The pandemic has resulted in accelerated participation in retail trading in the stock market. Retail investors accounted for 45% of total equity trades in January 2021 on the Toronto Stock Exchange, which is an increase from 35% in 2019.[1] Option trading has also become more popular for retail investors; data from the Chicago Board Options Exchange has indicated that single contract options have tripled in volume.[2] Further, the increased option trading has predominately been seen in short-dated call options.
News publications have frequently warned Canadians that “day trading” in a TFSA could cause them to become taxable if the trading activity constitutes “carrying on a business”.[3] In 2018, the CRA claimed to be owed more than $10 million in taxes from taxpayers whose TFSAs amounted to business-like activity. It appears the first TFSA test case will be considered by the Tax Court soon; a taxpayer is being challenged for “carrying on a business” which accumulated $1.2 million in the taxpayer’s TFSA.[4] This is not the case for RRSPs, the Tax Court in Prochuk stated: - “a person trading within his RRSP cannot be considered to be operating a business”.[5]
The CRA has indicated that the following non-exhaustive list of factors will be considered in determining if a taxpayer’s activity constitutes “carrying on a business”:
(a) frequency of transactions - a history of extensive buying and selling of securities or of a quick turnover of properties,
(b) period of ownership - securities are usually owned only for a short period of time,
(c) knowledge of securities markets - the taxpayer has some knowledge of or experience in the securities markets,
(d) security transactions form a part of a taxpayer's ordinary business,
(e) time spent - a substantial part of the taxpayer's time is spent studying the securities markets and investigating potential purchases,
(f) financing - security purchases are financed primarily on margin or by some other form of debt,
(g) advertising - the taxpayer has advertised or otherwise made it known that he is willing to purchase securities, and
(h) in the case of shares, their nature - normally speculative in nature or of a non-dividend type.[6]
The CRA has generally been accustomed to treating options on shares in the same manner as the shares to which they related according to the taxpayer’s usual mien and conduct in buying, holding, and selling securities.[7]
Investing in options is permitted in registered accounts under the definition of “qualified investments” in section 204 of the Income Tax Act. It is interesting to compare the qualities of option trading to the listed criteria above. Options allow investors to achieve significant leverage which can serve as a risk-reduction tool and/or as a speculative financial instrument. The growing number of retail investors have typically been using options speculatively, by targeting short-dated call options.
The short ownership period that typically accompanies options would satisfy item (b) of the list. Options are inherently more complex, which could demonstrate that a taxpayer has securities knowledge, satisfying (c). Options, although not strictly a financing arrangement, could satisfy (f) due to the ability to provide leverage. Options can be used speculatively and do not distribute dividends or for that matter can be source of any source of income, which satisfies (h). If a taxpayer is actively trading options, this could then provide evidence to satisfy (a) and (e). In summary, the default characteristics of options fall within the investment qualities needed to constitute “carrying on a business”, and when coupled with active trading, there is a strong possibility of satisfying the test.
The trading frequency needed to constitute “carrying on” a business will be a central concern for a retail investor; in the context of option trading, it appears to be a crucial factor. Whether one can “carry on” an “adventure or concern in the nature of trade” is an old and problematic question, which the law seems to say “no” for events considered to be isolated.[8] The trading activity of retail investors might be more akin to episodic “adventures in the nature of trade”; it is interesting to wonder how many seemingly isolated trades are needed to cross the divide to constitute “carrying on” a business.
When the “carrying on a business” provision was introduced into the Act, it is unlikely that Parliament was expecting hundreds of thousands of Canadians to start actively trading in their registered accounts. The ability to trade options in a TFSA demonstrates how easy it could be for permitted investments to establish “carrying on a business”. That said, like many tax issues, this will be subject to interpretation by the courts. A provision that was likely only intended to scare off a limited number of professional investors is now causing widespread concern for the growing number of retail investors.
With retail trading activity increasingly bearing a closer resemblance to professional trading, taxpayers are unable to predict when they might be subject to the rule. If there is large scale use of TFSAs in a business-like manner, it should result in legislative change to reflect the way in which they are now being used. Implementing restrictions such as limiting trading frequency or increasing prohibited investments would provide professional investors with an unfair advantage over retail investors. In my view, a bright-line test should rather be introduced to impose lifetime caps on accumulated amounts in TFSAs. This would lead to a fairer solution for taxpayers.
- Alex Kerslake (LLM Candidate, Osgoode Hall Law School)
[1] https://seekingalpha.com/article/4404668-tmx-group-limited-tmxxf-ceo-john-mckenzie-on-q4-2020-results-earnings-call-transcript
[2] https://www.cnbc.com/2021/01/22/trading-volume-is-up-so-far-from-2020s-breakneck-pace-as-retail-investors-get-even-more-active.html
[3] See Income Tax Act 1986, subsection 164.2(6.1) which can impose a tax if the TFSA constitutes “carrying on a business”; see also Income Tax Folio S3-F10-C1, “Qualified Investments – RRSPs, RESPs, RDSPs and TFSAs” at 1.86.
[4] https://www.theglobeandmail.com/investing/article-legal-showdown-nears-for-day-traders-cra-over-use-of-tax-free-savings/
[5] Prochuk v. R. 2014 TCC 17.
[6] https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/it479r/archived-transactions-securities.html
[7] Ibid, in paragraph 25: “25. For taxpayers, other than those described in 24 above, it is a question of fact whether the gains or losses on share option transactions are on income account or capital account. However, the Department generally presumes that (a) the gain or loss realized by a holder of options is on the same account as the holder's transactions in shares; (b) the gain or loss realized by a writer of covered options is on the same account as the underlying shares; and (c) the gain or loss realized by a writer of naked options is normally on income account. However, the Department will accept reporting of gains and losses on capital account provided this practice is followed consistently from year to year. The presumption indicated above may not apply in those unusual situations where the facts clearly indicate otherwise. This could be the case, for example, where a holder of options usually transacts in shares on income account, but holds a group of shares for investment purposes which are properly reported on capital account. In this situation, option transactions with respect to the former group should be reported on income account and the latter group on capital account.”
[8] MNR v. Tara Exploration and Development Company Limited [1970] C.T.C. 557 (Exch. Ct.)
Very good article, Alex! Is there a particular reason that the Prochuk precedent doesn't apply to TFSAs? Is it just down to the particular wording used in subsection 164.2(6.1) (which assumes that it must be possible to carry on a business within a TFSA)?