Wednesday, October 21, 2009

TFSA Abuse

There seems to be no limit to the number of clever schemes that tax experts come up with to avoid paying taxes. The Canadian government is planning to make some changes to the rules governing Tax-Free Savings Accounts (TFSAs) to close some loopholes.

The most interesting tax avoidance scheme involves swaps between RRSPs and TFSAs. Before now I wasn’t aware that such swaps were permitted without any tax implications. The idea is that if you have $5000 in cash in one account and $5000 worth of stock in the other, you can swap the cash for the stock without it counting as a withdrawal or contribution.

This makes some sense. After all, the total value in each account doesn’t change. It’s like one account bought the stock from the other account at fair market value. However, this swapping idea led to an amusing scheme to shift assets from an RRSP to a TFSA. I’ll explain it with an example.

Suppose that Tammy the tax avoider is nearing retirement with $100,000 in an RRSP and $5000 in a TFSA. Tammy is facing the prospect of having to pay income taxes on the $100,000 as she withdraws it from her RRSP over time. She’d much rather have the money in a TFSA where it can be withdrawn tax-free.

Tammy begins by buying 500 shares of (hypothetical) ABC shares for $10 each:

TFSA: $0 plus 500 ABC shares
RRSP: $100,000

Suppose that ABC stock goes up to $12. Then Tammy swaps the TFSA shares for $6000 cash in the RRSP:

TFSA: $6000
RRSP: $94,000 plus 500 ABC shares

Then the stock goes back down to $10, and Tammy swaps them back for $5000:

TFSA: $1000 plus 500 ABC shares
RRSP: $99,000

Since the stock went up then back down, Tammy hasn’t made any money, but notice that she has managed to shift $1000 from her RRSP to her TFSA. If ABC stock cooperates by continuing to bounce up and down, Tammy can keep shifting money from her RRSP to her TFSA.

The proposed new rules for TFSAs will apply a 100% tax (ouch!) to TFSA amounts that can be attributed to such a scheme. Tax avoidance is all fun and games until your money gets confiscated.

UPDATE: Some have suggested that when performing a swap, there is the opportunity to select any price in the day's trading range.  This means that when stock moves out of the TFSA, a high price can be chosen, and when it moves back into the TFSA, a low price can be chosen.  This makes this scheme much more effective.


  1. "Tax avoidance is all fun and games until your money gets confiscated."

    Oh man, that's classic.

    Anyway, that is a damn clever scheme. I wonder exactly what kinds of swaps are still allowed?

  2. I'm not sure what exactly a ban on swaps seeks to accomplish. In the example in your post, what stops Tammy from buying and selling (instead of swapping) ABC in her RRSP and TFSA accounts to accomplish the same thing?

  3. CC: Good point. Another concern I had when I first heard about this is whether one could find a stock that is so cooperative, and if so, why not buy low and sell high to make even more money? One concern for buying and selling as you describe is getting hit with spread losses in addition to commissions.

  4. Michael - I think you're right. This is just another way of trying to get big returns with market timing, and if you could do that, you wouldn't need this trick!

  5. Well, these are amazing ways for tax avoidance. Now, i have understood the basic concept of swapping.

  6. I don't think that market timing would be necessary if the loophole was left open.

    Let's say Tammy decides to invest her 100000 RSP into 20 different bonds that each make their payments on different dates (5000 into each bond). She could then "swap" each of the bonds into her TFSA just before the payment date, so that she never has to pay tax on the income generated.

  7. ChrisR: Your idea falls into the category of doing a swap for a value different from true fair market value. Obviously the bond is worth more just before making a payment, but if it can be traded for its initial value, then you can get an advantage. You may be right that clever people could find ways of doing swaps at prices different from fair market value.

  8. i bet there were more sophisticated strategies that investors were using that worried the government. Swapping options makes the most sense to me. You can substantially hedge the risk by buying an equal number of puts and calls and putting them in a RRSP, and putting an equal number of puts and calls in the TFSA. Because of the time value of options, they are by definition volatile day-to-day. When the puts are in the money, you swap the puts to the RRSP for cash. As soon as you have swapped tax-free a few thousand dollars from your RRSP to TFSA, you liquidate your call and put positions.

  9. Fred: I agree that finding something with much more volatility (like options) would be more effective than the basic strategy I described.

  10. very clear explanation. I finally understand it.