Getting screwed by the CRA

[rukawa]

I'm not getting screwed by the CRA. But I thought I would start this thread as a collection of stories of people who have gotten screwed by the CRA and how to avoid it. The best story I've found is this one:

 

http://business.financialpost.com/personal-finance/stop-using-your-tfsa-to-frequently-trade-stocks-the-cra-may-see-it-as-business-income

The taxpayer, a certified financial analyst, was the co-head of institutional trading at a Canadian investment firm and an investment industry veteran with over 25 years of experience. He was licensed by securities regulators in several Canadian and U.S. jurisdictions, including as a trader and dealer in securities.....In the remaining ten months of 2009, he bought and sold stocks of 34 issuers costing about $2,500,000, involving 38 purchase transactions and 50 sale transactions, realizing a total gain of about $550,000. His average hold period of stocks was about 50 days and his average return on any particular stock was about 30 per cent....Weighing all the evidence, the judge concluded that the taxpayer was trading in the securities as a business activity,...As a result, the judge held the taxpayer’s profits to be 100 per cent taxable as business income.

 

Note that the article title is totally misleading since it implies that this can only happen in a registered account (TFSA, RRSP). The truth is that in any account if you trade too frequently and you are considered a financial professional, you can be declared to be indulging in a "trading business" in your investment account in which case you gains are taxed as income instead of capital which basically doubles your taxes.

 

I'm guessing that no one on this forum has had this happen to them but if anyone has an interesting story please post it.

[Cigarbutt]

FWIW, I think that the distinction between trading (short term thinking) and investment (long term thinking) is fair and should be treated differently from the tax point of view.

And the rules are somewhat clearly spelled out.

 

I have had a large number of "interactions" with CRA and will share what may be interesting or relevant for others. This has quieted down in the last 2 or 3 years (in correlation to decreased turnover and level of activity).

 

With investment income, what seems to trigger their interest are unusual returns (especially if lumpy and in tax-deferred accounts RRSPs and TFSAs), "children" accounts (rules have been tightened here) and "professional" accounts (rules are being tightened here).

 

I have heard many negative comments and some went through horror stories but my experience has been relatively positive.

 

Negatives:

-CRA tends to send a dry first tax assessment notice with amounts owed having little correlation with reality.

(from interactions with CRA, I was told that many who receive such notice pay the amount on the spot)

-paperwork can be tedious and voluminous.

-may need to repeat the process as they often don't understand the first time around.

-with repeat interactions, often get confusing or contradicting information on the substance of the claim and on the steps required to fix the problem.

 

Positives:

-with adequate documentation and explanations (investor mindset and rationale, correlation across portfolios), in all episodes, matters settled for non material amounts.

-most people I spoke to or communicated with were open to well prepared presentations and supporting documentation.

-in my experience, CRA will accept substance over form arguments.

[rb]

Note that the article title is totally misleading since it implies that this can only happen in a registered account (TFSA, RRSP). The truth is that in any account if you trade too frequently and you are considered a financial professional, you can be declared to be indulging in a "trading business" in your investment account in which case you gains are taxed as income instead of capital which basically doubles your taxes.

 

I'm guessing that no one on this forum has had this happen to them but if anyone has an interesting story please post it.

 

You're right. Business income designation can happen for any account. I'd say it's reasonable. I would also say that in the incident you've quoted the person didn't get screwed by the CRA. The rules are what the rules are - the Income Tax Act. The CRA's job is also not to make the rules, it's to collect tax according to the rules. It seems to me that they were just doing their job the way they were supposed to. The individual in the article also knew or should have known the rules but chose to ignore them.

 

This has actually happened to two of my clients. One of them was guilty as hell. In that case the CRA agreed not to tax the whole account as business income but only specific trades. The other one, also guilty, was an idiot who didn't know what he was doing and thought he was a trader cause he watched CNBC. The CRA agreed to let him go if he didn't do it again.

 

From my experience dealing with the CRA they are very reasonable as long as you conduct yourself in a respectful and a professional manner. If you start with crap like the government are idiots and you shouldn't pay taxes cause you're special they tend to loose their grace. The IRS on the other hand.... those guys are all assholes. Every time you have to deal with them you know you're gonna have a bad experience.

[gokou3]

I wonder if CRA only taxes TFSA accounts with large gains from frequent trading by professionals?

 

My concern is if I buy and own a warrant (or whatever securities that the general public tends to view as "exotic") for a couple years and gain 10x on it, CRA will suddenly want to share my gain.

[rb]

I wonder if CRA only taxes TFSA accounts with large gains from frequent trading by professionals?

 

My concern is if I buy and own a warrant (or whatever securities that the general public tends to view as "exotic") for a couple years and gain 10x on it, CRA will suddenly want to share my gain.

In the situation you've described you're ok. But if your TFSA is chock full of warrants and call options you'll have to share.

[gokou3]

I wonder if CRA only taxes TFSA accounts with large gains from frequent trading by professionals?

 

My concern is if I buy and own a warrant (or whatever securities that the general public tends to view as "exotic") for a couple years and gain 10x on it, CRA will suddenly want to share my gain.

In the situation you've described you're ok. But if your TFSA is chock full of warrants and call options you'll have to share.

 

What if the whole TFSA account consists just that one warrant (i.e. 100% allocation)?  :)

 

Understanding that you are not providing tax advice here.

[rb]

I wonder if CRA only taxes TFSA accounts with large gains from frequent trading by professionals?

 

My concern is if I buy and own a warrant (or whatever securities that the general public tends to view as "exotic") for a couple years and gain 10x on it, CRA will suddenly want to share my gain.

In the situation you've described you're ok. But if your TFSA is chock full of warrants and call options you'll have to share.

 

What if the whole TFSA account consists just that one warrant (i.e. 100% allocation)?  :)

 

Understanding that you are not providing tax advice here.

You're fine.

[Cardboard]

How does the CRA find out what is going on in TFSA's and RRSP's as there are no trading summary sent to them unlike for non-registered accounts? Maybe that I am wrong on that one but, that is my understanding.

 

Regarding this, I disagree:

 

"The rules are what the rules are - the Income Tax Act. The CRA's job is also not to make the rules, it's to collect tax according to the rules."

 

The section describing what should be on capital vs income account is subject to wide interpretation. Of course, there is common sense to it but, I would not call it a rule.

 

Cardboard

[KCLarkin]

How does the CRA find out what is going on in TFSA's and RRSP's as there are no trading summary sent to them unlike for non-registered accounts?

 

AFAIK, they look for, and audit, TFSAs with high balances.

 

I'm not sure if they are as aggressive with RRSPs since these will eventually be taxed.

 

Here is a court case from 2014 saying that trading in RRSPs is not a business:

http://www.ey.com/ca/en/services/tax/taxmatters-november2014-active-trading-rrsp-not-evidence-trading-business

 

In the Court’s view, the RRSP regime is unique and intentionally provides special tax treatment under the Income Tax Act (the Act), with restrictions on the types of investments that may be acquired, tax benefits that flow from their ownership and tax consequences that flow from their disposal.

 

The Court concluded that because of this unique tax regime, trading activity within an RRSP cannot constitute a business of the taxpayer.

 

However, this was not a precedent setting ruling. And I'm not sure if later cases have set a precedent.

 

Edit:

Here is a link describing the auditing practice for TFSAs (and the lack of similar enforcement for RRSPs):

https://www.theglobeandmail.com/globe-investor/personal-finance/taxes/keep-your-tax-hands-off-my-tfsa/article22922076/

 

The issue

 

In my recent discussions with the CRA, it's clear that rumours of a tax-audit project focusing on TFSAs are true. The CRA seems to be focusing on TFSAs that have a very significant value. And perhaps this should be no surprise, because those dollars will one day be withdrawn tax-free. It's not clear what dollar value in a TFSA might create a red flag for the taxman.

 

A big area of concern for the CRA is where investors are actively trading – often called day trading – in their TFSAs. In these cases, when certain criteria are met, the CRA may come to the conclusion that an individual is actually carrying on a business when trading in securities – sometimes referred to as an "adventure in the nature of trade" – in which case the profit could be taxed as business income. The CRA's argument is that business income earned inside a TFSA should be taxable (unlike capital gains, which would be tax-free inside the plan). There have been no court cases yet on this issue, but I expect we'll see a case or two in the next couple of years.

 

The RRSP comparison

 

Let's think about registered retirement savings plans for a minute. RRSPs, to my knowledge, have never been attacked when a taxpayer is successfully day-trading in his account. And no wonder, because those assets are taxed when they're withdrawn. Why should the CRA take offence? In fact, the CRA will collect more tax if the taxpayer is successful in his or her RRSP investing.

[Cigarbutt]

Have incomplete information here and think that for RRSPs, the CRA disclosure requirements for financial institutions may be limited to contribution limits. For some reason, there seems to be less emphasis on RRSPs. Maybe CRA realizes that the amounts will eventually, by definition, be taxed at relatively high marginal rates for large accounts. (edit: KCLarkin said it first)

 

However, for TFSAs, my understanding is that CRA is "watching" as regulatory disclosure requirements seem to be very extensive. See appendix A.

https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/rc4477-tax-free-savings-account-tfsa-guide-issuers/tax-free-savings-account-tfsa-guide-issuers.html#P11

 

So, I think they know about the balance and number of transactions and simply trigger audits by defining thresholds.

 

It looks like CRA is becoming ever more sophisticated (aggressive tax planning teams etc) and have screening tools that even look at publicly available information (including Facebook and others) to make sure that your "lifestyle" fits with your tax bill.

 

The following link offers some interesting perspective:

http://www.millerthomson.com/assets/files/article_attachments3/TaxesAndWealthManagement_8-2.pdf?utm_source=Mondaq&utm_medium=syndication&utm_campaign=View-Original

 

In terms of the "rules" (nicely laid out in the previous link), they are more factors or criteria and there are grey zones.

For instance, for exactly the same transactions, if you're questioned/audited by security regulators, you may have to convincingly explain complex financial aspects in order to show that you are not an insider while, at the same time, if you're questioned/audited by CRA, you may underline the aspects that you do this on your free time, using basic knowledge and perhaps that you just got lucky. Not suggesting to lie, only saying that the way you paint the picture may have an effect on the interpretation of the rules.

 

Have heard that many people have been "screwed" by the CRA but imagine that it goes both ways. Need to find a balance.

 

[SharperDingaan]

It really comes down to 'intent'.

The concept behind the TFSA is that as a tax free savings vehicle, the amount in it shouldn't greatly exceed the cummulative limit ($57,500 for 2018) as funds should be both contributed AND withdrawn over time. Especially as the TFSA has now been around for 10 years.

 

BUT, assume that you have been a good saver, and learnt the virtues of patience & value investing. You make a $50,000 investment in a junior mining company at an average cost of 25c/share - in the expectation that at some point; there will eventually be a mine ;) Should it ever occurr, the 200,000 shares will be worth much more than you paid for them. 200K, if they go to $1.00/share.

 

Rather than take the $ out of the TFSA, you have the TFSA contribute it as the down payment on a 2nd house that you rent. To avoid 'complications' maybe you put up 60% of the downpayment, & the TFSA 40%; with ownership of this 2nd property divided 60/40. Tennant rent pays the costs, and 40% of the property appreciation and annual profit accumulates in your TFSA account, tax free. Ultimately, a lifetime of wealth could accummulate INSIDE the TFSA - & you may never take it out until you eventually die. When it passes to your estate TAX FREE as a withdrawal of capital from a tax free account (estate fees excluded).

 

Obviously this is not the intent of the account, and maybe 2% of the population end up in this position. But as these are also very smart individuals, the amounts in their TFSA's could also quite easily grow to the hundreds of millions. Most places don't penalizing citizens for simply being smart, but the outlying amounts are going to attract attention.

 

As with insurance we promote the big payouts, as marketing to purchase the product (insurance). However, promoting the top 2% to get the other 98% of the population to conribute to a TFSA, could really screw up your day. Too many people start doing this, even if only moderatly successful, and your tax stream drops like a brick.

 

Karma.

 

SD

[rb]

How does the CRA find out what is going on in TFSA's and RRSP's as there are no trading summary sent to them unlike for non-registered accounts? Maybe that I am wrong on that one but, that is my understanding.

They do get information about what's in your RRSP and TFSA. That's why you don't have to report foreign holdings in RRSP and TFSA on T1135. They also collect information to meet their duties under various information sharing agreements.

 

Regarding this, I disagree:

 

"The rules are what the rules are - the Income Tax Act. The CRA's job is also not to make the rules, it's to collect tax according to the rules."

 

The section describing what should be on capital vs income account is subject to wide interpretation. Of course, there is common sense to it but, I would not call it a rule.

 

Cardboard

That's fair.

[rb]

Rather than take the $ out of the TFSA, you have the TFSA contribute it as the down payment on a 2nd house that you rent. To avoid 'complications' maybe you put up 60% of the downpayment, & the TFSA 40%; with ownership of this 2nd property divided 60/40. Tennant rent pays the costs, and 40% of the property appreciation and annual profit accumulates in your TFSA account, tax free. Ultimately, a lifetime of wealth could accummulate INSIDE the TFSA - & you may never take it out until you eventually die. When it passes to your estate TAX FREE as a withdrawal of capital from a tax free account (estate fees excluded).

Yea..... you're not allowed to do this. In fact you're really not allowed allowed to do this. If you do it, you will get caught and the government will tax the living daylights out of you. Currently the penalty for doing that is 100% of income and 50% of assets.

[SharperDingaan]

Rather than take the $ out of the TFSA, you have the TFSA contribute it as the down payment on a 2nd house that you rent. To avoid 'complications' maybe you put up 60% of the downpayment, & the TFSA 40%; with ownership of this 2nd property divided 60/40. Tennant rent pays the costs, and 40% of the property appreciation and annual profit accumulates in your TFSA account, tax free. Ultimately, a lifetime of wealth could accummulate INSIDE the TFSA - & you may never take it out until you eventually die. When it passes to your estate TAX FREE as a withdrawal of capital from a tax free account (estate fees excluded).

Yea..... you're not allowed to do this. In fact you're really not allowed allowed to do this. If you do it, you will get caught and the government will tax the living daylights out of you. Currently the penalty for doing that is 100% of income and 50% of assets.

 

The financial instrument just has to be one of the many types of 'eligible' asset that a TFSA may hold. Were this transaction to occurr, it would be structured as one of those 'eligible' assets (expensive) - but the bigger the TFSA investment, the more cost effective that 'structuring cost' would become (& this 2% would very likely know the best of the creative). Ultimately it would come down to whether the undying attention of the CRA is really worth the hassle.

 

SD

 

 

 

[rukawa]

You're right. Business income designation can happen for any account. I'd say it's reasonable. I would also say that in the incident you've quoted the person didn't get screwed by the CRA. The rules are what the rules are - the Income Tax Act. The CRA's job is also not to make the rules, it's to collect tax according to the rules. It seems to me that they were just doing their job the way they were supposed to. The individual in the article also knew or should have known the rules but chose to ignore them.

 

What are the rules exactly. As far as I can see there are no hard and fast rules so I don't know exactly what you mean when you say a person knew the rules. I mean I can understand if a person is a market maker. That is pretty clearly a trading business. But as far as I can see the question seems to be based on :

- frequency of trades and turnover

- are you a professional broker or trader. 

- how much time and effort you spend and how much specialized knowledge you apply. Here working harder, spending more time or knowing more is a bad thing...very especially if has connection to a "finance" time position related to trading or investing.

- intent - meaning whether you are aiming at high short term high returns or "investing". But what this means is extremely unclear to me. I think a dividend/income investor could very easily defend the idea that he was "investing". But any holder that is interested in price appreciation is in a more tricky situation.

 

THis is especially true if you are aiming to take advantage of a special situation. For instance there was a going private transaction I invested in based on the fact that the stock was trading 15% under the price it was going to be bought at. The whole thing happened over few months. I believe a situation like this or an merger arb is pretty much against the rules. I'm guessing though the CRA won't go after you unless you do a lot of these.

 

I'm curious as to whether funds are treated in the same way.  I'm guessing that there are funds where trading frequency is quite high compared to the situation I described in the original post. But I doubt holders of these funds have their gains taxed as income.

[Cigarbutt]

Your question/comment about funds is very relevant in terms of deciding if capital gains should be tax-treated in the capital or income account.

After all, average holding periods for "professional" investors has considerably come down (now down to a few months  ???):

http://topforeignstocks.com/2017/10/01/average-stock-holding-period-on-nyse-1929-to-2016/

IMO, this is not healthy but, as far as I know, this is considered the norm and I have not heard of funds being hassled by the CRA for the short-term orientation.

 

On that topic, from Mr. Keynes (when he thought that investors were impatient):

 

"The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only."

 

 

From the individual point of view, if you are good enough to make profitable investments consistently, you should be good enough to know the basic criteria or factors that the CRA has published and there is relevant case law. In a way, the CRA will make an assessment as to whether you are involved in an "adventure in the nature of trade" or not.

 

Here's a nice recent example (public domain):

https://www.canlii.org/en/ca/tcc/doc/2017/2017tcc61/2017tcc61.html?searchUrlHash=AAAAAQAZYWR2ZW50dXJlIG5hdHVyZSBvZiB0cmFkZQAAAAAB&resultIndex=9

 

I would say that if go for a fight with the CRA, your credibility should be as unusual as your returns. :)

 

[rb]

You're right. Business income designation can happen for any account. I'd say it's reasonable. I would also say that in the incident you've quoted the person didn't get screwed by the CRA. The rules are what the rules are - the Income Tax Act. The CRA's job is also not to make the rules, it's to collect tax according to the rules. It seems to me that they were just doing their job the way they were supposed to. The individual in the article also knew or should have known the rules but chose to ignore them.

 

What are the rules exactly. As far as I can see there are no hard and fast rules so I don't know exactly what you mean when you say a person knew the rules. I mean I can understand if a person is a market maker. That is pretty clearly a trading business. But as far as I can see the question seems to be based on :

- frequency of trades and turnover

- are you a professional broker or trader. 

- how much time and effort you spend and how much specialized knowledge you apply. Here working harder, spending more time or knowing more is a bad thing...very especially if has connection to a "finance" time position related to trading or investing.

- intent - meaning whether you are aiming at high short term high returns or "investing". But what this means is extremely unclear to me. I think a dividend/income investor could very easily defend the idea that he was "investing". But any holder that is interested in price appreciation is in a more tricky situation.

 

THis is especially true if you are aiming to take advantage of a special situation. For instance there was a going private transaction I invested in based on the fact that the stock was trading 15% under the price it was going to be bought at. The whole thing happened over few months. I believe a situation like this or an merger arb is pretty much against the rules. I'm guessing though the CRA won't go after you unless you do a lot of these.

 

I'm curious as to whether funds are treated in the same way.  I'm guessing that there are funds where trading frequency is quite high compared to the situation I described in the original post. But I doubt holders of these funds have their gains taxed as income.

Ok, a couple of things. In my post i expressed myself incorrectly when I've said rules. That's because our tax system is not one based on rules. It is one based on principles. The other thing is that in your post you've pretty much answered your questions.

 

All of the points you've mentioned are taken into account when determining whether you are operating as a business or as an investor. In the case where you've found an arb opportunity because you're a smart guy, yes that's against the "rules" but really what you're doing is investing and just found an opportunity to make some more money cause you're smart. That's ok because you haven't broken the principle. If all or most of what you're doing is arb situations then you'r not really an investor. You're an arb business. Then you'll be taxed as a business.

 

When it comes to funds you're also spot on. The profits of people that have put the money into funds are not taxed as a business because they're not running a business. They've saved and given the money to other people to manage. The fees are even tax deductible. On the other side the profits of the fund management are fully taxable as business income. No carry charge loophole here.

 

It seems to me that you've got a good handle on how things work and it seems things are working pretty well.