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Ponzi Schemes are Painful in More Ways Than One

05/02/2014


Most of us have heard of Ponzi schemes. That term was coined from something that was set up by Charles Ponzi, who used it in the 1920s to get investors into a plan relating to postage stamps, but was using the money to pay off earlier investors, with a portion going to himself. Eventually, all such schemes collapse, usually within a few short years, but some of them can go on longer. For example, in the U.S., there was Bernie Madoff’s ponzi scheme which went on for decades. He was sentenced in 2009 to 150 years in prison. Then, we have our own Canadian version involving Earl Jones, which also went on for decades and was closed down in 2009. He was sentenced in 2010 to 11 years in prison for fraud.

At some point or another, most of us will have come across one of these and hopefully are able to avoid it. Some of us may even know someone who was conned into investing in one of them. In my role as tax specialist, I have often been asked about particular investments that clients come across and while my role is limited to considering tax matters, sometimes I have questioned the integrity of the investment and cautioned the client about getting more information before investing.

The Tax Implications of Ponzi Scheme Investments

Where it becomes particularly painful, however, is the tax treatment when someone gets roped into one of these schemes. Let’s look at a couple of cases that landed in court.

The first case is Hammill v. The Queen, which can be found at http://decisions.fca-caf.gc.ca/site/fca-caf/decisions/en/item/34005/index.do. Here, the taxpayer was trying to write off what he thought was an investment in gems that turned out to be a fraud, and the Canada Revenue Agency (CRA) denied the loss for income tax purposes.

The second case is a more recent one, The Queen v. Johnson, which can be found at http://decisions.fca-caf.gc.ca/site/fca-caf/decisions/en/item/37594/index.do. In this case, the taxpayer had apparently failed to report certain income received from the investment. She was relying on what she was being told by the person who set it up, who said that the return on her investment was tax -free, and nothing had to be reported. The CRA became aware of the scheme, and reassessed several taxation years for the income she had received. While she was initially successful at the Tax Court of Canada (TCC), she lost at the Federal Court of Appeal (FCA), and had to pay taxes on the amounts received as income.

Because these two cases were at the FCA level, they are essentially binding, since the only court level above is the Supreme Court of Canada (SCC). While an appeal to the SCC was filed for the Johnson case, they declined to hear it. In essence, the result is that to the extent that any income is received, it has to be reported, but if the investment is lost, there may be no write-off available.

How Rulings are Determined

This is really the worst of circumstances, since there may be taxpayers who would have received some income (which would be taxable), but others who have lost the investment (for which a loss may not be available). Having said that, each case is determined on its own facts and documentation, so I cannot definitively state that the tax treatment as outlined in the above cases would apply in all situations.

For example, in the Johnson case, there were documents that were prepared and relied on by the taxpayer, were reviewed by the courts and were apparently one of the factors used to determine that the income was in fact taxable. Would the same apply to loss situations? That would be up to the courts to decide. However, CRA tends to follow the decisions from cases such as these, and unfortunately, unless someone is willing to fight this all the way to court, CRA will likely assess taxes on income amounts and deny losses.

The bottom line is that if it is too good to be true, it probably is. By asking questions, doing research and consulting your trusted advisor, you’ll have better information to make more informed investment decisions.