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.