Juliet once said, “A rose by any other name would smell as sweet.” But would the tax-free savings account (TFSA) be as popular as it is without its “tax-free” descriptor?

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Massive TFSA overcontribution lands taxpayer in trouble with the CRA Back to video

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Probably not, according to a new paper, “Tax-Free”: The Effect of a Heuristic Cue on the Choice Between a TFSA and an RRSP, published earlier this month in the Canadian Tax Journal. The authors investigated whether a heuristic cue, specifically, the term “tax-free” causes individual investors to prefer contributing to a TFSA, rather than to a registered retirement savings plan (RRSP). They conducted three experiments to test this proposition, and concluded that individuals have a clear preference for a tax-sheltered savings plan with tax-free in its name, regardless of whether a TFSA is, indeed, the better retirement savings vehicle for them.

As I’ve often discussed in this column, the choice of whether to contribute to a TFSA or RRSP (assuming you don’t have sufficient funds to do both) will generally come down to your tax rate today versus your expected tax rate upon retirement (or withdrawal.)

The tax rate for many Canadians upon retirement will be lower than it was when they were working, suggesting that the savings plan of choice for most should be the RRSP, which provides a tax deduction today at a high(er) rate, and an income inclusion upon withdrawal at a low(er) rate.

But for lower-income Canadians, it’s likely better to pay some tax today at a low rate on their income, and then save those after-tax funds in a TFSA, where they can grow tax free and be taken out at any time, tax free, when one’s tax rate may be higher.

The authors of the paper said the TFSA has in the past decade become more popular than the RRSP, with total annual TFSA contributions surpassing total annual RRSP contributions each year since 2013. But the popularity of the TFSA has also led to some taxpayers getting penalized by the Canada Revenue Agency (CRA) for overcontributing.

Take the most recent case involving a taxpayer who in 2020 significantly overcontributed to his TFSA to the tune of $639,308 by drawing on his line of credit and investing the borrowed funds into stocks inside his TFSA.

Under the Income Tax Act, there’s a penalty of one per cent per month for each month there is a TFSA overcontribution. Accordingly, the taxpayer in July 2021 was reassessed and charged an overcontribution tax of $6,393.08, which is one per cent of the overcontributed amount, presumably relating to one month (December 2020) of overcontribution tax. He was also charged penalties and interest.

The act, however, allows the CRA discretion to grant relief, and states that the agency may waive or cancel the penalty tax if the excess arose through “reasonable error,” and is corrected by the individual “without delay.”

Shortly after receiving his reassessment, the taxpayer contacted the CRA and explained it was his first time using a TFSA and that he “was unaware of how it worked.” He further blamed his financial institution, which “did not inform him of the applicable rules.” When told by a CRA agent to immediately withdraw all the excess contributions from his TFSA, the taxpayer responded that his investments were down 35 per cent and that he would withdraw the money “as soon as the market improved.”

The following month, he followed up with a letter formally requesting the penalty tax be cancelled. In describing his “difficult financial situation,” he noted he was attempting to provide for his family and pay his mortgage all while being on disability due to a workplace accident. By this point, his investments were down by “about 50 per cent.”

He followed up with a second letter in October 2021 and said his portfolio was “now down about 45 per cent and that he is not in a position” to withdraw the overcontributions, but promised to do so “as soon as things get better with his investments.”

At this point, the CRA wrote to the taxpayer and said it had reviewed his situation and noticed the removal of all excess TFSA contributions did not occur, so it refused to cancel the overcontribution tax.

The taxpayer requested a second-level review, which was also denied. The taxpayer then took the matter to Federal Court, where the judge’s role is to determine whether the CRA officer’s refusal to exercise their discretion to deny the taxpayer relief was “reasonable.”

As in prior cases, a reasonable decision is one that is “based on an internally coherent and rational chain of analysis and that is justified in relation to the facts and law that constrain the decision maker.” Generally, a CRA decision is not set aside unless it contains “sufficiently serious shortcomings … such that it cannot be said to exhibit the requisite degree of justification, intelligibility and transparency.”

Upon reviewing the facts of the case, the judge found it “questionable” whether the taxpayer’s significant overcontribution was the result of a reasonable error since the taxpayer made no enquiries as to how TFSAs worked before making a very significant overcontribution. The judge also said that even if it was a reasonable error, the taxpayer chose not to withdraw his overcontribution when he was first notified of it by the CRA, thus failing to meet the requirement to do so “without delay.”

The judge cited a prior case that noted “the CRA is not responsible for the nature of the investments made by (a taxpayer) in his TFSA. He alone bears that risk. (The taxpayer) has decided to avoid economic loss in his TFSA but in doing so cannot then seek discretionary relief from the tax imposed on his excess amount.”

As a result, the judge concluded the CRA’s decision to deny relief was reasonable, as was its explanation and justification for doing so. The judge saw no reason to intervene.

Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. Jamie.Golombek@cibc.com.

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