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If you accidentally overcontribute to your tax-free savings account (TFSA), you will face the dreaded overcontribution penalty tax, which is equal to one per cent per month for each month you’re accidentally over the limit. You can request that the Canada Revenue Agency waive or cancel the tax, which it has the power to do, if it can be established that the tax arose “as a consequence of a reasonable error” and the overcontribution is withdrawn from the TFSA “without delay.”

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But what if by the time you realize that you overcontributed, the fair market value of the investments inside your TFSA has plummeted to such an extent that it’s below the value of the overcontribution you need to withdraw? Will the monthly penalty tax ever stop accruing?

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A federal court judge, writing in the latest TFSA overcontribution case just released, called this a “perpetual tax trap” for the unfortunate taxpayer, adding that it “appears to be inconsistent with (Parliament’s) intent.” Let’s review the details of this recent case before considering, practically, what a taxpayer might do should they find themselves in such a dilemma.

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The taxpayer’s TFSA woes began back in December 2017, when he opened a TFSA with online broker Qtrade. His portfolio consisted largely of penny stocks. In 2018, he also contributed to a separate Sun Life Financial Inc. TFSA. He contributed a total of $183,000 to his TFSA accounts, resulting in a total overcontribution of $131,719. In July 2019, the CRA issued the taxpayer a TFSA Notice of Assessment (NOA) for 2018 resulting in $6,424 of tax, interest and penalties. The taxpayer received this NOA, but claimed that he misunderstood it, believing that it applied to unpaid regular income tax, and therefore simply paid it.

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In 2019, the taxpayer contributed an additional $70,562 to his TFSAs when only $6,000 of new room opened up for 2019. Thus, by the end of 2019, he had overcontributed a total $196,281 to his TFSAs. In July 2020, the CRA issued a TFSA NOA for 2019, and assessed him an additional $22,086 in overcontribution tax, interest and penalties. Once again, the taxpayer claimed that he misunderstood the 2019 NOA and thought that it applied to unpaid income tax.

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In 2020, the taxpayer contributed a further $33,894 to his TFSAs, such that by the end of 2020, he had overcontributed $224,175 to his TFSAs. In July 2021, the CRA issued a TFSA NOA for the 2020 taxation year, assessing $26,522 in tax on excess TFSA amounts, as well as penalties, interest and a previous unpaid for a total balance owing of $44,114.

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According to the taxpayer, it was only after receiving this 2020 NOA, in July 2021, that he understood the nature of the overcontribution issue. By that time, however, the value of his Qtrade account had fallen below the amount necessary to withdraw the excess and therefore, according to him, he could not simply liquidate his portfolio to the required amount.