  • Quebec: $4168

  • Ontario: $4771

  • Manitoba and Saskatchewan: $3220

  • Alberta: $3849

  • British Columbia: $5898

Overall Canadian average: $4592

Participants stated they expect to contribute even less this year. But that doesn’t mean TFSAs are losing their attraction. According to StatsCan, TFSAs are becoming more popular than RRSPs.

Auditing Tax-Free Savings Accounts

Tax-free savings accounts were introduced in 2009. These accounts allow you to save money, without paying any tax on the interest you earn or when the money is withdrawn. However, if your TFSA carries on a business, according to subsection 146.2(6) of Canada’s Income Tax Act, the income earned is taxable.

Individuals amassing huge balances in their tax-free savings accounts, without going over the contribution limit, has prompted aggressive auditing. The Canada Revenue Agency claims to have already uncovered over $75 million in unpaid taxes from improper use of TFSA funds. Of this money, the CRA says 20% is from TFSAs being operated as a business.

When auditing a TFSA, the Canada Revenue Agency first determines whether the account is carrying on a business. Several factors are considered based on case histories of selling securities. The big question is whether losses and gains should be on an income account or a capital account.

These factors may indicate your TFSA is carrying on a business:

  • frequent securities transactions
  • quick relinquishment of ownership of the securities
  • experience with or knowledge of the security market
  • you work in securities
  • you study the securities market
  • you openly try to buy securities
  • you buy securities with debt financing and transfer them to your TFSA
  • your securities are speculative or don’t pay out dividends
  • extraordinary growth

Many people wonder if Parliament is heading towards banning frequent securities trading within a TFSA. The Income Tax Act explicitly states business income generated with TFSA funds is taxable, however, this caveat apparently ensures taxable businesses that they don’t need to compete with tax-exempt TFSAs.

Also, publicly traded securities are a permissible form of investment and the contribution limit formula used for TFSAs seems to allow somewhat frequent transactions.

Setting Yourself Up For an Audit

The CRA will occasionally do a random audit, but there are a few things that grab their attention and almost guarantee you will be audited. These include:

  • Ignoring requests for more information. When the CRA wants proof of an expense you claimed, send it in right away. Thinking they might go away if you don’t reply doesn’t work. According to Ernst & Young, “If the taxpayer does not respond on a timely basis or is unable to provide adequate support for a claim, the CRA will issue a reassessment, perhaps denying a claim completely or adjusting an income or expense figure based on the information on file.” This can also lead to investigations into future tax returns.
  • Claiming unusually large deductions for your home office. Generally, you can claim about a quarter of the space (and expenses such as heat, hydro, etc.) of your home, or less, as your home-office. Trying to claim more invites a closer look from the CRA. “To be able to exercise this deduction, you must use the space exclusively and regularly as your principal place of business,” says accountant Marvin Khoshkhassal of Vancouver-based MK & Associates. “That makes it difficult to successfully claim a guest bedroom or rec room as a home office, even if you also use the space to do your work.”
  • Unusual or large changes in credits or deductions. Red flags go up when things change. “Major changes in income or expenses or tax deductions from one year to the next will raise suspicion,” says Barrett Tax Law, “so do try to be consistent in your declarations.”
  • Claiming your vehicle is used exclusively for business. Even driving to and from work is considered personal use. PricewaterhouseCoopers points out that the CRA “wants to ensure that employees do not receive personal benefits tax-free, when salary, bonus and other forms of compensation would give rise to income tax.”
  • Reporting income that is significantly lower than others in your field or your neighbourhood. Claiming a $30,000 income in a multi-millionaire dollar neighbourhood catches the attention of auditors. Tax lawyers at Gowlings say, “This suggests that an individual may have unreported income. Unreasonably, low reported income is not only an audit trigger but may cause the CRA to initiate a so-called ‘net worth’ or arbitrary assessment, whereby various tools are deployed by the CRA to impute income to the taxpayer.”
  • Not reporting all of your T-slips. The CRA has an excellent system that matches reported T-slips with those claimed by employers or financial institutions. If a mismatch is detected your return will be reassessed and you could face a hefty penalty.
  • An extraordinarily high TFSA. The CRA has recently begun to target people with very large tax-free savings accounts – hundreds of thousands or even millions of dollars – apparently because of active trading within their TFSA. The issue is that taxpayers are not supposed to use a TFSA to carry on a business. In this case, a trading business. Tax law firm Thorsteinssons LLP warns, “It seems clear that the CRA is intent on challenging those who have enjoyed significant growth within their TFSA.” The tax department wants to tax these gains.

The CRA audited or examined 144,013 accounts during the past fiscal year. No criminal charges were laid in most of these cases, however close scrutiny from the tax department can still be a daunting experience.

Some taxpayers were found guilty. An examination of the account of a certified financial analyst revealed several large transactions and a total gain of about $550,000. In the end, the judge held the taxpayer’s profits to be 100% taxable as business income.

The methodology used by the CRA is not limited to professional traders. Although they seem to be more likely targets, amateur investors with frequent-trading strategies generating huge profits could also find themselves under investigation.

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