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Why ban swap transactions in TFSA accounts?

October 21st, 2009 · 13 Comments

The Department of Finance is cracking down on what it calls “the use of inappropriate transactions to draw excessive benefits” from Tax-Free Savings Accounts. The amendment targets deliberate overcontributions to TFSAs, holding non-qualified investments in TFSAs and swap transactions between TFSAs and other accounts. Penalizing the first two strategies makes sense but it is not clear what problem a blanket ban on swap transactions is trying to achieve. Finance describes the problem as follows:

“Asset transfer transactions” (sometimes known as “swap transactions”), in this context, refer to transfers of property (other than cash) for cash or other property between accounts (for example, a Registered Retirement Savings Plan (RRSP) and another registered account) that are generally not treated as a withdrawal and re-contribution, but instead as a straightforward purchase and sale. Subject to the application of existing anti-avoidance rules in the Income Tax Act, these transfers, when performed on a frequent basis with a view to exploiting small changes in asset value, could potentially be used to shift value from, for example, an RRSP to a TFSA without paying tax, in the absence of any real intention to dispose of the asset.

Michael James wrote a pretty good explanation on how frequent swaps between a RRSP and a TFSA can slowly transfer assets from the former to the latter, which can then be withdrawn tax-free. But banning swaps entirely doesn’t really solve the problem. Though it is more expensive, selling an asset in one account and buying it in another achieves the same result that a swap does and is still open for someone wanting to shift value from a RRSP to a TFSA. So, why ban swap transactions altogether? Informed speculation is welcome.

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13 responses so far ↓

  • 1 Michael James // Oct 21, 2009 at 9:58 pm

    I’ll take a shot at seeming informed. I wrote more about this issue on my own blog:

    link

    including the following possibilities:

    1. The government hasn’t thought of this.

    2. The new rules will actually cover this kind of dual activity in an RRSP and TFSA.

    3. The government thinks that the costs of commissions and spreads will make it impossible to profit from this strategy.

  • 2 Robillard // Oct 22, 2009 at 2:40 am

    I can sort of see why asset transfers are banned, but I think it is far more draconian than it needs to be. I think the ability to swap securities might have been seen by some as a way of getting around the required withholding tax when funds are deregistered from an RRSP. I don’t see why they need to ban swaps between taxable accounts and TFSAs though.

  • 3 Chris // Oct 22, 2009 at 2:47 am

    I think that swaps between taxable accounts and TFSA’s could be abused just as easily. If you know the date that a security will generate income, you simply swap it into your TFSA the day before, avoiding tax.

    For example, if you have 2 bond funds that make payments on different dates, you would be able to avoid any tax on the income from both of them, by swapping back and forth to make sure that each fund is always held in the TFSA on the day it pays interest.

    This loophole seems to get shut when you ban swaps.

  • 4 Canadian Capitalist // Oct 22, 2009 at 9:23 am

    @Michael: I think more clarity will emerge when the Government explains the changes in more detail. You could be right about (2). After all, the Government shut down harvesting tax losses in taxable accounts and purchasing the same investment within a RRSP.

    @Robillard: Assuming, swaps do result in abuses, I agree that banning swaps altogether is too broad. I did consider if there were any scenarios in which I would legitimately want to swap assets between RRSP and TFSA. I couldn’t think of any. Even in your example, the option remains to purchase the same investment within a TFSA and withdrawing it exists (though it is slightly more expensive).

    @Chris: I’m not so sure. A swap with a taxable account would be considered as deemed disposition. To the extent that buying and selling between a taxable account and TFSA results in frequent taxable events, what you are describing may not result in any tax savings — in fact, it may turn out to be even more expensive tax-wise.

  • 5 0xcc // Oct 22, 2009 at 9:26 am

    Robillard brings up a very interesting point. It isn’t that interesting if you think about it today where the TFSA contribution limit is only $5k and will be $10k in a few months. However, if you cast your mind forward about 10 years this becomes a very, very interesting strategy. The TFSA limit would be at least $50k (assuming you haven’t contributed or haven’t made any profit in a TFSA account over the 10 years). On December 30 or 31 you could withdraw your whole TFSA and stick it in a taxable account. Then on January 2 you could swap $50k + $5k from your RRSP into your TFSA. I would expect that to generate a RRSP withdrawal though so you would have to pay tax on the actual withdrawal but maybe you would be able to get away without paying the 10% withholding tax, which I think you can get away without paying right now anyway by withdrawing less than $5k at a time. Of course you end up having to pay the full tax owed in April of the following year anyway and if you use this strategy for more than 2 years you will be asked to pay income tax by quarterly installments and if you don’t pay and you end up owing when you file your taxes you will have penalties to pay…

    The loophole that I sort of see that Chris suggests is that swaps don’t impact contribution room (after all you are just moving equal amounts of cash or investments around). And as Chris suggests there is the potential to effectively double the income inside the TFSA by holding two interest paying instruments that pay out on different days and just swap one for the other. Again, this isn’t too big of an issue today but imagine in 10 years what you might be able to do with contribution room of $50k+.

  • 6 0xcc // Oct 22, 2009 at 9:36 am

    @Canadian Capitalist: If you take the suggestion that Chris makes and do it on something that only pays interest and doesn’t have any capital gains (like a GIC) and as long as the interest payout dates happen on a different day then you could double your tax free income. And you could do even more than double it if you structured a ladder-like GIC portfolio all with payouts in different months of the year (or even weeks of the year or if you wanted to get really tricky days of the year).

    So imagine a portfolio of GICs worth a combined total of $60k and an average interest rate of 3% so in a given year you would have $1800 in interest. If you used just the TFSA for $5k of that you would shelter $150 of interest income. However, if each of those GICs payed the interest out in a different month of the year you could shelter the whole $1800 of interest if you did the swaps at the right time and your ‘effective’ rate of return in your TFSA is 36% (minus the swap fees of course). You could do the same thing with a bond portfolio (and get a better interest rate).

  • 7 Canadian Capitalist // Oct 22, 2009 at 10:14 am

    0xcc: I’m not sure I understand your first comment. How would you get around the withholding tax? The moment you withdraw from a RRSP to contribute to a TFSA, you’ve triggered a taxable event.

    I’ve never contributed GICs in-kind to registered accounts but I’d be very surprised if Chris’ idea works with GICs (and I’m pretty sure you can’t do with GICs. Bonds are very liquid and it is easy to obtain their market value). The current value of a GIC is not its purchase price. It is at least its purchase price plus accumulated interest. Otherwise, you could game the system with GICs even with RRSPs. You can buy compound interest GICs that pay interest on maturity and contribute in-kind to a RRSP a day before it matures. You can then shelter tax on interest to the future if the current value of GIC is taken as its purchase price!

  • 8 0xcc // Oct 22, 2009 at 10:22 am

    Canadian Capitalist: When I say withholding tax I mean ‘tax withheld at source’. So after looking it up (http://www.taxtips.ca/rrsp/withholdingtax.htm) I see that the minimum withholding tax is 10% and it goes up to as much as 30% (I was thinking that the minimum was 0%). So the only benefit I can see is that if you want to not pay the 20% 0r 30% tax immediately you could do a transfer to the TFSA and then withdraw but in the end the income tax you owe wouldn’t change, just when you had to pay it would change.

  • 9 Michael James // Oct 22, 2009 at 2:15 pm

    I’ve seen a plausible explanation for banning swaps in a few places now including Canadian Financial DIY. If the swapper gets to choose any price in the day’s trading range after the fact, he can deliberately choose a low price when stock leaves the TFSA and a high price when the stock returns. This can’t be done when simulating a swap by buying and selling.

  • 10 Canadian Capitalist // Oct 22, 2009 at 2:22 pm

    @Michael: I saw Jean’s post and think that the FWF post he refers to makes sense on how a swap can be used to transfer cash from RRSP to TFSA. However, as Jean points out a ban on swapping altogether is far too punitive. Finance could have simply clarified how to value swaps and proscribed transactions they deem as not kosher.

    http://www.financialwebring.org/forum/viewtopic.php?p=342538&sid=64e68e93ef1207fb2c6ca17e18c37ae0

    http://canadianfinancialdiy.blogspot.com/2009/10/government-ban-on-rrsp-tfsa-swaps.html

  • 11 Michael James // Oct 22, 2009 at 2:34 pm

    When there is an actual sale involved, brokerages are very good at keeping track of the sale price and other data. But when you just move some equities from one of your accounts to another, brokerages aren’t set up to record a fair price. They could change to meet this new requirement, but I don’t think they would want to. If they do it poorly, then it will be open to abuse by their clients and we’re back where we started. To do it well would cost money. It’s far easier for them to have the government ban swaps.

  • 12 Canadian Personal Finance Blog » Blog Archive » Random Bond and TFSA Thoughts // Oct 23, 2009 at 2:51 am

    [...] Canadian Capitalist also comments on the TFSA changes and also wants to know Why Ban Swap Transactions in TFSA Accounts [...]

  • 13 uberVU - social comments // Oct 25, 2009 at 10:48 pm

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