The tax-free savings account has not even celebrated its first birthday, but the Department of Finance is already cracking down on TFSA abuses.

The TFSA, which debuted on Jan. 1, this year, allows each Canadian resident who is 18 years of age or older to contribute up to $5,000 annually. While contributions to a TFSA are not tax-deductible, any investment income or gains earned inside a TFSA are 100% tax-free. TFSA withdrawals are also tax-free.

The Department of Finance has announced it was proposing amendments to the Income Tax Act to penalize those exploiting TFSAs to avoid paying tax. While the changes are punitive, they are not likely to affect the vast majority of Canadians, who use their TFSAs to save for a rainy day, their kids' education or retirement. The new rules are aimed at sophisticated investors who are using TFSAs as trading accounts, to exploit what may have been perceived to be fairly modest penalties in exchange for gargantuan tax-free profits.

The proposed amendments target four main areas of concern:

• Any income attributable to deliberate overcontributions beyond your TFSA contribution limit ($5,000 in 2009) will be taxed at 100%;
  
  
• Any income from prohibited investments held inside a TFSA, such as private company shares of which you own 10% or more, will also be subject to a 100% tax;
  
  
• Any income attributable to non-qualified investments held by a TFSA, such as land or general partnership units, will be taxable at regular income tax rates;
  
  
• Swap transactions, in which shares or other property are transferred from an RRSP or non-registered account to a TFSA in exchange for cash or other property, will effectively be prohibited by taxing amounts attributable to these transactions at 100%.

Finally, while TFSA withdrawals generally increase your TFSA contribution room the following taxation year, the proposed rules specify that any withdrawals of deliberate overcontributions, prohibited investments, non-qualified investments or amounts attributable to swap transactions or of related investment income, will not create additional TFSA contribution room.

Related article: Taxman plans crackdown on TFSA loopholes

Jamie Golombek, CA, CPA, CFP, CLU, TEP is the managing director, tax and estate planning with CIBC Private Wealth Management in Toronto.