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.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.