TaxMatters@EY - July 2014

Good documentation results in a happy taxpayer

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Roszko v The Queen, 2014 TCC 59
Bob Neale, Toronto, and Allison Blackler, Vancouver

In this case, the Tax Court of Canada (TCC) considered whether funds received by the victim of a Ponzi scheme were taxable interest income or a return of a portion of the taxpayer’s original investment. Important documents retained by the taxpayer were key to the favourable decision.

Facts

The taxpayer sold the family farm in 2006 and sought to invest a portion of the proceeds in a reputable Alberta financial enterprise. While reviewing investment opportunities and their tax implications, the taxpayer attended a presentation of a company promising returns on investment of 18% to 22%. The taxpayer was led to believe, and entered into contracts on the basis that, the company bought and sold commodities at considerable profit to achieve the high returns.

The taxpayer decided on an initial investment in the company of $100,000 in 2006. After consistently receiving the promised monthly returns, the taxpayer invested a further $100,000 later that year, followed by an additional $300,000 in the spring of 2007 and a further $300,000 in the fall of 2007, for a total investment of $800,000.

Between 2006 and 2009, the taxpayer received a total of $408,000 by way of the promised monthly returns and annual bonus payments (2006: $22,500, 2007: $81,000, 2008: $156,000 and 2009: $148,500).

However, in late 2009, the taxpayer requested a return of a portion of his investment to cover funeral costs following his son’s death. The request was denied in a manner that made the taxpayer suspicious. As a result, the taxpayer made enquiries which eventually led to an Alberta Securities Commission investigation and a subsequent finding that the company was running a Ponzi scheme and had perpetrated a fraud on its investors.

Tax Court of Canada decision

This case dealt only with the 2008 taxation year, in which the taxpayer reported the $156,000 that he received from the company as interest income on his T1 personal income tax return. The issue before the TCC was whether this amount was interest income, or whether the amount represented a return of capital, for income tax purposes.

The taxpayer argued the amount was received as a return of the loan principal and should not be included in his income for tax purposes, on the basis that:

  • The original lending arrangement was based on a fraudulent misrepresentation. When the taxpayer became aware of this, he rescinded the contract, rendering it void ad initio and of no effect with respect to the payment of interest.
  • The terms of the lending agreement provided that any misrepresentation resulted in the principal and interest becoming due and payable without demand.

The taxpayer argued that it was therefore reasonable to characterize the amount received as a return of capital. The taxpayer also suggested that because there was no enforceable agreement between the company and the taxpayer, the company held the taxpayer’s funds in a resulting trust. Essentially, the beneficial ownership of the funds remained with the taxpayer, and therefore when funds were paid to the taxpayer, it was no more than the transfer of legal title to those beneficially owned funds back to the taxpayer.

Not surprisingly, the Crown argued that the terms of the contract were enforceable and that the receipts were interest income of the taxpayer. The Crown argued that the payments the taxpayer received met all three requirements for being characterized as interest:

  • The amounts were compensation for the borrower’s use of the money.
  • The amounts were ascertainable on a daily basis.
  • The amounts were related to the outstanding principal sum.

The TCC preferred the taxpayer’s arguments and found that the amount was a return of capital. In reaching its decision, the TCC relied on the following significant facts:

  • The taxpayer’s agreement with the company stipulated how the funds were to be invested.
  • The taxpayer was led to believe the funds would be so invested.
  • The funds were not so invested and therefore the taxpayer’s contractual rights were not respected. Although $156,000 was paid to the taxpayer, that amount was not derived as contracted. The company represented it was making significant lucrative investments, but in reality it was simply shuffling investor money around to give the appearance of profitability.
  • It was agreed as a fact that the company had perpetrated a fraud. In fact, the TCC accepted the description of the fraud from the Alberta Securities Commission decision and concluded that decision was a finding of law which could be relied upon. As a result, the taxpayer was not required to prove that the investment was a Ponzi scheme.

To determine whether the payments were interest income, the TCC considered two earlier decisions involving Ponzi schemes. The TCC first considered Johnson, which involved contracts that were vague and did not clearly set out the scheming company’s obligations. Rather, the company was only required to invest the funds and then provide an agreed return — which it did — so much so that the taxpayer in that case did earn a profit. In this context, the Federal Court of Appeal concluded that there can indeed be a source of income in a Ponzi scheme.

The TCC also considered Hammill, a case which involved the fraudulent sale of gems. In that case, it was clear that the taxpayer had been a victim of a fraud from the very start. The Federal Court of Appeal ruled on this basis that a fraudulent scheme from beginning to end can’t give rise to a source of income or be a business.

The TCC clarified the difference between the approach in Johnson and that in Hammill, stating that “there is a distinction, I would suggest, between earning income based on a fraudulent act or illegal activity versus a finding that the contract itself is a fraud. In the former situation there can be a source of income which can be taxable. In the latter situation there cannot.”

The TCC distinguished Johnson on the basis that the taxpayer’s documents were unequivocal, and unlike Johnson, the company clearly had not complied with its legal obligations under the contract. Instead, the TCC found the Hammill decision to be much more applicable, because they both involved a taxpayer who had been induced to enter into a contract based on fraudulent misrepresentations. The TCC concluded that in the circumstances “the purported interest is a fraud from the outset. It cannot be considered income from property, but rather a return of capital to the extent of the original amounts invested: only excess returns might be considered income.” Accordingly, the taxpayer did not earn interest income of $156,000 in 2008.

Implications

The taxpayer was successful largely because he had retained all of the relevant documents associated with his investment and the arrangement between the parties. It was clear from these documents that the company did not undertake the activities as represented and therefore, there was no doubt the company’s representations were fraudulent.

Unfortunately, the case only dealt with the 2008 taxation year and was silent on the appropriate tax treatment of the taxpayer’s net loss of approximately $400,000. As a result, we expect that there will be future litigation of this matter.

This case serves as a reminder that if an investment sounds too good to be true, it likely is.