Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: 1(a) Would an unintended short-term overdraft in a TFSA trust constitute “borrowing money or other property” in contravention of the prohibition in paragraph 146.2(2)(f)? 1(b) What about a temporary advance of funds to a TFSA trust as part of a cashless exercise of warrants? 2. Whether we support the CRA adopting an administrative position to provide relief in certain circumstances? 3. In the event a borrowing is found to have occurred, would the resulting de-registration of the TFSA cause a permanent loss of TFSA savings room, or would it be considered a distribution and therefore added back to next year’s TFSA contribution room?
Position: 1(a) and (b). Question of fact, but in most cases, yes. 2. Yes. 3. The de-registration of the TFSA would cause a permanent loss of TFSA savings room.
Reasons: 1(a) and (b). Where it can be established that there is a lender/borrower relationship, the TFSA trust would be considered to have “borrowed money”. 2. It is reasonable to ignore these temporary technical overdrafts. 3. The deemed disposition resulting from the TFSA de-registration is not considered a distribution under the TFSA.
October 22, 2015
Leslie Row Income Tax Rulings
ATP Projects section Directorate
International and Large Business Wayne Doiron
Directorate Dave Wurtele
Restriction on borrowing in a tax-free savings account (TFSA)
We are replying to your correspondence in which you requested our opinion with respect to the meaning of the words “borrowing money or other property” in paragraph 146.2(2)(f) of the Income Tax Act (the “Act”). Specifically, you raised the following questions:
(a) Would an unintended short-term overdraft in a TFSA trust constitute “borrowing money or other property” in contravention of the prohibition in paragraph 146.2(2)(f)?
(b) What about a temporary advance of funds to a TFSA trust as part of a cashless exercise of warrants?
2. Whether we support the CRA adopting an administrative position to provide relief in certain circumstances?
3. In the event a borrowing is found to have occurred, would the resulting de-registration of the TFSA cause a permanent loss of TFSA savings room, or would it be considered a distribution and therefore added back to next year’s TFSA contribution room?
As you are aware, XXXXXXXXXX raised similar questions with the CRA about how “administrative/procedural” overdrafts could be treated under the Act. XXXXXXXXXX asserts that these unintended and incidental short-term overdrafts are not meant to enhance TFSA values through the use of leverage and that these types of overdrafts arise through the ordinary functioning of the capital markets. XXXXXXXXXX requested that the CRA consider appropriate administrative relief in these cases in the event we conclude that the transactions give rise to borrowing.
In their submission, XXXXXXXXXX outlined several examples that they believe warrant relief. We have reproduced these examples below as they will form the basis of our response to your questions 1(a) and 2.
Overdrafts of very short duration that are quickly or naturally reversed or not client-directed
- Settlement mismatch – Depending on the nature of the security, a security can settle on the same day or up to three days from the transaction date consistent with industry-wide standard settlement cycles. Given the different settlement dates for different types of investments, on occasion, there can be a settlement mismatch in respect of a purchase and sale order which results in a short-term overdraft. For example, if a long-term bond were sold and a T-bill was bought on the same day, there would be a three-settlement-day mismatch where the T-bill had to be paid for before the cash was received from the sale of the long-term bond. Financial institutions’ systems may automatically charge a small amount of interest (two-days’ interest), which will show up on the client’s statements. Where there were insufficient funds otherwise available, this would result in an incidental short-term overdraft which would be corrected naturally when the long-term bond settles. The payment of fees in the TFSA trust through the sale of securities is another example of a potential settlement mismatch.
- Trading error – A financial institution may inadvertently purchase a larger quantity of an investment or sell a smaller quantity of an investment than instructed by the TFSA holder. Where there were insufficient funds to cover the error, this would result in an unintended short-term overdraft which would be corrected as soon as reasonably possible.
- Portfolio rebalancing – Typically, investment plans are designed with a mix of various types of investments (e.g. 70% equity/30% fixed income). Portfolio rebalancing is a typical strategy used by a TFSA holder to shift the mix of investments (e.g. 70/30 to 60/40). Occasionally a short-term overdraft arises were rounding occurs amongst the different categories.
Infrequent unintended short-term overdrafts
- NSF cheque or debit – A TFSA holder may inadvertently write a cheque or authorize a debit transaction for a TFSA contribution in which ‘not sufficient funds’ were available. Where a purchase request was made in relation to that intended contribution and there were insufficient funds to otherwise cover the purchase transaction, an unintended short-term overdraft would result. The TFSA holder would be instructed to correct the error as soon as reasonably possible or the transaction would be reversed or the financial institution would sell sufficient securities within the TFSA to cover the overdraft. XXXXXXXXXX has stated that any repeat behaviour would be dealt with strictly.
- NSF withdrawal – In extremely rare situations, a TFSA withdrawal may be processed before the settlement of a sale transaction. Where there were insufficient funds, this would result in an incidental short-term overdraft which would be corrected naturally when the related security settles.
- Fees – Occasionally, there may be insufficient funds in the TFSA to cover fees which would result in an unintended short-term overdraft. The TFSA holder would be instructed to correct the error as soon as reasonably possible.
- Stock certificate – In extremely rare circumstances, a TFSA holder may deposit a physical stock certificate which is found to be invalid only after it is sold. Where there were insufficient funds, this would result in an unintended short-term overdraft. The TFSA holder would be instructed to correct the error as soon as reasonably possible.
- Client-initiated trading error – While not outlined by XXXXXXXXXX, a TFSA holder could request a purchase of securities in which insufficient funds are available. Where the financial institution inadvertently actions the purchase request, an unintended short-term overdraft would result. Interest is normally charged. We understand that the TFSA holder is instructed to correct the error as soon as reasonably possible or the transaction would be reversed or the financial institution would sell sufficient securities within the TFSA to cover the overdraft. It is presumed that any repeat behaviour would be dealt with strictly.
To qualify as a TFSA, paragraph 146.2(2)(f) requires that the terms of a TFSA trust must prohibit the trust from borrowing money or other property. If a TFSA is not administered in accordance with this condition, paragraph 146.2(5)(c) provides that the arrangement automatically ceases to be a TFSA, and thus loses its tax-exempt status, effective at the time the borrowing occurs.
The meaning of the term “borrowed money” has been interpreted by the CRA and the courts, as explained in Income Tax Folio S3-F6-C1 Interest Deductibility:
1.23 In MNR v T. E. McCool Limited,  CTC 395, 49 DTC 700 (SCC), it was noted that for income tax purposes the term borrowed money is interpreted to require "a relationship of lender and borrower between the parties". A requirement of any lender and borrower relationship is the existence of a loan outstanding between the two parties.
In the case of an overdraft in a TFSA, where it can be established that there is a lender/borrower relationship we would consider the TFSA trust to have “borrowed money or other property” in contravention of paragraph 146.2(2)(f). This will always be a question of fact.
1(a) Unintended short-term overdraft
Each of the examples described above (with one exception noted below) involves the payment of monies out of the TFSA trust in which insufficient funds were available to complete the transaction. It is clear that monies were provided to the TFSA trust in order to complete the payment out of the TFSA trust thereby creating a lender/borrower relationship. Interest is normally charged (although it may be reversed in certain cases). As a result, the TFSA trust would be considered to have “borrowed money”.
In the example where fees are charged to the TFSA, we would consider the TFSA trust to have borrowed money similar to the results above where funds are provided to the TFSA trust to cover the payments of fees to a third party (e.g., broker). However, where an overdraft is created in respect of fees charged to the TFSA but which remain unpaid, we would not consider this to be borrowing as no actual funds would be borrowed in this case. While indebtedness is created in the latter case (a debtor/creditor relationship), it is not a lender/borrower relationship and therefore would not constitute “borrowing of money or other property” for the purposes of paragraph 146.2(2)(f).
1(b) Cashless exercise of warrants
In the situation you considered, we understand that the broker advanced the funds to the TFSA trust necessary to exercise the warrants in question. The broker, acting as an agent of the TFSA trust, exercised the warrants, obtained the underlying shares, and then sold the shares to a third party. Using the sale proceeds, the broker recovered their portion of monies used to exercise the warrants plus any fees or charges and provided the remaining monies to the TFSA trust.
In our view, this is a form of buying on margin which clearly involves a lender/borrower relationship and therefore would be considered “borrowing money”. There may be other methods of performing a cashless exercise of warrants and each method would have to be reviewed to determine whether a borrowing occurred.
2. Administrative position
We agree with your recommendation that the CRA adopt an administrative position to accommodate the situations considered in 1(a) above, as follows.
The CRA will not apply paragraph 146.2(5)(c) to an overdraft in a TFSA if it:
- is temporary in nature and covered without undue delay;
- arises as a result of (i) a mismatch of cash flow due to differences in standard settlement cycles for securities, (ii) a reasonable error, or (iii) an unintended infrequent event; and
- does not have the character of leveraged investing.
This administrative position is intended to accommodate certain overdrafts of very short duration that are quickly or naturally reversed or that are infrequent and inadvertent. This position does not apply to borrowing that arises in connection with a cashless exercise of warrants or a margin account.
You note that other registered plans are subject to similar borrowing restrictions as TFSAs. If a trust governed by a registered retirement savings plan, registered retirement income fund or registered disability savings plan borrows money in a year (or in a previous year that has not been repaid before the beginning of the year), it is required to pay Part I tax on its taxable income for the year in accordance with paragraph 146(4)(a), subsection 146.3(3) or paragraph 146.4(5)(a), respectively. If a trust governed by a registered education savings plan borrows money, paragraph 146.1(2.1)(d) provides that the plan is revocable (subject to certain conditions that accommodate short-term borrowing).
We agree with your recommendation that the administrative position should also apply for the purposes of these provisions.
3. TFSA de-registration
Where a TFSA is not administered in accordance with the conditions in subsection 146.2(2), the arrangement will cease to be a TFSA pursuant to paragraph 146.2(5)(c) at the earliest time at which the failure to so administer occurs. In the case of a trust that ceases to be a TFSA, subsection 146.2(8) deems the trust:
- to have disposed, immediately before the particular time, of each property held by the trust for proceeds equal to the property's fair market value immediately before the particular time; and
- to have acquired, at the particular time, each such property at a cost equal to that fair market value.
The essence of the question at hand is whether this deemed disposition would be considered to be a “distribution” under the TFSA for the purpose of variable C of the definition of “excess TFSA amount” and variable B of the definition “unused TFSA contribution room” in subsection 207.01(1). If considered a distribution, the amount would be added back to the taxpayer’s TFSA contribution room in the following year.
A “distribution” under a TFSA is defined in subsection 146.2(1) to mean a payment out of or under the TFSA in satisfaction of all or part of the holder's interest in the TFSA. Where a TFSA trust disposes of property for fair market value proceeds, the transaction would not constitute a distribution under the TFSA since the holder has received nothing in satisfaction of their interest in the arrangement. This is true regardless of whether the disposition is an actual disposition or a deemed disposition.
Accordingly, the de-registration of an individual’s TFSA would cause a permanent loss of TFSA savings room for the individual.
We trust that these comments will be of assistance.
Mary Pat Baldwin, CPA, CA
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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