TaxMatters@EY: Family Wealth Edition – July 2023

Gael Melville, Vancouver, and Jennifer Chandrawinata, Toronto

Canadians now have a range of registered programs they can use to save and invest for various purposes, like buying a first home or financing further education. Use of self-directed investment accounts, both registered and non-registered, surged during the pandemic, with many novice investors entering the market.¹

If you’re using registered plans or accounts to invest, it’s critical that you understand the applicable features and restrictions. A recent tax case illustrates an important difference between the tax implications of certain stock trading activities an individual undertakes in a tax-free savings account compared to a registered retirement savings plan or registered retirement income fund.

Rules on carrying on business in a TFSA or RRSP/RRIF

Tax-free savings accounts (TFSAs) were first launched in 2009, offering Canadians a flexible way to save or invest in a tax-sheltered account. Account holders who abide by the TFSA rules and restrictions can benefit from tax-free income and growth in the account, as well as tax-free withdrawals.

There are two important limitations on TFSAs. First, the account must hold only qualified investments: for example, mutual funds and listed securities. Second, a TFSA must also not carry on a business. If a TFSA does hold non-qualified investments or carry on a business, its income from those investments or that business will be taxable.²

Registered retirement savings plans (RRSPs) have similar limitations to TFSAs on the types of investments they can hold and also on carrying on a business, but there are also some differences. In particular, an RRSP that carries on a business that earns income from the disposition of qualified investments is not subject to tax on that income.³ A similar exception exists for a registered retirement income fund (RRIF)^.4

The Canada Revenue Agency’s (CRA’s) administrative position is that day trading in an RRSP or RRIF that is limited to the buying and selling of qualified investments does not cause the income from trading those investments to be taxable as income from carrying on business.⁵

The reason for the differing approach in the taxation of a business of trading qualified investments was not expressly stated in the explanatory materials issued when the TFSA rules were introduced. However, while an RRSP is a tax deferral mechanism and tax is eventually paid on distributions from the plan, a TFSA is funded by after-tax dollars and there is generally no tax on distributions. Therefore, if a large balance is generated in a TFSA, it may be possible to distribute it to the holder without payment of tax.

Activities that constitute carrying on a business

Due to their nature, self-directed or “trusteed” plans or accounts execute trades to acquire and dispose of investments. The Income Tax Act does not set out a specific number of trades that will automatically cause a plan or account to be viewed as carrying on a business of trading, rather than engaging in normal investment behaviour. However, outside the context of registered plans, the courts have developed general criteria to determine when a business is being carried on. The CRA applies these criteria to trading in the context of registered plans, with some exceptions.⁶

The factors most applicable to trading in registered plans are:

• Frequency of transactions
• Period of ownership of securities
• Nature of the investments (for example, whether they are speculative)
• Taxpayer’s knowledge of securities market
• Whether security transactions form part of the taxpayer’s ordinary business
• Time the taxpayer has spent studying the market and investigating potential purchases⁷

In each case it will be a question of fact whether a registered account is being used to carry on a business of trading. However, taxpayers who are experienced investors or who work in the financial markets should take particular care when investing through a TFSA since they already fulfill some of the criteria listed above.

As can be seen from a recent tax case involving an investment advisor, frequent transactions inside a TFSA where securities are owned for short periods may lead to the determination that the TFSA is carrying on a business, and as a result gains on the disposition of securities would become taxable.

Canadian Western Trust case

Canadian Western Trust⁸ is the first decided case that deals with a CRA assessment based on trading in a TFSA. In January 2009, Mr. X, who was a professional investment advisor, opened a trusteed TFSA. Mr. X was the TFSA holder and its beneficiary. In this case, the appellant taxpayer was the TFSA issuer and the trustee.

Mr. X invested a total of $15,000 in his TFSA, making a $5,000 contribution in each of January 2009, 2010 and 2011. Mr. X bought and sold only qualified investments in his TFSA, but the majority of his purchases were short-term, speculative “penny stock” investments in companies operating in the junior mining sector. His trades were very successful, and by the end of 2012 Mr. X’s TFSA was worth over $560,000.

In January 2013, the TFSA trust sold its securities and transferred the sale proceeds of $547,789 to Mr. X. The CRA reassessed the appellant in its capacity as trustee of the TFSA for the 2009-12 years on the basis that the TFSA earned income from carrying on a business of trading qualified investments in each of the 2009-12 taxation years and the income was taxable under the Income Tax Act.

When the taxpayer appealed the reassessments to the Tax Court of Canada, the court had to decide whether a TFSA that carries on a business of trading qualified investments is exempt from tax on the income from that business. The taxpayer’s main argument was based on a comparison between the treatment of income earned from a business of trading carried on in an RRSP and a TFSA. The taxpayer argued there would have been no rational legislative purpose for Parliament to have enacted different rules that taxed income from a business of trading qualified investments if it was earned in a TFSA but not if it was earned in an RRSP. The taxpayer also argued that the buying and selling of qualified investments did not constitute carrying on a business for the purposes of subsection 146.2(6).

In its review, the court noted that RRSPs and TFSAs are separate and highlighted the difference between the two. The court reasoned that had Parliament intended to create an exemption for income from a business of trading qualified investments, it would have specified this exception in the legislation, as it had already done for RRSPs.⁹ Parliament chose not to do so, and as such the differing income treatment between TFSAs and RRSPs was intentional. The court also noted that the term “carrying on business” has a large volume of jurisprudence and that trading securities constitutes carrying on business.

The court analyzed the relevant legislative provisions using a textual, contextual and purposive framework and found that the rules for RRSPs and TFSAs were separate and their components could not be interchanged unless the legislation specifically allowed it.

According to the court, Parliament’s primary purpose in creating the TFSA regime was to encourage Canadians to save, with its secondary purpose being to achieve that objective with certain limits. One of those limits was that income a TFSA trust earns from carrying on any kind of business is taxable under the Act.

The Tax Court of Canada dismissed the taxpayer’s appeal. The taxpayer has appealed to the Federal Court of Appeal; at the time of writing that appeal had not yet been heard.

Conclusion

Despite the name, income and gains earned in a TFSA are not always tax free and the Canadian Western Trust case serves as a useful reminder that TFSAs and RRSPs/RRIFs are governed by different rules. Since each case depends on its facts, there is no easy way to determine whether an individual’s pattern of trading activity has crossed over into what the CRA may consider to be a business of trading investments. However, fact patterns that include short holding periods, a high volume of activity and speculative trades should be examined closely. Financial institutions that offer TFSAs report the balances to the CRA each year, so it’s reasonable to expect that large increases in account balances year over year could precipitate further investigation. 

1. See, for example, https://www.iiroc.ca/news-and-publications/notices-and-guidance/canadians-opening-do-it-yourself-diy-accounts-unprecedented-numbers.
2. Subsection 146.2(6) of the Income Tax Act.
3. Paragraph 146(4)(b) of the Income Tax Act.
4. Paragraph 146.3(3)(e) of the Income Tax Act.
5. Paragraph 1.89 of Income Tax Folio S3-F10-C1, Qualified Investments – RRSPs, RESPs, RRIFs, RDSPs and TFSAs.
6. Paragraph 1.87 of Income Tax Folio S3-F10-C1, Qualified Investments – RRSPs, RESPs, RRIFs, RDSPs and TFSAs. It should be noted subsection 253.1(1) of the Act specifically provides that, for the purposes of the TFSA carrying on business rules, a TFSA will not be considered to be carrying on a business solely as a result of acquiring or holding a limited partnership interest. See also paragraph 1.88 of Income Tax Folio S3-F10-C1.
7. Interpretation Bulletin IT-479R, Transactions in securities.
8. Canadian Western Trust Company as Trustee of the Fareed Ahamed TFSA v The King, 2023 TCC 17.
9. The RRSP rules originally contained no exception for income from trading qualified investments; however, the Income Tax Act was amended in 1994 to include such an exception.

Summary

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