Holding Cryptocurrency in Your Tax-Free Savings Account (TFSA): Tax Delight or Tax Disaster?

Holding cryptocurrency in your Tax-Free Savings Account (TFSA):  tax delight or tax disaster?

A tax-free savings account (TFSA), which was introduced in 2009, enables people to earn investment income without paying taxes on it. Although you cannot deduct your TFSA contributions, the earnings that accumulate there are tax-free. The profits you accrued inside your TFSA are also not taxed when you withdraw them. To put it another way, a tax-free savings account, as its name implies, essentially enables you to grow your savings without paying taxes.

Canadians seeking investment options may regard cryptocurrencies as a means of generating higher profits given the competition amongst cryptocurrencies like Bitcoin, Binance, Coinbase, Kraken, and Ethereum for adoption in the mainstream financial scene. Smart contracts, cryptocurrency liquidity mining and yield farming, and non-fungible tokens (NFT), to mention a few, are only a handful of the opportunities, arrangements, and assets that have been made possible by advancements in blockchain technology. And Canadians could be interested in combining these possibilities with a TFSA's tax benefits.

Thus the question is: Can you add cryptocurrencies and other blockchain-based assets to your tax-free savings account? Or is this a potential tax disaster?

This article examines whether cryptocurrency or other blockchain assets can qualify as TFSA investments by first discussing the fundamental tax regulations governing tax-free savings accounts, namely the requirement that a TFSA must contain "qualified investments." In order to help Canadian taxpayers hold qualified cryptocurrency investments in their tax-free savings accounts, this article offers professional tax advice. It then provides Pro crypto tax tips from our experienced Canadian crypto tax lawyers and ends with some frequently asked questions.

TFSAs, "Qualified Investments," and the Penalty Tax on TFSA

Any person who is at least 18 years old and a Canadian tax resident may open a tax-free savings account. To put it another way, the holder of a TFSA must be a natural adult person (as opposed to a corporation or other entity). Also, you cannot open or make contributions to a tax-free savings account if you are not a Canadian tax resident.

It may be necessary to carefully examine both Canadian domestic tax law and the tax regulations under a tax treaty between Canada and another state in order to determine a person's status as a Canadian tax resident, which is dependent on multiple intricate, interconnected tax rules. Importantly, tax residence is different from immigration residence: You can be a Canadian tax resident even if you aren't a Canadian citizen or a permanent resident, and you can be a Canadian citizen or permanent resident but fail to be a Canadian tax resident. You can get guidance from our knowledgeable Canadian tax lawyers regarding your status as a tax resident in Canada and the ensuing Canadian tax obligations.

The tax benefit of a tax-free savings account is that you don't have to pay taxes on any income that accumulates in your TFSA, including interest, dividends, capital gains, and other income. (Contributions to a TFSA are not tax-deductible, and withdrawals are not taxed, unlike contributions to a registered retirement savings plan or RRSP.)

The amount that you can contribute to your TFSA each year is capped under the Income Tax Act of Canada. Since 2009, when the Canadian Parliament first introduced the tax-free savings account, the TFSA dollar limit has generally been between $5,000 and $6,000 per year. (The only exception is 2015 when the TFSA dollar limit was raised by Stephen Harper to $10,000 for the entire year.) The TFSA dollar limit for the 2021 tax year is $6,000.

Notwithstanding this, there is a cumulative TFSA dollar limit. This implies that even if you haven't opened a tax-free savings account, the annual TFSA contribution limit results in more room for contributions. To give an example, your total TFSA contribution room in 2021 is $75,500 if you have never opened a tax-free savings account and have been eligible since the TFSA was introduced in 2009. Furthermore, any money you take out of your tax-free savings account is added to the amount you can contribute to a TFSA the following year.

This means that your TFSA contribution room for the year is actually the sum of the following three amounts: (1) the TFSA dollar limit you have for that year, (2) any withdrawals from the previous year from your TFSA, and (3) your previous year’s unused TFSA contribution room.

A TFSA penalty tax is imposed on over-contributions to your tax-free savings account. You will be subject to a TFSA penalty tax on the excess amount at a rate of 1% per month if, at any point throughout the year, you make a TFSA contribution that exceeds your TFSA contribution room. You must also submit a special tax return (Form RC243, "Tax-Free Savings Account Return," and Form RC243-SCH-A, "Schedule A - Excess TFSA Amounts") that reports the TFSA penalty tax; failing to do so could result in extra penalties. Interest at the established rate is further charged on the penalty tax.

If a non-qualified investment is acquired by the tax-free saving plan, there is also a penalty tax that is charged and due. The TFSA holder is subject to a TFSA penalty tax equal to 50% of the fair market value of the non-qualified investment if the TFSA purchases a non-qualified investment or if an existing TFSA investment turns into a non-qualified investment. Additionally, any income from the non-qualified investment or any capital gains from selling the non-qualified investment must be taxed by the TFSA holder.

In other words, the tax-preferred treatment of a TFSA only applies to its "qualified investments." The term "qualified investments" is defined in the Income Tax Act to include all of the following:

• cash, GICs, and various deposits;
• the majority of securities that are listed on a certain stock exchange, including shares of corporations, warrants, options, units of exchange-traded funds, and real estate investment trusts;
• segregated funds and mutual funds;
• Provincial savings bonds as well as Canada Savings Bonds;
• a corporation's debt obligations posted on a certain stock market;
• debt obligations with a rating of investment-grade; and
• mortgages or hypothecs with insurance.

Determining whether cryptocurrencies, non-fungible tokens, or other blockchain-based assets qualify as "qualifying investments" is the key tax concern for Canadian taxpayers who want to hold them in their tax-free savings accounts.

What Are "Qualified Investments" in a Tax-Free Savings Account for Cryptocurrency, Non-Fungible Tokens, and Other Blockchain Assets?

As stated above, the Income Tax Act's definition of "qualified investments" essentially relates to two items: (i) money and (ii) securities that are listed on an authorized stock exchange. As such, cryptocurrencies and non-fungible tokens themselves are not "qualified investments." Digital currencies, such as [B]itcoins, are not deemed to be money issued by a government of a country and are not qualifying investments, according to the Canada Revenue Agency (CRA), which is legally correct (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). Furthermore, no cryptocurrency or NFT is traded as a security on a stock exchange that has been authorized to do so by the Department of Finance of Canada. Hence, since they don't fall within the Income Tax Act's definition of "qualified investments," cryptocurrencies and non-fungible tokens cannot be held in your TFSA.

Nonetheless, the number of cryptocurrency-based exchange-traded funds (ETFs) has recently increased, with many of them being traded on certain stock exchanges. The result is that even if cryptocurrencies themselves aren't "qualified investments," many of the publicly traded cryptocurrency ETFs are. As a result, these cryptocurrency ETFs might be acceptable TFSA investments. The cryptocurrency-based ETF specifically qualifies as a "qualified investment" if it trades on one of the stock exchanges the Canadian Finance Minister has designated for the purposes of the Income Tax Act of Canada, such as the Toronto Stock Exchange (TSX), the New York Stock Exchange (NYSE), or any other Canadian or foreign stock exchange.

In conclusion, since cryptocurrencies and non-fungible tokens are not "qualified investments" in and of themselves, your TFSA cannot hold them directly. But only if the fund is listed on a designated stock exchange, such as the Toronto Stock Exchange or the New York Stock Exchange, can your TFSA hold cryptocurrency-based ETFs or other funds. Beware, however, not to acquire cryptocurrencies and non-fungible tokens directly in your TFSA, otherwise, you will be subject to the penalty tax.

Tax Pro Tips - Exemption from TFSA Penalty Tax for Non-Qualified Cryptocurrency Investments, as well as CRA Tax Audits for TFSAs Operating a Business: Tax Guidance from an Expert Canadian Crypto Tax Lawyer

Cryptocurrencies and non-fungible tokens are ineligible for holding in your tax-free savings account as previously stated because they do not fall within the Income Tax Act's definition of "qualified investments." You will be subject to a TFSA penalty tax equal to 50% of the fair market value of each non-qualified investment in your tax-free savings account if your tax-free savings account contains cryptocurrencies, non-fungible tokens, or any other non-qualified investment.

The Canada Revenue Agency has the authority under subsection 207.06(2) to partially or fully waive the TFSA penalty tax incurred as a result of holding non-qualified investments, such as cryptocurrencies or non-fungible tokens, in your tax-free savings account. In particular, the CRA has the authority to cancel the TFSA penalty tax if it "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].”

Numerous crypto tax clients have requested that our experienced tax lawyers specializing in Canadian cryptocurrency tax arrange for the cancellation of TFSA penalty taxes under paragraph 207.06(2), and we have aided them in doing so. Your application under Section 207.06(2) can be thoughtfully planned and quickly completed. If your application for the cancellation of penalty taxes on your TFSA is properly written, it will boost your chances of getting approved by the CRA and establish the framework for a request for judicial review at the Federal Court in the event that the CRA unjustly rejects your request.

In accordance with section 146.2(6) of the Canada Income Tax Act, the income from your tax-free savings account is taxable if it is used to operate a business. In other words, while any interest, dividends, or capital gains that build in your TFSA are tax-free, any business income that is generated in your TFSA will be subject to tax. The issue is that a lot of cryptocurrency transactions blur the distinction between capital transactions and transactions that generate income for businesses. Therefore, even if your cryptocurrency-based assets meet the criteria for investments that you may hold in your TFSA, you may still be subject to tax liability if the nature of your transactions leads one to believe that actively trading these assets inside of your tax-free savings account constituted the conduct of a business. The ambiguity between investing, which results in a capital gain, and trading, which generates business income, has been the subject of extensive case law produced by Canadian courts. When determining whether to classify gains or losses from a transaction as on an account of capital or income, courts consider a wide range of factors.

On how to handle problems with your TFSA holdings and transactions, our Certified Expert Canadian tax lawyer can provide guidance. This professional tax assistance can be very helpful in avoiding a CRA finding that you misrepresented information on your tax returns, reducing your exposure to tax liability, and avoiding fines.

Frequently asked questions

I want to invest in bitcoin or NFTS. Can my TFSA hold cryptocurrency or NFTS?

Cryptocurrency or NFTS are not qualified investments for your tax-free savings account. If you do acquire them in your TFSA you will be subject to a penalty tax. However your TFSA can acquire exchange-traded funds (ETFs) that do qualify as a TFSA investment.

I acquired Ethereum (ETH) in my TFSA without knowing it was not eligible as a qualified investment. I understand I am subject to a penalty tax. What can I do?

Our experienced Canadian crypto tax lawyers can apply for the cancellation of TFSA penalty taxes under paragraph 207.06(2).

Disclaimer:

"This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a lawyer."