The 10% Test Behind a Prohibited Investment in a TFSA Is Not 10% of the Company
Nothing in the Income Tax Act stops a TFSA from holding a prohibited investment. The rules invalidate nothing. They tax the holder, which is why the same Part offers a route to sell the property and claim the tax back. And what decides who pays is not the size of the stake. It is how closely held the company is. In one illustration below, a couple deemed to hold 12.50% of a small share class clears the two excluded-property conditions our figures test. In another, a holder who owns no shares at all is caught in full.
Two tests run in parallel. The qualified-investment test in ITA 204 and 207.01(1) asks what the property is. The prohibited-investment test asks what the holder is to the issuer, and a share can pass the first and fail the second. Our TFSA rules guide covers the account’s room, withdrawals and the qualified-investment side of the ledger, and this piece follows the relationship test through to the bill.
What the definition reaches
ITA 207.01(1) defines a prohibited investment for a trust governed by a registered plan as property (other than excluded property for the trust) that is a debt of the controlling individual under paragraph (a), prescribed property under paragraph (d), or:
(b) a share of the capital stock of, an interest in, or a debt of (i) a corporation, partnership or trust in which the controlling individual has a significant interest, or (ii) a person or partnership that does not deal at arm’s length with the controlling individual; (c) an interest (or, for civil law, a right) in, or a right to acquire, a share, interest or debt described in paragraph (a) or (b);
Paragraph (b)(ii) reaches any “person or partnership” that does not deal at arm’s length with the holder, which is wider than (b)(i)’s list of corporations, partnerships and trusts, and paragraph (c) reaches an interest in such a share as much as a right to acquire one. Most important are the opening words. “Other than excluded property for the trust” governs the whole definition.
Significant interest runs through the specified shareholder test
ITA 207.01(4) sets the threshold at 10%. For a partnership or a trust it is 10% of the fair market value of all members’ or all beneficiaries’ interests, counting non-arm’s-length interests alongside the holder’s own. For a corporation it routes to the “specified shareholder” definition in ITA 248, read at a point in time rather than across a year: ownership, direct or indirect, of not less than 10% of the issued shares of any class of the capital stock. That definition widens twice on its own words:
- “Of any class.” Ten percent of a class, not of the company. A small class inside a large company can be crossed on a modest holding.
- Related corporations. The 10% can be measured against any corporation related to the one in question.
Then five deeming paragraphs, (a) to (e). Four of them add other people’s shares to the holder’s own. The fifth deems the individual to be a specified shareholder outright.
- (a), non-arm’s-length persons. A taxpayer is deemed to own each share owned by a person with whom they do not deal at arm’s length. ITA 251(2)(a) makes individuals connected by blood relationship, marriage or common-law partnership or adoption related, and 251(1)(a) deems related persons not to deal at arm’s length. A spouse’s shares are the holder’s.
- (b), beneficiaries of a trust. Each beneficiary is deemed to own the proportion of the trust’s shares that the value of their beneficial interest is of all beneficial interests in the trust.
- (c), members of a partnership. Each member is deemed to own the proportion of a class held by the partnership that the value of their partnership interest is of all members’ interests. A family partnership or a limited partnership passes shares through the same way.
- (d), services. An individual who performs services for a corporation that would be carrying on a personal services business if the individual or a related person were a specified shareholder is deemed to be one, where the individual or a non-arm’s-length person is, or by any arrangement may become, entitled to not less than 10% of the assets or of the shares of any class.
- (e), discretionary trusts. Where a beneficiary’s share of the income or capital depends on the exercise by any person of, or the failure to exercise, a discretionary power, paragraph (e) overrides (b)’s proportionate rule and deems the beneficiary to own each share the trust owns. Not a slice. Every share.
An illustration where the test is met and the holding clears the two conditions our figures test
The company is invented and the percentages are our arithmetic on invented holdings. A TFSA holds shares of a thinly issued second class, and the holder and their spouse own more of the same class personally.
| Line | Figure |
|---|---|
| common shares outstanding | 9,000,000 |
| Class B shares outstanding | 400,000 |
| all classes | 9,400,000 |
| Class B held in the holder’s TFSA | 4,000 |
| Class B held personally by the holder | 30,000 |
| Class B held by the holder’s spouse | 20,000 |
| deemed owned by the holder, ITA 248(1)(a) | 50,000 |
| holder alone, share of Class B | 7.50% |
| holder and spouse, share of Class B | 12.50% |
| holder and spouse, share of all shares outstanding | 0.53% |
| significant interest | met |
| arm’s-length equity, condition (c)(i) needs 90% | 99.43%, met |
| holder-side votes, condition (c)(iii) needs under 10% | 0.57%, met |
| result | conditions (c)(i) and (c)(iii) are met on these figures |
Both of those last two rows put the plan’s own 4,000 shares on the holder’s side, outside the arm’s-length equity and inside the votes the holder side can cast, for the reason the second illustration gives. Two assumptions also carry the percentages, because (c)(i) and (c)(ii) are fair market value tests and (c)(iii) is a votes test while our inputs are share counts: every share carries one vote and every share is worth the same. Both matter here. A thinly issued second class can be the multiple-voting class in a Canadian dual-class structure, and on those facts the same shareholdings could fail the votes condition and the conclusion would flip.
What the illustration shows is that meeting the significant-interest test does not settle anything, because on a widely held company the excluded-property conditions are the ones a holder clears without trying. For an ordinary shareholder of a listed and widely held company, that is the whole answer: crossing 10% of a class does not by itself make the shares a prohibited investment, because the excluded-property conditions are what decide it.
Most excluded-property conditions measure how widely held the company is
Paragraph (c) of the excluded property definition covers equity of a corporation, partnership or trust, the “investment entity”. Its seven conditions, all of which must hold at that time, are these:
- (i) arm’s-length holders, meaning persons who deal at arm’s length with the controlling individual, own at least 90% of all the entity’s equity by value;
- (ii) that arm’s-length equity plus the entity’s debt held by arm’s-length persons is at least 90% of all its equity and debt;
- (iii) the controlling individual, alone or with non-arm’s-length persons, does not have the right to cast at least 10% of the votes, if any, that could be cast on the entity’s governance;
- (iv) the terms of each unit of equity the plan holds are the same as, or substantially similar to, particular equity inside the arm’s-length equity;
- (v) that particular equity is worth at least 10% of all the entity’s equity carrying those or substantially similar terms;
- (vi) the controlling individual deals at arm’s length with the entity; and
- (vii) it is reasonable to conclude that no main purpose of the entity’s structure, or of the terms of the equity, is to accommodate transactions or events that could affect the value of the plan’s property in a way that would not occur between arm’s-length parties acting prudently, knowledgeably and willingly.
Most of those measure how widely held the entity is. Conditions (i), (ii) and (iii) are dispersion tests, two on value and one on votes, and (iv) and (v) ask whether the plan’s shares look like the equity outsiders hold. The last two are different in kind: (vi) is a relationship test between the individual and the entity, and (vii) is a purpose test on the structure. A public company clears the dispersion conditions without anyone trying. A closely held company fails them structurally, and keeping the holder’s own stake small does not help, because (i) and (ii) count everyone else’s holdings. These rules catch holders of closely held shares, not holders of big stakes.
An illustration where the holder owns nothing and is caught anyway
Invented again, our arithmetic again. One class of shares, a founder, some outside investors, a discretionary family trust, and a small block inside our holder’s own registered plan. Our holder is a discretionary beneficiary of the trust and owns no shares personally.
| Line | Figure |
|---|---|
| common shares outstanding, one class | 1,000,000 |
| held by the founder | 500,000 |
| held by outside investors | 242,000 |
| held by a discretionary family trust | 250,000 |
| held in our holder’s registered plan | 8,000 |
| held personally by our holder | 0 |
| deemed owned by the holder, ITA 248(1)(e) | 250,000 |
| deemed holding as a share of the class | 25.00% |
| significant interest | met |
| arm’s-length equity, condition (c)(i) needs 90% | 74.20%, not met |
| result | a prohibited investment |
Two steps get there. Because the holder’s entitlement depends on the trustees’ discretion, ITA 248(1)(e) applies instead of the proportionate rule in 248(1)(b) and deems the holder to own each of the trust’s 250,000 shares, which is 25.00% of the class, so significant interest is met. Then ITA 251(1)(b) deems a taxpayer and a personal trust, other than the registered and employee trusts the provision carves out, not to deal at arm’s length where the taxpayer, or a person not dealing at arm’s length with them, would be beneficially interested in the trust. That takes the trust’s shares out of the arm’s-length equity. The plan’s own 8,000 shares are not arm’s-length equity either, and that does not rest on any deeming rule: ITA 251(1)(c) leaves arm’s length a question of fact between persons who are not related, and a registered plan and its own controlling individual are not at arm’s length on the facts. What is left is 74.20% against the 90% condition, so excluded property does not apply. A holder who owns not one share of the company personally holds a prohibited investment, because of who else owns it and how the family’s trust is drafted.
The 50%, the refund, and the exit the Act carries
ITA 207.04 makes the controlling individual personally liable to a tax for a calendar year if at any time in the year the trust acquires property that is a prohibited or non-qualified investment for the trust. Subsection (2) sets the amount at 50% of the property’s fair market value at that time.
ITA 207.01(6) deems a trust holding property that becomes, or ceases to be, a prohibited or non-qualified investment to have disposed of it immediately before that time at fair market value and to have reacquired it then at that value. Read with 207.04(1) and (2), that deemed reacquisition is on our reading the acquisition the 50% attaches to, which would measure the charge against the value on the day the holding turned rather than against what the plan paid. CRA Income Tax Folio S3-F10-C2, Prohibited Investments is the agency’s chapter on this category. Its companion chapter, which addresses non-qualified investments, puts that tax at 50% of fair market value “at the time it is acquired or becomes non-qualified” and describes the 207.01(6) deeming in the same terms. Subsection 207.01(6) is worded to cover both categories.
The 50% can also come back in full. Subsection 207.04(4) entitles the individual to a refund equal to the tax imposed where the trust disposes of the property, and cuts the refund to nil in two cases: where it is reasonable to consider the individual knew, or ought to have known, when the trust acquired the property, that it “was, or would become”, prohibited, and where the property is not disposed of before the end of the calendar year following the year the tax arose, or a later time the Minister considers reasonable.
A refund needs a disposition, and a closely held share has no market, so the obvious buyer is the holder. That route meets the swap-transaction rules. ITA 207.01(1) defines a swap transaction as “a transfer of property between the registered plan and its controlling individual or a person with whom the controlling individual does not deal at arm’s length, but does not include” a list of exclusions, and under paragraph (b)(iii) of the advantage definition an increase in the plan’s fair market value that is reasonably attributable to a swap transaction is a benefit, which section 207.05 taxes at that benefit’s fair market value. Paragraph (c) of the exclusions covers “a transfer of a prohibited investment or a non-qualified investment from the registered plan for consideration, in circumstances where the controlling individual is entitled to a refund under subsection 207.04(4) on the transfer”. So a purchase out of one’s own plan for consideration sits outside the swap definition precisely where the refund is available on the transfer, and where the refund is denied the exclusion does not reach it.
Paragraph (a) of the same exclusions carries no such condition. It takes out “a payment out of or under the registered plan in satisfaction of all or part of the controlling individual’s interest in the registered plan”. Moving the share out of the plan in kind, as a distribution of the holder’s interest in the plan, is a different act from selling the property to oneself for consideration, and it is outside the swap definition on any facts rather than only where the refund is available.
Where a holding fails both tests, ITA 207.04(3) deems it not to be non-qualified and leaves it prohibited. What the other route costs, including the tax the plan itself pays, is the subject of our piece on the 50% tax on a non-qualified TFSA investment.
Liability sits with the individual rather than the plan. For the advantage tax below, ITA 207.05(3) makes each controlling individual jointly and severally, or solidarily, liable, “except that, if the advantage is extended by the issuer, carrier or promoter of the registered plan or by a person with whom the issuer, carrier or promoter is not dealing at arm’s length, the issuer, carrier or promoter, and not the controlling individual, is liable to pay the tax.”
It also repeats. Subsection 207.04(2) charges the tax “in respect of each property described in subsection (1)”, so every further acquisition of a prohibited holding is a fresh 50% charge on what is acquired, a rights issue taken up being the plain case. The 100% advantage tax applies in every year there is income.
What the position costs, and the part that runs the other way
How a closely held share sits in a TFSA at all is Regulation 4900(14), and it takes two things. The company here is stipulated to be a specified small business corporation, which is one of the three kinds of share 4900(14)(a) prescribes, and 4900(14)(b) then requires that the share “was not a prohibited investment for the trust” when the trust acquired it. That second condition is what makes the scenario below possible: the trust that catches the holder was settled after the purchase.
Our arithmetic on invented facts. On 2026-03-02 the plan buys 8,000 shares at $2.50 for $20,000.00, when no trust exists and the shares are a qualified investment. On 2027-05-04 the family trust is settled over the 250,000 shares and our holder becomes a discretionary beneficiary. At $7.50 the plan’s position is worth $60,000.00, which is also the deemed reacquisition cost. On the reading above, the 50% charge on that value is $30,000.00, against the $20,000.00 of cash the holder ever committed, or 150.00% of it.
The wording of the refund’s knowledge ground then matters more than the dates do. Subsection 207.04(4)(b)(i) asks what the holder knew or ought to have known at the time the trust acquired the property, that it “was, or would become”, a property described in subsection (1). Those words look forward. The trust’s not existing on 2026-03-02 means the property was not prohibited then, and it leaves the ground turning on whether the holder ought to have known the trust was coming, which is a question of fact. The asymmetry survives in a weaker form. A position that turns prohibited through someone else’s later act leaves the holder an arguable case, and the owner-manager who buys their own company’s shares into a plan has the weakest case of all, because on those facts the property is prohibited at the moment of acquisition.
The cost reset cuts both ways too. Because the deemed cost becomes $60,000.00, the $40,000.00 of growth that accrued before the crossing sits outside the 100% advantage tax, which reaches only what is attributable to the property while it is prohibited. On a sale on 2028-06-12 at $70,000.00 against that $60,000.00 cost, the capital gain after the crossing is $10,000.00 and the advantage tax at 100% is $10,000.00. The plan keeps the $10,000.00 gain. The holder pays the $10,000.00 tax from outside the account. That sale is a disposition, and it falls before the end of 2028, which is the deadline for a charge arising in 2027, so both branches are live: if the 50% is refunded the episode costs the $10,000.00 advantage tax alone, and if the refund is denied it costs $40,000.00.
Dividends are caught too, and annually. Paragraph (c)(i) of the advantage definition reaches income as well as a capital gain, so a position paying $1,200.00 a year draws $1,200.00 of advantage tax a year, $3,600.00 over three years.
The 100% tax on income and gains
Paragraph (c) of the “advantage” definition in ITA 207.01(1) covers a benefit that is income, determined without reference to paragraph 82(1)(b), or a capital gain, reasonably attributable directly or indirectly to a prohibited investment in respect of the plan “or any other registered plan of the controlling individual”, so an RRSP holding is caught the same way. ITA 207.05 taxes an advantage extended to, or received or receivable by, the controlling individual, the trust or a person not dealing at arm’s length with the individual, and subsection (2)(a) sets the amount at the fair market value of the benefit. Section 207.05 contains no refund provision, where 207.04 has one in 207.04(4).
The same gain, prohibited against non-qualified
Our arithmetic on a position bought 2026-03-02 for $20,000.00 and sold 2027-05-04 for $24,000.00, a capital gain of $4,000.00, with no distributions. Federal tax only in both columns.
| Line | Prohibited | Non-qualified, not prohibited |
|---|---|---|
| 50% on acquisition value, ITA 207.04(2) | $10,000.00 | $10,000.00 |
| tax on the $4,000.00 gain | $4,000.00, as a 100% advantage under ITA 207.05(2)(a) | $1,320.00, on a trust taxable capital gain of $4,000.00 under ITA 146.2(6)(b) |
| total if the 50% is refunded, federal only | $4,000.00 | $1,320.00 |
| total if the refund is denied, federal only | $14,000.00 | $11,320.00 |
| who pays | the controlling individual, from outside the account. The plan keeps the gain | the 50% is the holder’s, but the $1,320.00 is the trust’s Part I tax and comes out of the plan, permanently shrinking it |
The timing ground is satisfied here. The tax arises in 2026, on acquisition, and 207.04(4)(b)(ii) denies the refund only where the property is not disposed of before the end of the following calendar year, the end of 2027. The sale on 2027-05-04 is inside that window. In the prohibited column the knowledge ground is the harder one, because there the property is prohibited at the moment the plan acquires it rather than turning later, which is the pattern that gives a holder the least to argue, so the denied row is the more realistic of the two on that side. The reasoning does not carry across to the other column, where a holder may not have known the property was non-qualified when they bought it.
The comparison holds either way, because the identical $10,000.00 cancels out of it. The gap on the same $4,000.00 of gain is $2,680.00, federal only, or $0.67 per dollar of gain by our arithmetic, whichever branch applies. The $1,320.00 is the $4,000.00 gain at the top federal rate for 2026, 33%, which ITA 122(1)(a) applies to the trust through the highest individual percentage.
The provinces move that gap one way. The 50% and the 100% charges are Part XI.01 taxes with no provincial analogue, so the prohibited column does not grow, while the 33% is Part I tax on the trust, which a province adds to. Provincial tax therefore narrows the gap, and the federal-only figure is the widest version of it. Outside a registered plan the ordinary half inclusion in ITA 38(a) would make the same gain a $2,000.00 taxable capital gain, and what that costs depends on the reader’s own bracket, which our capital gains tax calculator works out.
Where private company shares actually sit
In the ordinary case a private company share is caught by 207.01(1)(b)(i), the significant-interest limb, rather than by the prescribed property limb in paragraph (d). Regulation 4900 reaches a narrower and later case. Alongside the condition already described, 4900(14) covers three things and no others: a share of a specified small business corporation, a share of a venture capital corporation described in any of sections 6700 to 6700.2, and a qualifying share in respect of a specified cooperative corporation.
Regulation 4900(15) is the later flip. Property that is a qualified investment solely because of 4900(14) becomes prescribed property, and so is caught by paragraph (d), at any time it is no longer one of those three things. The status changes without the holder doing anything.
The waiver is discretionary
ITA 207.06(2) lets the Minister waive or cancel all or part of a liability under 207.04(1) or section 207.05 where the Minister considers it just and equitable to do so having regard to all the circumstances, including whether the tax arose as a consequence of reasonable error, the extent to which the same transaction or series gave rise to another tax under the Act, and the extent to which payments have been made from the plan. That middle factor describes this case exactly, since the 50% and the 100% arise from the same facts. The over-contribution waiver in 207.06(1) turns on a reasonable error and distributions made without delay, conditions an individual can go and satisfy. Subsection (2) sets none. It is discretion, so a request rather than an entitlement.
Nobody is watching this for the holder, and the return is the holder’s to file
ITA 207.01(5) requires the issuer, carrier or promoter of a registered plan to “exercise the care, diligence and skill of a reasonably prudent person to minimize the possibility that a trust governed by the registered plan holds a non-qualified investment.” That duty runs to non-qualified investments. It says nothing about prohibited investments.
Reporting is self-assessed to match. Per CRA Folio S3-F10-C2 and its companion chapter, a taxpayer liable for the tax files Form RC339 (Individual Return for Certain Taxes for RRSPs or RRIFs, RESPs or RDSPs), RC728 (First Home Savings Account (FHSA) Return), or Form RC243 (Tax-Free Savings Account (TFSA) Return), as applicable, “by no later than June 30 of the following year.”
The facts the test turns on
- how many classes of shares the company has, and how many shares are in the class the plan holds
- who else is on the register, and whether the holder is related to any of them within ITA 251(2)(a)
- whether any trust holds shares, and whether the holder is a beneficiary of it
- whether the holder’s entitlement under that trust is discretionary
- how many votes the holder’s side can cast
- whether the holder provides services to the company
Which is the shape of these rules. They do not measure how much of a company a plan holder wanted to own. They measure the whole shareholder register, and in the discretionary trust case a document the beneficiary may never have read.
Disclaimer: The content on bestcanadianstocks.ca is for informational and entertainment purposes only and does not constitute financial advice. Past performance is not indicative of future results. Always consult a qualified financial advisor before making investment decisions. Statutory text is from the Income Tax Act and the Income Tax Regulations on the Justice Laws Website, current to September 3, 2026 and last amended June 18, 2026, fetched September 27, 2026. Administrative positions and the reporting requirement are from Canada Revenue Agency Income Tax Folio S3-F10-C2, Prohibited Investments, page last modified May 28, 2024, and from Folio S3-F10-C1 where noted in the text. The 33% is the top federal rate for 2026 from the Canada Revenue Agency’s published brackets. Both corporations and both worked positions are illustrative, the percentages and dollar figures in them are our arithmetic on the holdings shown, and every tax figure is federal only.
