TFSA Tax: Canadian Tax Lawyer Guidance

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

Introduced in 2009, a tax-free savings account (or TFSA) allows individuals to earn investment income tax free. While you cannot claim a deduction for your TFSA contributions, your earnings within the TFSA accumulate tax free. Moreover, you pay no tax when you withdraw the profits that you racked up within your TFSA. In other words, as the name suggests, a tax-free savings account essentially allows you to grow your savings on a tax-free basis.

With cryptocurrencies like Bitcoin, Ethereum, Dogecoin, Dash, and XRP wrestling for acceptance in the mainstream financial landscape, Canadians looking for investment opportunities may view cryptocurrency as a way to induce greater returns. The developments in blockchain technology bring about an ever-increasing range of opportunities, arrangements, and assets—smart contracts, cryptocurrency liquidity mining and yield farming, and non-fungible tokens (NFT), to name a few. And Canadians might be curious about uniting these opportunities with the tax advantages of a TFSA.

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

To answer these questions, this article first discusses the basic tax rules concerning tax-free savings accounts—in particular, the requirement that a TFSA contain only “qualified investments.” The article then analyzes whether cryptocurrency or other blockchain assets can qualify as TFSA investments. This article concludes by offering pro tax tips to Canadian taxpayers seeking to hold qualifying cryptocurrency investments in their tax-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 who is at least 18 years of age and a Canadian tax resident. In other words, the TFSA holder must be an adult natural person (as opposed to a corporation or other entity). And if you’re not a Canadian tax resident, you cannot open or contribute to a tax-free savings account. For more information on determining your status as a tax resident, see our article “Tax Residence in Canada – Are Significant Residential Ties Less Significant for Immigrants to Canada than for Emigrants from Canada?” A person’s status as a Canadian tax resident depends on several interrelated, complex tax rules, and it may require a careful analysis of not only Canada’s domestic tax law but also the tax rules in a tax treaty between Canada and another country. Notably, tax residence is distinct from residence for immigration purposes: You can be a Canadian tax resident even if you aren’t a Canadian permanent resident or a Canadian citizen, and you can be a Canadian citizen or permanent resident yet fail to be a Canadian tax resident.  Our experienced Canadian tax lawyers can provide you with advice on your status as a tax resident in Canada and your resulting Canadian tax liabilities.

The tax benefit of a tax-free savings account is that you pay no tax on any interest, dividends, capital gains, or other income that accumulates within your TFSA. (Unlike contributions to a registered retirement savings plan or RRSP, contributions to a TFSA are not tax deductible and not taxable on withdrawal.)

Canada’s Income Tax Act limits the amount that you may contribute to your TFSA per year. The TFSA dollar limit is based on inflation, and it has generally been about $5,000 to $6,000 per year since 2009 when Canada’s Parliament introduced the tax-free savings account. (The one exception is 2015 when the TFSA 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 that the TFSA dollar limit results in additional TFSA contribution room each year—even if you haven’t opened a tax-free savings account. To illustrate: If you have never contributed to a tax-free savings account and have been eligible since the TFSA’s introduction in 2009, your cumulative TFSA contribution room in 2021 is $75,500. Moreover, if you withdraw funds from your tax-free savings account, the amount of the withdrawal is added to your TFSA contribution room for the following year.

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

Excess contributions to your tax-free savings account result in a TFSA penalty tax. If, at any time during the year, you make a TFSA contribution that exceeds your TFSA contribution room, you incur an TFSA penalty tax on the excess amount at a rate of 1% per month. You must also file a special tax return reporting the TFSA penalty tax (Form RC243, “Tax-Free Savings Account Return” and Form RC243-SCH-A, “Schedule A – Excess TFSA Amounts”), and you may suffer an additional penalty for failing to file this return.  The penalty tax is also subject to interest at the prescribed rate.

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

In other words, the TFSA’s tax-preferred treatment only extends to the “qualified investments” within the TFSA. The Income Tax Act’s definition of “qualified investments” captures all the following:

• money, GICs, and other deposits;
• most securities listed on a designated stock exchange, such as shares of corporations, warrants and options, and units of exchange-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 stock exchange;
• 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 their tax-free savings accounts, the key tax issue is whether these assets constitute “qualifying investments.”

Do Cryptocurrency, Non-Fungible Tokens, or Other Blockchain Assets Constitute “Qualified Investments” for a Tax-Free Savings Account?

Cryptocurrencies and non-fungible tokens themselves aren’t “qualified investments.” As mentioned above, the Income Tax Act’s definition of “qualified investments” basically refers to two items: (i) money and (ii) securities that are listed on a designated stock exchange. The CRA holds the—legally correct—view  that “digital currencies, such as [B]itcoins, are not considered to be money issued by a government of a country and are not qualified investments” (see paragraph 1.12 of Canada Revenue Agency, Income Tax Folio S3-F10-C1, “Qualified Investments – RRSPs, RESPs, RRIFs, RDSPs and TFSAs,” October 1, 2018). Likewise, no cryptocurrency or NFT is itself traded as a security on a stock exchange designated as such by Canada’s Minister of Finance. So, cryptocurrencies and non-fungible tokens don’t meet the Income Tax Act’s definition of “qualified investments,” and they cannot be held in your TFSA.

Yet the investment market has seen a recent surge in cryptocurrency-based ETFs (or exchange-traded funds), many of which are traded on designated stock exchanges. So, while cryptocurrencies themselves aren’t “qualified investments,” many of the publicly listed cryptocurrency ETFs are. As such, these cryptocurrency-based ETFs may qualify as a TFSA investment. In particular, the cryptocurrency-based ETF meets the definition of a “qualified investment” if the fund appears on a designated stock exchange, like the Toronto Stock Exchange (TSX), the New York Stock Exchange (NYSE), or any of the other Canadian or international stock exchanges that Canada’s Minister of Finance has designated for the purposes of Canada’s Income Tax Act.

In summary, your TFSA cannot directly hold cryptocurrencies or non-fungible tokens because these assets aren’t themselves “qualified investments.” Your TFSA can, however, contain cryptocurrency-based ETFs or other cryptocurrency-based funds—but only if the fund is listed on a designated stock exchange, such as the Toronto Stock Exchange or the New York Stock Exchange.

Pro Tax Tips – Expert Canadian Tax Guidance from a Canadian Tax Lawyer: Relief from TFSA Penalty Tax Resulting from Non-Qualified Cryptocurrency Investments & CRA Tax Audits for TFSAs Carrying on a Business

As mentioned above, cryptocurrencies and non-fungible tokens don’t meet the Income Tax Act’s definition of “qualified investments,” so they cannot be held in your tax-free savings account. As a result, if your tax-free savings account holds cryptocurrencies, non-fungible tokens, or any other non-qualified investment, you will sustain a TFSA penalty tax equal to 50% of the fair market value of each non-qualified investment in your tax-free savings account.

Subsection 207.06(2) gives the Canada Revenue Agency the power to cancel some or all of the TFSA penalty tax resulting from holding non-qualified investments—like cryptocurrencies or non-fungible tokens—in your tax-free savings account.  In particular, the Canada Revenue Agency may cancel the TFSA penalty tax if the CRA “considers it just and equitable to do so having regard to all the circumstances, 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 transactions that gave rise to the [TFSA penalty tax] also gave rise to another tax under [the Income Tax Act]; and (c) the extent to which payments have been made from [the tax-free savings account].”

Our experienced Canadian tax lawyers have assisted numerous clients with applications to cancel TFSA penalty taxes under subsection 207.06(2). We can carefully plan and promptly prepare your subsection 207.06(2) application. A properly prepared penalty-tax-cancellation application not only increases the odds that the CRA will accept your application but also lays the groundwork for a judicial-review application to the Federal Court should the CRA unfairly deny your application and refuse to cancel your TFSA penalty taxes.

If your tax-free savings account carries on a business, that income is taxable under subsection 146.2(6) of Canada’s Income Tax Act. In other words, while you pay no tax on any interest, dividends, or capital gain that accumulates within your TFSA, you will incur tax on any business income that’s generated within your TFSA. The problem is that many cryptocurrency transactions straddle the line between capital transactions and transactions resulting in business income. So, even if your cryptocurrency-based assets qualify as investments that you may hold in your TFSA, you may nevertheless attract tax liability should the nature of your transactions suggest that you carried on a business by actively trading these assets within your tax-free savings account. Canadian courts have churned out a large body of case law grappling with the ambiguity between investing, which produces a capital gain, and trading, which results in business income. Courts assess a wide range of factors when deciding whether to characterize a transaction’s gains or losses as on an account of capital or income.

Our Certified Specialist Canadian tax lawyer can provide advice on how to address issues with your TFSA holdings and your TFSA transactions. This expert tax guidance can prove invaluable in ensuring that the CRA doesn’t fault you for misrepresenting the information in your tax returns, and thereby minimizing your exposure to tax liability and penalties.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch