Just about everyone with an email account has received at least one of these: a letter from a far off place (often in Africa) promising a very substantial reward if the recipient will provide the financing required to free up a large sum of money (or other valuable property) belonging to the writer but being held for one or more reasons. All that the recipient need do is send a stipulated amount to the writer, the funds or property will be released, and the reward paid. I have read about a number of variations of this theme, all of which have been described as frauds. There are even a number of reported tax cases in which the frauds have been discussed. But before looking at a couple of recent cases involving ponzi schemes, consider this question: what principles ought to govern the deductibility of payments made with the hope of earning the reward, and what, pray tell, ought to be the result if there is actually a payoff, notwithstanding the fraud?
The answer involves a rather nebulous (and undefined) concept in the tax law known as “income from a source.” It’s a sweeping up sort of provision, designed to catch amounts having the character of income, but which cannot otherwise be characterized as income from employment, from business, or from property. For the victim of a fraud looking to deduct the amount paid to the fraudster, there must be a source of income to which the payment relates if it is to be deductible. In a case decided by the Federal Court of Appeal in 2005 (Hammill), the court was emphatic in stating that a fraudulent scheme cannot give rise to a source of income from the victim’s point of view, with the consequence that there is no tax relief for the resulting loss. But what if the ‘victim’ actually receives something from the fraudster, would that be taxable on some basis? Interestingly enough, the CRA thinks the ‘something’ should be included in income, notwithstanding it strongly advocated for the result in Hammill.
In a case in the Tax Court last year (Donna M. Johnson), the issue was the taxability of amounts received by a participant in a ponzi scheme. The taxpayer thought she was giving money to a financial advisor for investment in an options trading program. There was no trading program. The advisor sold the same bill of goods to a number of other, unrelated “investors.” The taxpayer was fortunate in being near the start of the scheme. She received payments during 2002 and 2003 that exceeded the amounts paid to the advisor. The court held that the advisor made these payments out of the amounts received from the unrelated parties; no amounts were ever invested in any income earning activity. In the CRA’s view of things, the taxpayer advanced funds expecting to receive a return, and this is what in fact happened. It argued that the source of the funds used to pay the returns was irrelevant. The Tax Court disagreed and held, in effect, that there was no “source of income” here. Whatever the taxpayer expected to be done with her payments, no money was ever invested in a trading program. The receipts did not constitute income to the appellant.
Unfortunately for Ms. Johnson, the Crown appealed her case to the Federal Court of Appeal and that court, in a judgment released this month (2012 FCA 253), reversed the Tax Court and required her to pay tax on the amounts she received. The court acknowledged its earlier decision in Hammill that a fraudulent scheme cannot give rise to a source of income, but said Ms. Johnson’s case was distinguishable. She had a contractual right to receive a return of her payments plus an agreed return. This “right” was a “property” source for tax purposes. It was immaterial that her advisor was committing fraud in using the money from other investors to pay her the return rather than generating income through a legitimate trading program. The court also held that the Crown was entitled to assess Ms. Johnson beyond the normal assessing period because she was careless in accepting her advisor’s assertion that she was not taxable on the payments to her. This is an important aspect of this case, and is one I will return to in next week’s post.
In a way, the Court of Appeal decisions in Hammill and Johnson are something of a ‘heads I win, tails you lose’ for the CRA. That being said, there is some comfort in the Johnson decision for taxpayers who get caught in a ponzi scheme and, unlike Ms. Johnson, don’t recover their investment. Provided they can establish a contractual arrangement with the perpetrator of the scheme, they should be able to establish a “property” source of income against which to deduct their losses. It’s likely, though, that the losses will be of the capital kind, and only deductible against capital gains.