Peter is a small investor. He has some money he’d like to invest in a Tax-Free Savings Accounts (TFSA) in order to earn some tax-free investment income, as millions of Canadians do. Paul, his brother, has an interesting business project. As is the case for many small entrepreneurs and innovators, financing is a major challenge.
Peter would like to invest in Paul’s business, both to encourage his brother and in the hope of earning a return on his investment. Unfortunately, investments in a small business are not permitted in a TFSA. As brotherly love has its limits, Peter will therefore invest his money in stocks. A large corporation listed in Toronto or New York, which already has easy access to funds, will thus benefit from Peter’s desire to invest his money, and Paul will be out of luck.
Created in 2009, Tax-Free Savings Accounts provide a flexible savings option. Unlike Registered Retirement Savings Plans (RRSPs), contributions to a TFSA are not deductible for income tax purposes, but withdrawals are tax-free, including for investment income earned in the account. TFSAs can therefore be used to save money in anticipation of a major purchase or a trip, or in case of unforeseen events, and to invest money for retirement. Withdrawals are at one’s discretion, without penalty.
The flexibility that is characteristic of TFSAs does not extend to the kinds of investments that are permitted, however. These are the same ones as for RRSPs: basically, mutual funds, shares listed on a stock exchange, bonds and guaranteed investment certificates.
Small businesses, rarely listed on stock exchanges, are thus at a disadvantage. As in the example of Peter and Paul, an investor cannot finance the business of a friend or loved one through a TFSA. If he finances it anyway, any earnings will be taxable, which makes this investment a lot less appealing. The savings of Canadians thus in fact finance big businesses listed on stock exchanges.
Yet small businesses with fewer than 100 employees account for a significant share of economic activity. Despite their small size, they are so numerous — over 1.1 million in Canada — that they account for 70 per cent of all jobs in the private sector.
These businesses have more difficulty than larger businesses when it comes to obtaining funds from financial institutions, and they pay higher interest rates on the loans they do get, as documented by the Canadian Federation of Independent Business. Furthermore, 84 per cent of the heads of startup enterprises rely on personal financing, but relatively few of them (17 per cent) receive financing from friends or relatives. Ironically, they are more likely to obtain credit from their suppliers (19 per cent) than from their loved ones.
Modifying the rules that govern TFSAs by allowing Canadians to invest in small businesses instead of restricting them to large ones would not only expand their savings options, but also improve the access that small businesses have to private funding. This would stimulate the startup and growth of businesses financed by the savings of loved ones, of a community, or of small investors using their TFSAs for this purpose. And it would entail no additional costs for governments.
Tax-Free Savings Accounts are used by nearly 12 million Canadians as savings vehicles, and contain $151.6 billion. This is a considerable sum, a portion of which could stimulate our small and medium-sized businesses. Just like the Quebec’s Stock Savings Plan (better known in French as Régime d’épargne-actions, or REA), which led to the creation of several of today’s large Quebec businesses, the opening up of TFSAs to investments in small businesses not listed on a stock exchange could constitute a minor revolution. It would further involve Canadians in the development of a culture of savings in support of entrepreneurship.
Youri Chassin is Economist and Research Director at the Montreal Economic Institute and the author of "Should Small Business Investments Be Permitted in a TFSA?" The views reflected in this op-ed are his own.