The federal government surprised most policy watchers by announcing the introduction of tax-free savings accounts in the February 2008 budget. It was a surprise because, while talked about several years ago, TFSAs had fallen off the radar screen and very few had them on their February budget wish list.

Indeed, the policy debate in recent years has focused more on the lagging productivity problem in Canada, and the need for incentives and tax relief to promote productive investment in the economy. The Canadian securities industry, through the Investment Industry Association of Canada, has advocated aggressively in the past three federal budgets for capital gains tax relief, trying to turn the government’s policy platform promise of lower capital gains tax rates into reality.

The new TFSAs will boost savings, although modestly in the initial years of the program, and over time will provide an effective vehicle to generate tax-sheltered dividend and interest income and capital gains. Even though TFSAs will have small portfolio impact and be costly to administer, we anticipate investment advisors will incorporate these savings instruments as an integral component in investment and tax-planning strategies. These TFSAs are very much the mirror image of RRSPs, allowing investors to contribute eligible financial assets in the account from after-tax income instead of pre-tax income. However, for both types of accounts, investment returns accumulate tax free.

Although contributions to TFSAs are not tax deductible, assets in TFSAs can be withdrawn at any time without incurring any tax penalty or affecting eligibility for federal income-tested benefits, with the accounts subsequently “topped up” with new funds to replace any withdrawals. Further, similar to RRSPs, TFSAs have a carry-forward provision for unused contribution room. It’s conceivable that, once TFSAs are in the marketplace for several years, the lump-sum contribution to a new TFSA could be significant, reflecting the accumulation of unused annual contributions.

Unfortunately, TFSAs are plagued with the same problem as RRSPs, providing a modest allowable contribution limit that constrains the potential benefit of the account. The maximum annual contribution is $5,000, with the annual contribution threshold indexed to inflation in $500 maximum annual increments. Even though TFSAs offer limited scope and value for middle-income Canadians who need the incentive to save for retirement, the allowable ceilings will likely be adjusted upward over time in subsequent budgets, in much the same way as RRSPs.

There are numerous operational issues that dealers now face with the planned introduction of TFSAs. These problems will have to be addressed well before the end of this year in order to enable investors to access the plans by the effective date of Jan. 1, 2009. Although the Department of Finance and the Canada Revenue Agency have responded to many concerns raised, several key issues remain. The industry would prefer to see the process moving more quickly to ensure clarity is forthcoming and the tight deadlines can be met for systems and operational changes.

Several questions remain outstanding: Will the reporting frequency to the CRA for individual contributions and withdrawals be on a daily, monthly or annual basis? What level of responsibility will the dealers have for monitoring ineligible investments in these accounts? How will TFSAs be treated under international tax protocols? Can the accounts be opened before Jan. 1, 2009, with transfers in on the first business day of the year to avoid long line-ups when doors open? If a spouse is a beneficiary under the will but was not designated formally as a “successor holder,” can TFSAs be transferred tax free to a designated beneficiary upon a TFSA holder’s death, as is the case for RRSPs?

In the latest IIAC submission to Finance, the industry has argued for annual reporting to CRA to limit the administrative bur-den, and yet provide adequate reporting to the tax authorities. The IIAC has also argued in its submission, and in subsequent discussions with government officials, that TFSAs could be offered under contract rather than as trusts, to maximize flexibility of the accounts and provide investors with a cost-effective tax-assisted savings vehicle. Although we understand the new instrument was defined as a trust to expedite the drafting and passage of related legislation, there is no rationale why these accounts couldn’t also be provided under contract between the investor and investment dealer, rather than through a trust agreement involving a third-party trustee, to alleviate administrative complications and costs.

@page_break@The IIAC will also emphasize that even though the new TFSAs will promote increased savings — albeit modestly, given the small tax incentive — these tax-assisted accounts are not a substitute for a vigorous tax incentive to promote and encourage risk investment in the Canadian economy. Access to scarce capital to fund risk investment, particularly the equities of small and mid-sized businesses, is the key to capital formation, global competitiveness and economic growth. Increased savings through TFSAs will not necessarily flow to risky investments. Lower capital-gains tax rates, by reducing the income inclusion rate below 50% for the gains earned on the common shares of Canadian companies, is the most effective mechanism for unlocking capital and stimulating the flow to productive investment. Moreover, all research has indicated that lowering capital gains tax rates actually increases tax revenue by stimulating investment activity.

Ian Russell is president and CEO of the Investment Industry Association of Canada.