DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Archive for the ‘Losses’ Category

Tax Court Rules On Ponzi Scheme Victims

In Canadian Income Tax, Losses on January 3, 2012 at 2:00 am

The Tax Court of Canada has recently confirmed the tax treatment of Ponzi scheme victims as I feared they would in the very first issue of The Tax Issue.

In a Ponzi scheme, taxpayers unwittingly entrust funds to a promoter, who, rather than investing them, uses them to make payments to other investors. The flow of funds continues this way until enough people finally ask for their money back, at which point, the fraud is exposed.

The taxpayer in the case of Johnson (2011 TCC 540) was a winner because the court ruled that in a Ponzi scheme, there is no investment and thus no source of income. The good news for this taxpayer, a victim of Andrew Lech, was that she was one of the few who cashed in her capital after a few years of receiving what she thought was a great return on her investment. The “income” she dutifully reported over the years was held not to be “income from a source” and thus not subject to income tax.The court stated that “the net receipts were nothing more than the shuffle of money among innocent participants.”

The bad news for those who have lost their investment, however, is that there is no tax relief available for the loss of their capital.  In a normal investment, the loss would be considered a capital loss, 50% of which can be used to offset capital gains. For these victims of fraud, since no income source existed, no tax deduction is available on the loss of the investment.

The only consolation is for taxpayers who reported income in past years to amend their returns and request refunds on the tax they paid on the payments received from fraudulent schemes.

Update: The CRA has decided to appeal this decision….To be continued…..

A No-Lose Situation

In Canadian Income Tax, Losses on April 22, 2010 at 9:20 am

In today’s environment, the transfer of a stock portfolio as part of a corporate reorganization or an attempt to realize losses must be handled carefully to ensure that accrued capital losses don’t vanish.

There are a number of situations in which a taxpayer may wish to make a transfer of a stock portfolio. For example, a substantial investment by an individual in U.S. stocks may be subject to estate tax. One way to sidestep this problem would be to transfer the portfolio to a Canadian holding company. In the course of a “purification” of a small business corporation for purposes of accessing the capital gains exemption, a stock portfolio may have to be transferred from an operating company to a holding company. Finally, an individual may wish to crystallize accrued losses while retaining the stock in order to shelter capital gains in the year, or the three prior years.

If a stock portfolio is to be transferred to a related party, knowledge of the “stop loss” rules contained in the Income Tax Act (“the Act”) is essential. There are a number of such rules that will affect losses in different ways, depending on the transaction.

Transfer by an Individual to a Corporation

The “superficial loss” rules generally deny capital losses where a taxpayer disposes of capital property and, within 30 days, an affiliated person has acquired the property. An individual is affiliated with a corporation when he or his spouse controls the corporation. The corporation must add the denied loss to the adjusted cost base (“ACB”) of the property it receives. Thus, a transfer of a stock portfolio with both gains and losses may be performed through the use of the rollover provisions in section 85 of the Act. The elected amount for the shares with accrued gains would be their ACB. For the shares with accrued losses, the elected amount cannot exceed the fair market value of the shares. The loss on the transfer will be added to the corporation’s ACB of the shares, and the rollover will effectively be completed.

Transfer by a Corporation

The superficial loss rules discussed above will not apply where the transferor is a corporation. Rather, if a corporation transfers loss property to an affiliated person, losses are “suspended” in the transferor’s hands. Corporations are affiliated where they are controlled by the same person, or affiliated persons. When the property is subsequently sold by the transferee to an arm’s length party, the loss is realized, and may only be used by the original owner. A capital loss may be of little use unless the original corporation incurs capital gains from other sources in the future.

Depending on the nature and reasons for the reorganization, there may be a number of solutions to the above problem. The transferor could retain a sufficient portion of the portfolio to ensure that future gains will be realized to offset the losses. Another answer might be to retain the stock portfolio, and transfer other assets into a new corporation.

Transfer Between Individuals

A transfer between affiliated individuals is subject to the superficial loss rules discussed earlier. The definition of affiliated individuals is restricted to persons who are spouses. Thus, a parent, for example, could transfer stock with accrued losses to a child, and realize the losses for tax purposes.

A planning opportunity exists if one spouse has accrued gains that need to be sheltered. The spouse with losses could transfer assets such that the superficial loss rules apply (care must be taken to avoid certain attribution rules). The accrued losses are effectively transferred from one spouse to the other.

Transfer to an RRSP

Specific rules deny losses where an individual transfers capital property to his RRSP. In effect, the loss is lost forever, since the RRSP is tax exempt. It may be possible to circumvent this rule by selling stock on the open market and repurchasing it immediately within the RRSP. The superficial loss rules will not apply. The CRA may apply the General Anti-Avoidance Rule in such a case. On the other hand, a delay of 30 days to circumvent the superficial loss rules does not seem to be offensive to the CRA.

Earl Jones Victims Get A Raw Deal From CRA

In Canadian Income Tax, Losses on March 3, 2010 at 11:50 am

The latest news that the victims of Earl Jones are now about to suffer even further at the hands of the CRA comes as no surprise to me. Back in August, in the very first issue of The Tax Issue, I speculated on the possibility that these taxpayers might be in for a bit of a shock around tax time. Lo and behold, I was right.

You see, the investors are caught in an unfortunate Catch-22 situation. They made an investment which was supposed to earn them income – a hefty return on their money. Theoretically, these “phantom earnings” were reinvested, although we now know they were used to support the Earl Jones pyramid.

In the real world, investment income such as dividends that are reinvested are still reported on a T5 slip and investors must pay tax on them, even though they don’t see the actual cash. What happens to it? Well, the reinvested earnings get added to the capital cost (ACB) of the investment.

So, here comes the Catch-22. Either the victims pay tax on their phantom earnings, add it to their ACB and claim a capital loss on their invested capital, as I suggested in my August article, or they go with the theory that this was a  fraud from the start, in which case there was never any investment income. In this case, because the investment generated no income, the capital that was lost cannot be taken as a capital loss. However, would the CRA accept that the income was never earned, and allow the victims to claim refunds for 2009 and previous years?  I imagine that will be the topic of the discussions coming up this week.

In a 1991 statement, the CRA concluded that an investor who suffers a loss due to fraud may be entitled to claim a capital loss if certain criteria are met. This makes me think that this is the position the CRA will take here. However, a capital loss may not be of much use to these victims. Capital losses can only be deducted against capital gains, not regular income. While they may be carried forward forever, it may be a while, if ever, before these taxpayers are in a position to generate capital gains and actually benefit from these tax losses.

Contrast this Canadian quagmire with the U.S. victims of fraudsters such as Bernard Madoff. On March 17, 2009, the IRS released a clear and generous tax relief package for these taxpayers. They are allowing the victims of fraud to claim the total of their capital and their reinvested phantom income as “theft losses”, which are fully deductible and may be carried back and forward against all other types of income, thereby generating tax refunds.

Update: In an announcement on March 3, 2010, the Quebec Minister of Revenue has stated that Quebec will, in fact, be granting relief to the victims of the Earl Jones and similar frauds. This relief mirrors somewhat the package offered by the IRS. The victims will be allowed to deduct all phantom income not received from their investment in their 2009 returns. Should this deduction create a loss, it will be considered as a “non-capital loss”, and will be therefore available to be carried back to any of the 3 prior tax years and forward 20 years. No statement was made concerning the loss of capital invested.

Deducting Business Losses? Make Sure You’re In Business!

In Canadian Income Tax, Losses on December 10, 2009 at 12:36 pm

It is said that everyone has at least one great song inside of them. Thinking of going into the music business? Got that CD in the works? Got a few good songs to record? Those costs can add up. Studio time, CD packaging, travel expenses, etc. Would you like to deduct your expenses for tax purposes? Consider the case of Singh Binning.

The recent case of Binning v. The Queen (2009 DTC 1311) highlights the logical notion that in order to deduct business losses, you must have an actual business.

More specifically, the law has always been predicated on the idea that, to deduct losses, there must be a business and a reasonable expectation of profit.

In Binning’s case, he was employed full time as a supervisor in a lumber mill in Ontario, but managed the less-than-bourgeoning music career of his brother back in India. He financed the production of an album and two music videos in New Delhi, paying close to $100,000 which he reported as business losses over five years from 2001 to 2005. A good chunk of these expenses were for travel, and there were ostensibly no revenues to speak of during that period.

Financing a music star in India - There has to be some semblance of a business

The Supreme Court of Canada, in the case of Stewart v. The Queen (2002 DTC 6983) set out a twofold test to determine the deductibility of business losses, as follows:

Where the activity contains no personal element and is clearly commercial, no further inquiry is necessary. Where the activity could be classified as a personal pursuit, then it must be determined whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income…

The Tax Court in Binning summarized this case as follows

…there is an absence of the businesslike conduct that one would expect if this were a profit-seeking venture. There is no plan. There is no evidence of efforts to try to make sure the business becomes profitable or to ensure that royalties are in fact being received. All of this is incompatible with there being a source of income…

Binning’s tax losses were denied.

So if you’re a parent of a child who wants to make it in the entertainment industry, instead of deflating his ego by telling him he lacks the talent, you can try discouraging him by presenting a dissertation on the law on tax losses. That should bring him to his senses!

What’s Your Tax Issue?

In Canadian Income Tax, Losses on September 25, 2009 at 12:41 pm

The Tax Issue:

I loaned some money to my son’s company and now he can’t pay me back. Is there a tax deduction I can claim?

The Answer:

Unfortunately, I get this question quite frequently after it’s too late –  a loan has already been made and gone bad. Often, a loan is made from a parent to a child’s company with no interest charged. Under the rules of the Income Tax Act, any loss on a loan made for no consideration is not deductible for tax purposes. So if you are thinking of helping out a family member, don’t be so generous as to deny yourself a tax deduction of you don’t get paid back. Always check with a professional before making a business loan.

If interest was charged, or if you are also a shareholder of the company to which you loaned the funds, 50% of the loss is considered  an allowable  capital loss. Such a loss may be claimed only against taxable capital gains. Unused losses can be carried back three years and forward indefinitely.

Under certain circumstances, the allowable capital loss may qualify as an allowable business investment loss, in which case it is deductible against any income for the year. The company would have to meet certain tests in order to establish that it meets the definition of a small business corporation. Essentially, this is a corporation that uses all or substantially all of its assets in an active business carried on in Canada.

Before any loss can be claimed, the debt must be established to be uncollectible. According to the CRA you must have exhausted all legal means of collecting the debt and/or the company is insolvent. The courts have taken a more lenient view and require only that the debt be uncollectible in the eyes of the creditor, without the need to exhaust all legal means of collection. If a debt is established to have gone bad in a year, then you must make an election in your income tax return to establish it as a bad debt and claim whatever loss you are entitled to based on the above criteria.