The Federal Court of Appeal (the "FCA") released its reasons in The Queen v. Donna M. Johnson (2012 FCA 253) on October 4, 2012. In that decision, the FCA ruled that payments made to an unwitting participant in a Ponzi scheme were taxable as income. This was a reversal of a decision by the Tax Court of Canada (the "TCC"), which held that the payments were not taxable because they were not from a "source" of income (Johnson v. The Queen (2011 TCC 540, 2012 DTC 1022)). This case is of particular interest because it asks whether those who profit from a Ponzi scheme (while unaware of the underlying fraud) should be taxed on distributions received, and it raises the unsettled issue of whether innocent parties who lose money in such schemes should be allowed to deduct their losses.
The Facts
In 1997, Ms. Johnson, through a friend, took part in an "investment opportunity" offered by Mr. Andrew Lech ("Lech"). Ms. Johnson had never met Lech but knew of him through her church and other connections in her community. After a few months of profitable investments, Lech approached Ms. Johnson directly and offered her the chance to participate directly in an investment plan based on options trading. Ms. Johnson provided capital to Lech by issuing a cheque to him. In return, Lech gave her several cheques, postdated for the next 8 to 10 months, which would return her invested capital over time, with profits included in the final cheque.
According to the trial decision, Lech told Ms. Johnson that he would invest her money in options and pay her the profits, less a commission. Lech also told her that the investments were secure and there was no risk of loss. He further told Ms. Johnson that the profits were tax-free, as the investment was held by his family trust, which paid any tax arising from the investment. Lech went so far as to sign a document declaring that all taxes on the profits were being paid by his family trust, and another document stating that if Lech passed away, payments to Ms. Johnson on the investment were to be funded from his estate.
Unknown to the investors in Lech's scheme, there was no trading in options and no family trust. Lech was, according to the FCA decision, simply shuffling money received from investors through bank accounts to pay other investors. The scheme continued until April 10, 2003, when Lech's bank froze his accounts. A month later, a group of investors, including Ms. Johnson, filed a class action law suit against Lech. A three-year police investigation subsequently led to Lech pleading guilty to a criminal charge of fraud over $5,000. He was sentenced to six years in prison in 2007.
The Minister of National Revenue (the "Minister") subsequently audited the investors involved in Lech's scheme, and found that Ms. Johnson and 31 others had profited from it. The Minister reassessed Ms. Johnson for income tax on the profits she had made in 2002 and 2003. These funds totalled $614,000 in 2002 and $702,000 in 2003. Ms. Johnson appealed to the TCC.
Tax Court of Canada Decision
At trial, the TCC considered whether the profits made by Ms. Johnson were from a source of income, as required by paragraph 3(a) of the Income Tax Act (the "Act"). Ms. Johnson argued that the income was not from a source, relying on the FCA decision in Hammill v. The Queen (2005 FCA 252, 2005 DTC 5397), where a fraudulent scheme was held not to be a "source" of income to the victim of the scheme, because such a scheme could not be considered a "business". In reply to Ms. Johnson, the Crown argued that the income was taxable because it was not a "windfall" as defined in The Queen v. Cranswick (82 DTC 6073 (FCA)). In Cranswick, at page 6075, the FCA held that the following factors determine whether a payment is a windfall to the recipient:
(1) the recipient had no enforceable claim to the payment;
(2) there was no organized effort on the part of the recipient to receive the payment;
(3) the payment was not sought after or solicited by the recipient in any manner;
(4) the payment was not expected by the recipient, either specifically or customarily;
(5) the payment had no foreseeable element of recurrence;
(6) the payer was not a customary source of income to the recipient; and
(7) the payment was not in consideration for or in recognition of property, services, or anything else provided or to be provided by the recipient; it was not earned by the recipient, either as a result of any activity or pursuit of gain carried on by the recipient or otherwise.
The TCC held the payments were not from a source of income, and were therefore not taxable, because the funds paid to Ms. Johnson arose from fraud, not through returns on an investment. The TCC held that while Ms. Johnson had given capital to Lech, and had received payments in exchange for that capital, there was very little connection between the invested funds and the profits received, because the invested capital was not actually invested in anything and therefore, was not earning any income. Lech had never invested in any options and had no intention of ever investing Ms. Johnson's money. The profits came from fraud, and were not paid pursuant to any legally enforceable agreement between Lech and Ms. Johnson, and applying Hammill, the TCC held the profits could not have come from a source of income.
Finally, the TCC ruled that the profits were, in effect, windfalls, under the Cranswick criteria, because what the appellant bargained for were profits from investment, but what she actually received were funds provided to her through fraud on other parties. Being windfalls, the profits were not from a source and were not taxable under the Act.
Federal Court of Appeal Decision
The FCA reversed the TCC's decision. The FCA again considered the issue of whether Ms. Johnson's profits were income from a source as required under the Act. The Crown changed its approach on appeal, and instead of trying to prove Ms. Johnson's profits were not a windfall, argued that the profits were income from property.
The Crown submitted that the exchange of cheques between Ms. Johnson and Lech amounted to a contract and, as rights under a contract are choses in action, they are "property" within the meaning of subsection 248(1) of the Act. Subsection 9(1) of the Act requires income from property to be included in computing taxable income and therefore, Ms. Johnson was taxable on the profits from the scheme. The Crown argued that the appropriate test was set out in Stewart v. Canada (2002 SCC 46, 2002 DTC 6969), where the Supreme Court of Canada ruled that as long as an activity is undertaken in the pursuit of profit and is not a personal endeavour, income from the activity can be considered income from business or property. As Ms. Johnson's income was from property, the Crown argued that the fact that Lech used funds obtained by fraud to pay Ms. Johnson did not change the fact that she received exactly what she had bargained for, i.e., returns on the investment of capital.
The FCA acknowledged that the Crown would be successful if the analysis were to end with the rule in Stewart. However, the FCA said it was necessary to go further and consider whether the fact that Ms. Johnson was unaware that the profits came from a Ponzi scheme, rather than from investing in options, made the profits non-taxable. The FCA said it did not, and held that the TCC, in narrowly construing the agreement between Lech and Ms. Johnson, erred in applying the test from Cranswick to that agreement.
The agreement between Ms. Johnson and Lech, according to the FCA, was not an agreement for Lech to invest funds in a certain way. To the FCA, this was not a finding open to the TCC, as the agreement between Ms. Johnson and Lech was never reduced to writing. Rather, the only evidence of the contract between them was the cheques exchanged between Lech and Ms. Johnson. The only agreement that could be construed from those instruments was that Lech would repay the funds invested, along with a profit, according to a schedule set out by the amounts and dates on the postdated cheques. Lech was not under an obligation to earn profits for Ms. Johnson by a particular method. Rather, he was only obliged to return the invested capital along with a certain amount of profit, and this is what he had done. The FCA held the TCC had erred by finding the contract required that the funds be invested in options, and that because the funds were not, the contract was invalid.
After recharacterizing the agreement between Lech and Ms. Johnson, the FCA held that the profits paid to Ms. Johnson were not a windfall. In applying the Cranswick factors, the FCA concluded that:
- Johnson had an enforceable claim to the payments she received, as there was no basis for saying the agreement between her and Lech was unenforceable under the law;
- she had made an organized effort to receive the payments;
- she sought or solicited the payments;
- the payments were expected by Johnson, either specifically or customarily;
- the payments came from a source of income (an agreement to pay a return on capital); and
- the payments were in consideration for something provided by Johnson (the initial investment).
On this basis, the FCA held that the funds paid to Ms. Johnson were taxable as income from property. The FCA also commented on the taxability of income from Ponzi schemes in general. Despite the fact that a Ponzi scheme is a shuffling of funds, and not the creation of any new wealth, income received from such a scheme can still be a source of income. Ms. Johnson was being taxed on the income, not because she was a participant in a Ponzi scheme, but because she entered into an agreement by which she would realize a profit and received that profit as promised. The fact that the source of the funds she received was a fraudulent scheme did not affect whether she was taxable.
The FCA also dealt with Ms. Johnson's contention that it was inconsistent to tax her on income from a Ponzi scheme, but to disallow losses for those who have been victims of such a scheme. The FCA said that, in general, whether a person is taxable on income or can claim losses arising from a Ponzi scheme is to be decided on the circumstances particular to each taxpayer involved.
The FCA further held that a victim of a Ponzi scheme may not be able to claim losses if the circumstances are similar to those in Hammill v. The Queen. Hammill had purchased a sizable amount of precious gems over a period of several years, and then paid fees to an investment company to sell his gems for a profit. He discovered later on that the company had absconded with his money and the gems, and had never intended to sell his gems in the first place. Hammill claimed losses for both the gems and the selling fees. The Minister allowed a loss on the gems that were stolen, but disallowed the losses on the fees because Hammill did not establish they were incurred for the purpose of earning income from a business.
Hammill appealed the denial of the expenses to the FCA. The FCA held that the expenses were not deductible because the expenses could not have been incurred for the purpose of earning business income, as the presence of the fraudulent scheme, in those circumstances, meant no business had ever existed. At paragraph 27, the FCA stated, This finding by the Tax Court Judge that the appellant was the victim of a fraud from beginning to end, if supported by the evidence, is incompatible with the existence of a business under the Act. 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 (Stewart, supra, Tonn v. The Queen, 96 DTC 6001 etc.). Nor is this a defalcation case of the type described in Parkland Operations, supra; Cassidy's Limited, supra; Agnew, supra; and IT-185R, where a business is defrauded by an employee or a third party, and the issue becomes whether the resulting loss is reasonably incidental to the income-earning activities.
In other words, Hammill suggests that the existence of a fraudulent scheme unto itself precludes the possibility of the scheme being a business, and therefore, a source of income for the purposes of the Act. There is no need in these circumstances to consider the perspective of the victim because there was never a business to begin with. The FCA in Johnson clarifies that decision, saying that it is the arrangement the taxpayer is involved in that must be fraudulent for this principle to apply. If a taxpayer is receiving funds as part of a legitimate agreement which is otherwise a source of income under the Act, then regardless of whether the source of the funds themselves was fraud, the taxpayer would still be taxable on the income and, in some cases, permitted to deduct losses against that income.
It was therefore not inconsistent to tax Ms. Johnson on her income while denying losses to other parties. The income to Ms. Johnson arose because of a scheme in which she had in fact earned income from property. Simply because the funds that were used to pay her came from a fraudulent scheme does not seem to be enough to say the income did not have a source for the purposes of the Act. However, losses in a fraudulent scheme will be denied where there was in fact no business, and therefore, no possibility of earning income.
A number of tax lawyers from Fraser Milner Casgrain LLP write commentary for CCH's Canadian Tax Reporter and sit on its Editorial Board as well as on the Editorial Board for CCH's Canadian Income Tax Act with Regulations, Annotated. Fraser Milner Casgrain lawyers also write the commentary for CCH's Federal Tax Practice reporter and the summaries for CCH's Window on Canadian Tax. Fraser Milner Casgrain lawyers wrote the commentary for Canada–U.S. Tax Treaty: A Practical Interpretation and have authored other books published by CCH: Canadian Transfer Pricing (2nd Edition, 2011); Federal Tax Practice; Charities, Non-Profits, and Philanthropy Under the Income Tax Act; and Corporation Capital Tax in Canada. Tony Schweitzer, a Tax Partner with the Toronto office of Fraser Milner Casgrain LLP, and a member of the Editorial Board of CCH's Canadian Tax Reporter, is the editor of the firm's regular monthly feature articles appearing in Tax Topics.
For more insight from the tax practitioners at Fraser Milner Casgrain LLP on the latest developments in tax litigation, visit the firm's Tax Litigation blog at http://www.canadiantaxlitigation.com/.
INDEXING FACTOR FOR 2013
The CRA has posted its Guide T4127-JAN, Payroll Deductions Formulas for Computer Programs—96th Edition— Effective January 1, 2013. The guide contains the formulas needed by payroll professionals to calculate federal, provincial (except Quebec), and territorial income taxes and CPP and EI deductions effective January 1, 2013. As a result, it contains the indexing factor for 2013 tax brackets and personal amounts.
The federal indexing factor for 2013 is 2%; therefore, to calculate the indexed income thresholds and personal amounts for 2013, the 2012 amounts should be multiplied by 1.02. The guide states that for 2013, the federal indexing factor of 2% also applies to New Brunswick, Northwest Territories, Nunavut, Saskatchewan, and Yukon. The indexing factors for the other provinces are as follows: Alberta, 1.8%; British Columbia, 1.5%; Newfoundland and Labrador, 2.6%; and Ontario, 1.8%. There is no indexing applied to Manitoba, Nova Scotia, and Prince Edward Island.
It is expected that as usual, later this year the CRA will release a Fact Sheet that lists all of the indexed amounts for next year. In the meantime, the personal income tax bracket thresholds and some of the personal amounts for 2013 that are noted in the T4127-JAN are shown below.
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