Tax Court Rules On Ponzi Scheme Victims

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…..

Salt in the Wounds?

If Charles Ponzi could see us now. The recent news reports of multiple Ponzi schemes and their unfortunate victims has me worried from a tax perspective.

Maybe I’m being paranoid, but then if you think the CRA would have any sympathy for any taxpayer, under any circumstance, well, let’s say I wouldn’t rely on it. Still….would the Minister of Revenue go so far as to disallow the losses incurred by victims of Earl Jones and the like? Impossible? I wonder.

Generally, when a taxpayer invests his funds, he expects to earn income from property. This expectation is reasonable, and it is the basis upon which one is allowed to take deductions such as related interest and management fees. It is also the reason why, if a loss is incurred on an investment such as stocks and mutual funds, it is generally deductible as an allowable capital loss. Accordingly, you would think that the investors who have come away with little or none of their money as a result of being defrauded in these schemes would at least benefit from the capital losses incurred.

I really hope I’m wrong here, but the jurisprudence in this area is troubling to say the least.

Let’s start with the leading case on the topic. In Hamill v. Her Majesty the Queen (2005 DTC 5397), William Hamill was defrauded. He entered into a scheme whereby he would purchase “precious gems”, and then, through a broker, sell them for huge profits. Unfortunately, the broker turned out to be less than trustworthy, milking the taxpayer for fees at every turn, while the gem sales kept mysteriously falling through. Around two million dollars later, the taxpayer sought to claim his losses for tax purposes.

Both the Tax Court and the Federal Court of Appeal disallowed the losses, and the reasoning is most disturbing. The court stated that “a fraudulent scheme from beginning to end or a sting operation, if that be the case, cannot give rise to a source of income from the victim’s point of view and hence cannot be considered as a business under any definition”.

The court goes on to state that “this is not a case where the Court must have regard to the taxpayer’s state of mind, or the extent of a personal element in order to determine whether a certain activity gives rise to a source of income under the Act”.

Based on the above reasoning, regardless of whether the victim of the fraud was aware he was being scammed, and regardless of the intention of the victim to enter into a profit-motivated transaction, the mere fact that he was a victim of a fraud from beginning to end was enough for the court to disallow the deductions.

The Court of Appeal’s comments are slightly different than those of the Tax Court judge. At the lower level, the court made it clear that Mr. Hamill’s bad judgment was a factor in his demise. The court states that he did not do his homework and “he became a willing victim from the beginning”. This statement leads one to imagine to what extent a taxpayer must do “homework” before he is considered prepared or even intelligent enough to make a business or investment decision.

Perhaps even more disturbing is that the Court of Appeal did not factor this bad decision-making into its decision. Providing a more objective test, the mere fact that the activity constituted a fraud from the beginning was enough to strip it of its eligibility for tax relief.

All of this would be nothing more than mildly entertaining tax reading (albeit not for Mr. Hamill) if it was an isolated case based on a narrow set of circumstances; however, Hamill is not an isolated case. Victims of Nigerian email scams (2008 DTC 2001) and fraudulent partnership schemes (2006 DTC 6199) have suffered similar fates at the hands of the Court of Appeal.

Where does all this leave us with the Canadian victims of the modern day Ponzi disciples? I’m slightly worried. The Income Tax Act disallows the deduction of capital losses where an investment is not made for the purposes of earning income from a business or property. If the rational in Hamill is followed, then any victim of a fraud, where the monies were never invested in any income-producing vehicle could be denied a deduction for income tax purposes, in addition to the loss suffered at the hands of the crooks.

Could the CRA be so cruel????