Sleepwalking into day trading can cause tax nightmares

Day trading can have adverse tax consequences, such as an unexpectedly large tax bill.

And day trading within a TFSA can be even more of a surprise, especially since many people think the account is tax-free in all circumstances.

Alexander Demner, partner in the Vancouver office of tax law firm Thorsteinssons LLP, said accountholders deemed to be “carrying on a business” inside their TFSA will typically see the associated income taxed at the top combined federal and provincial marginal rates, which exceed 50% in most provinces.

In addition, taxpayers who don’t realize they’re day trading in their TFSA and fail to declare the appropriate income may be subject to late-filing penalties of up to 17% of the tax owing for amounts that are over a year overdue, plus interest.

“So it’s not uncommon to see an assessment that is larger than the value of the TFSA,” Demner said.

Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth in Toronto, said the combination of a pre-pandemic CRA audit crackdown and a 2023 Tax Court of Canada victory for the agency has created “quite a chill” around day trading in TFSAs.

In a high-profile case, the judge sided with the CRA in its reassessment of a Vancouver investment advisor who grew $15,000 in TFSA contributions to more than $600,000 over three years, largely through active trading of penny stocks.

The CRA found the advisor was carrying on a business in his TFSA, and so the associated gains and income were fully taxable as business income.

The case has been appealed to the Federal Court of Appeal. Golombek said the appeal will likely revolve around the advisor’s claim that business income derived from “qualified investments” should be subject to the same exemption from tax in a TFSA that is available in an RRSP under the Income Tax Act.

Qualified investments are the types allowed in registered accounts, and include money, GICs, shares in most listed companies and units of mutual funds and ETFs.

A decision from the court is unlikely before 2025, Golombek said. “My advice is don’t hold your breath for this, because I think the Income Tax Act is pretty clear,” Golombek said. “Quite frankly, looking at the arguments that were made, I would highly doubt that the taxpayer would be successful on appeal.”

For TFSA holders worried about their volume of trading, Toronto tax lawyer David Rotfleisch said the accountholder may be able to mitigate the risk of a reassessment by adjusting their behaviour.

“If you’re doing a couple of trades a day for 90 days, and then you stop in March, at least you have an argument that it was temporary,” he said. “If the stop comes at the end of November, that’s a harder argument to make.” 

Rather than waiting for a potential audit, Demner said taxpayers who have unknowingly engaged in day trading in their TFSA may prefer to proactively file a return declaring the income with the CRA. However, this is easier said than done, he added.

The TFSA “is not designed to be a business vehicle,” Demner said. “So it gives rise to practical issues as well as simply tax and legal issues.”

For example, those who hold their TFSA as an arrangement in trust may need to discuss the matter with their financial institution, since the primary responsibility for filing returns and objections typically lies with them, rather than the individual taxpayer whose benefit it is held for.

In such a situation, the income would be reported as business income, Demner said.  

If clients are determined to conduct frequent trading inside a registered account, they should consider doing it inside an RRSP or RRIF, Golombek said. That’s because, as the advisor mounting the appeal noted, the Income Tax Act exempts such accounts from paying tax on business income, as long as the income is derived from qualified investments.

“Our advice has always been the same: if you really do want to do this sort of tax-free trading, don’t do it in your TFSA. And as long as you use qualified investments, you can do it in an RRSP or even a RRIF,” Golombek said.