Are tax free savings account swap transactions legitimate?
In Louie v Canada, a Canada Revenue Agency cross-appeal was allowed
There are exceptions to the general rule that gains from TFSAs are not taxed, explains David J. Rotfleisch, CA, CPA, JD, of Rotfleisch & Samulovitch P.C.
TORONTO – A Tax Free Savings Account ("TFSA") allows Canadians to increase their savings by earning tax-free investment income. Generally speaking, the gains made within a TFSA are not taxed when the income is earned or when funds are withdrawn. However, contributions to a TFSA are not tax-deductible, and there is a limit to how much contributions are allowed to the TFSA. If a taxpayer contributes beyond the TFSA contribution limit, then the person will be considered to be over-contributing to the TFSA and thus will be subject to a tax penalty equal to 1% of the highest excess amount in the month.
However, there may be instances where the gains earned within a TFSA are taxed. According to subsection 207.05(1) of the Income Tax Act ("Tax Act"), tax is payable if an "advantage" in relation to the TFSA was extended to the holder of the TFSA. In paragraph 207.01(1)(b) of the Tax Act, the term "advantage" is defined as a benefit that is an increase in the total fair market value of the property held in the TFSA "if it is reasonable to consider, having regards to all the circumstances, that the increase is attributable, directly or indirectly to. a series of transactions that would not have occurred in an open market in which parties deal at arm's length. and had as one of its main purposes to enable a person to benefit from the exemption from tax under Part I of any amount in respect of the TFSA [emphasis added]." In the Federal Court of Appeal ("Federal Court") case Louie v Canada, the Court was tasked with determining whether a series of swap transactions to a TFSA constitutes an "advantage" in the Tax Act.
Facts of Louie v Canada
The taxpayer in this case was an investor with vast experience and knowledge of the stock market. She managed a trading account and a self-directed RRSP account. When the TFSA rules were implemented in January 2009, the taxpayer opened a TFSA. In May 2009, to eliminate and defer the tax payable on future gains, the taxpayer conducted swap transactions by transferring her stocks from her Canadian trading account to her TFSA and RRSP accounts. She shifted the stocks that had the most upward price momentum to her TFSA, while she transferred out the shares that had the most downward price momentum from her TFSA. She chose the stocks to transfer and the timing to move them.
In 2009, the taxpayer completed 71 swap transactions with respect to her TFSA. The swap transactions caused the value of her TFSA to increase. In 2009, she made a $5,000 contribution to her TFSA, which was the maximum contribution amount for the year. By the end of the year, the market value of her TFSA was $206,615.09. The taxpayer stopped making swap transactions at the end of 2009 because a legislative amendment was made, which included swap transactions into the definition of an "advantage" in paragraph 207.01(1) of the Tax Act. The value of her TFSA was $281,826.11 in 2010 and $220,485.00 in 2012.
The CRA reassessed the taxpayer with respect of the 2009, 2010 and 2012 taxation years. The basis of the reassessment was that for each of the relevant taxation years, the taxpayer had received an "advantage" within the meaning of the word in subsection 207.05(1) of the Tax Act. The taxpayer subsequently appealed to the Tax Court of Canada ("Tax Court").
The Tax Court of Canada Analysis of Louie v Canada
The Tax Court dismissed the appeal with respect to the 2009 taxation year but allowed the appeals for the 2010 and 2012 taxation years. The Tax Court concluded that the taxpayer had indeed received an "advantage" in 2009 with respect to her TFSA. The Tax Court stated that the swap transactions were a part of "a series of transactions," and they would not have occurred in an open market in which parties deal with each other at arm's length. Also, the Tax Court stated that one of the primary purposes for the swap transactions was to benefit from the Part 1 tax exemption. However, the Tax Court concluded that the taxpayer did not receive an "advantage" to her TFSA in 2010 and 2012 taxation years. The Tax Court adopted a narrow interpretation of the phrase "directly or indirectly," and the Tax Court stated that the increase in the value of the TFSA in 2010 and 2012 was not attributable to the swap transactions. The Canadian tax lawyer for the taxpayer subsequently appealed the judgment regarding the 2009 taxation year to the Federal Court, and the Canadian tax lawyer for the CRA cross-appealed the judgment that allowed the appeal for the 2010 and 2012 taxation years.
The Federal Court of Appeal Analysis of Louie v Canada
The Federal Court dismissed the taxpayer's appeal and allowed the CRA's cross-appeal. First, the Federal Court agreed with the Tax Court on the finding that the swap transactions were part of a "series of transactions." The Federal Court agreed with the decision in Copthorne Holdings Ltd v R that the common law meaning of series is expanded by subsection 248(10) of the ITA, which deems any related transactions that are completed in contemplation of a series to be a part of that series. Second, the Federal Court held that the Tax Court did not err by finding that the parties to the series of transactions were not dealing at arm's length. The Federal Court found that the taxpayer was in fact the single mind directing all of the swap transactions. Third, the Federal Court held that the Tax Court did not err in finding that one of the primary purposes of the series of transactions was to benefit from the TFSA's tax exemption. The Federal Court made a factual inquiry. The Federal Court held that the taxpayer implemented a strategy to shift significant amounts of value into the TFSA and that the taxpayer was aware of the tax-exempt status of the TFSA. Thus, the Federal Court held that one of the primary purposes of the series of transactions was to benefit the taxpayer from the TFSA's tax exemption.
The Federal Court held that the Tax Court did in fact err in its interpretation of the phrase "directly or indirectly" of paragraph 207.01(1)(b) of the Tax Act. First, the Federal Court denied that the words "it is reasonable to consider, having regard to all the circumstances" constrains the broad, textual meaning of the phrase "directly or indirectly." The Federal Court also stated that the statutory context does not require nor favour a narrow and restrictive definition of "advantage." Finally, the Federal Court held that the anti-avoidance purpose of sections 207.01 and 207.05 of the ITA supports a broad interpretation of "advantage." The Federal Court thus allowed the CRA's cross-appeal and dismissed the taxpayer's 2010 and 2012 appeals.
Although the TFSA allows Canadians to increase their savings by earning tax-free investment income, taxpayers must be aware of the governing rules of the TFSA. There are exceptions to the general rule that gains from TFSAs are not taxed.
David J Rotfleisch, CPA, JD, is the founding tax lawyer of Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law firm. With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax litigation. Visit www.Taxpage.com and email David at email@example.com.