Taxability of Funds Received from a Ponzi Scheme
The Queen v Johnson, 2012 FCA 253
[see also this Draft Paper analyzing this case]
There were two issues in this case, with the asking:
- Are payments made to an investor in a Ponzi scheme, without her knowledge, taxable income as emanating from a source of income?
- Whether reassessments made outside of the normal reassessment period were valid?
The FCA here held that the payments were made to the taxpayer pursuant to a contractual agreement that was a commercial agreement (not a personal one), and having received her part of the bargain, her profit therefrom was income from a source (248(1) “property” – chose in action being the contract) being property income (section 9), that was to be included in income pursuant to paragraph 3(a).
The FCA also stated that a misrepresentation was an incorrect statement on the return, and that the failure to meet the standard of care required (not satisfied by relying on others who had also invested or the reassurance of the scammer) – to obtain a factual basis for not including the amounts in her income – means that she “cannot claim to have considered the matter thoughtfully, deliberately and carefully as a wise and prudent person would have done” leads to the conclusion that she was careless. Thus the Minister was able to reassess outside the normal reassessment period.
The FCA dealt with the issue of a fraud not constituting a source of income in cases where victims were denied a deduction of their losses resulting from being defrauded, though they had an honest belief that they were engaged in business activities. Specifically the court distinguished the case at bar from the case in Hammill v. Canada, 2005 FCA 252, on the basis that in this case the taxpayer’s contractual rights were respected and she obtained a gain based on the contract. The FCA’s reasoning very fine (nearing the unconvincing) on the basis that the fraudsters never intended to honour the word they gave to the victim in Hammill – thus there was no contract (ad idem lacking??), while here the only reason that the scammer made any payments was to continue the scheme with likely no intention to pay the victim as per the contract.
The FCA’s statement that whether a Ponzi scheme constitutes a source of income is one that is made on a person per person basis (and every year), means only that gains are taxable and losses are not deductible unless the jig is not up at the time the loss is incurred (which will never be the case with a Ponzi scheme). The lack of satisfaction doesn’t come from the gainers having to pay tax on their gains, but that the losers in the same circumstances are not able to deduct losses – there is no principled basis for differentiating between the two circumstances, though there is a policy basis for differentiating (government not subsidizing frauds, but taking from those who gain). The policy reason is hidden behind a shroud of legal reasoning that lacks a sound foundation.
The Crown appealed the decision of the TCC that held that since the amounts paid to the taxpayer were not after-tax profits from trading transactions, but rather fraudulent amounts from a Ponzi scheme, there was no source of income, and therefore the payments were not taxable in the taxpayer’s hands.
The taxpayer thought she was investing in options trading, and was told when she received funds that the taxed has been paid by the trust that operated the options trading. Thus, the amounts paid to here were after tax profits, with no obligation on her to report the income. The taxpayer didn’t seek professional tax advice before entering into these deals.
The accounts of the investment manager were frozen in 2003, a class action was brought against him (which the taxpayer joined to recover the rest of money owed to her), and the taxpayer was interviewed by the police in 2005. She says that it was at this time that she began to doubt the trustworthiness of the investment manager. The taxpayer did not know of the Ponzi scheme.
The Court began by looking at section 3 of the ITA, particularly paragraph 3(a) that states that a taxpayer must “determine the total of all amounts each of which is the taxpayer’s income for the year […] from a source inside or outside Canada, including, without restricting the generality of the foregoing, the taxpayer’s income for the year from each office, employment, business and property”.
The Court dealt with the interpretation of the word “source” and stated that though “source” is used in various phrases in the ITA, and is not defined in the ITA, its meaning is clear from the context in which it is used. The Court stated that paragraph 3(a) used the word “including” before listing the sources of income, which indicates that there may be sources of income that are not listed. The court then referred to section 56 – which is part of subdivision d “other sources of income”, which provides other amounts that are treated as income for income tax purposes. It remains an open question of whether there are other sources of income other than those listed in sections 3 and 56, though the question may never need to be decided given the broad definitions of “business” and “property” in subsection 248(1) of the ITA.
The Crown argued that the taxpayer entered into contracts over a number of years, each of which but the last one was performed. Each contract is a chose in action, and therefore property, pulling the income from that property into taxable income through paragraph 3(a). The taxpayer got what she bargained for, and the source of the satisfaction of her bargain is of no import.
The Crown relied on the decision of the SCC in Stewart v Canada, 2002 SCC 46, where the court said that a reasonable expectation of profit does not serve to determine the source of income for tax purposes as this merely invites hindsight evaluations of business judgements to deny bona fide commercial ventures. The SCC then went on at paragraph 50 to set out the manner in identifying whether there was a source of business or property income pursuant to section 9 of the ITA:
It is clear that in order to apply s. 9, the taxpayer must first determine whether he or she has a source of either business or property income. As has been pointed out, a commercial activity which falls short of being a business, may nevertheless be a source of property income. As well, it is clear that some taxpayer endeavours are neither businesses, nor sources of property income, but are mere personal activities. As such, the following two-stage approach with respect to the source question can be employed:
(i) Is the activity of the taxpayer undertaken in pursuit of profit, or is it a personal endeavor?
(ii) If it is not a personal endeavour, is the source of the income a business or property?
The first stage of the test assesses the general question of whether or not a source of income exists; the second stage categorizes the source as either business or property.
The Court then referred to the decision of the FCA in R. v. Cranswick,  1 F.C. 813, where the following list of factors were referred to so as to determine whether an amount is income from a source of a non-taxable receipt:
|(a)||The recipient had no enforceable claim to the payment.|
|(b)||There was no organized effort on the part of the recipient to receive the payment.|
|(c)||The payment was not sought after or solicited by the recipient in any manner.|
|(d)||The payment was not expected by the recipient, either specifically or customarily.|
|(e)||The payment had no foreseeable element of recurrence.|
|(f)||The payer was not a customary source of income to the recipient.|
|(g)||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.|
The Court then disagreed with the construction of the agreement between the taxpayer and the scammer. The TCC has constructed the agreement as requiring the investment of money, and the payment of profits therefrom. the FCA held that the agreement was never reduced to writing, and the evidence shows nothing more than an agreement to return the capital plus a return – there was no objective evidence to establish that the agreement required a specific manner of generating profits. The Court then went through the Cranswick factors and found that they all pointed to a source of income (para 41).
The Court noted that since income is calculated on an annual basis, a ponzi scheme may constitute a source of income for some participants for some periods of time. The Court was also not moved by some evidence that tax officials disallowed deductions from income of those who lost money in the polzi scheme on the basis that this was not a source of income.
The court looks to see if a Ponzi scheme for a particular person, and the determination of whether there is a source of income from that scheme depends on the fact for each person. The court said that there may well be instances where a victim would not be able to get tax relief for losses as part of fraud, and referred to Hammill v. Canada, 2005 FCA 252, where the court said: ” 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 FCA differentiated between that case and the case at bar by saying:
 However, the principle upon which Mr. Hammill was precluded from claiming tax relief for his losses is not applicable to Ms. Johnson. Their circumstances are entirely different, not because she profited from her transactions with Mr. Lech, but because her contractual rights were respected. As a matter of law, the fact that Mr. Lech used the proceeds of his unlawful Ponzi scheme to fund the profits he was contractually obliged to pay to Ms. Johnson is not relevant in determining the income tax consequences to Ms. Johnson of her transactions with Mr. Lech.
In dealing with the limitation period question, and whether there was a misrepresentation that would allow the Minister to reassess outside of the normal reassessment period, the Crown argued that the TCC has failed to consider whether the taxpayer has met the requisite standard of care:
[…] that of a wise and prudent person who has considered the matter thoughtfully, deliberately and carefully. That legal test is based on the following passage from the decision of Justice Addy in Regina Shoppers Mall Ltd. v. Canada (1990), 90 D.T.C. 6427 (F.C.T.D.), adopted by Justice MacGuigan, writing for this Court in Regina Shoppers Mall Ltd. v. Canada (1991), 91 D.T.C. 5101, at page 5013:
Where a taxpayer thoughtfully, deliberately and carefully assesses the situation and files on what he believes bona fide to be the proper method there can be no misrepresentation as contemplated by section 152 [1056 Enterprises Ltd v. The Queen,  2 C.T.C. 1]. In Joseph Levy v. The Queen,  C.T.C. 151 at 176, Teitelbaum J. quotes with approval the following statement by Muldoon J. in the above case:
Subsection 152(4) protects such conduct, and perhaps only such conduct, where the taxpayer thoughtfully, deliberately and carefully assesses the situation as being one in which the law does not exact the reporting of that which the taxpayer bona fide believes does not exist.
It has also been established that the care exercised must be that of a wise and prudent person and that the report must be made in a manner that the taxpayer truly believes to be correct. In another decision by Mr. Justice Muldoon, namely Iris M. Reilly, Executrix and Trustee of the Estate of Cleo E. Reilly,  C.T.C. 21, in which he dealt again with the subject, we find the following statement at p. 38:
In order to make any determination of making “any misrepresentation that is attributable to neglect, carelessness or wilful default . . . in filing the return or in supplying any information under the Act” it is necessary to have direct evidence of the state of mind and intention of “the taxpayer or person filing the return” or other evidence upon which reasonable inferences can be drawn in regard to the taxpayer’s or other person’s state of mind and intention.
And at p. 40:
The issue is not whether Mr. Tetz, in forming his opinion at the material time was wrong, but whether his not reporting the disposition was attributable to neglect, carelessness or wilful default.
Finally, at p. 42:
So, when it is now said that the standard of care is that of a wise and prudent person, it must be understood that wisdom is not infallibility and prudence is not perfection.
The Crown argued that by failing to consult a knowledgeable advisor and taking comfort in the beliefs of others who’d entered into similar arrangements, and relying on the word of the scammer, was not enough to meet the standard of care. The Court agreed with the crown and said a paragraph 58
I am unable to accept the submissions of Ms. Johnson on this point. In early 2003 when Ms. Johnson would have been preparing to file her 2002 income tax return, she would have known that her net receipts from Mr. Lech for 2002 were substantial – over $600,000. She had Mr. Lech’s assurance that the net receipts were not taxable in her hands. However, she had no factual basis for assessing the reliability of those assurances, and she failed to do what any reasonable person in her position would have done, which was to seek independent advice (and here I agree with the Crown that seeking assurances from a fellow investor, even one who is a bookkeeper, is not the kind of independent advice that would demonstrate reasonable care). Having failed to take that obvious and simple step, she cannot claim to have considered the matter thoughtfully, deliberately and carefully as a wise and prudent person would have done. I agree with the Crown that the only reasonable conclusion on the evidence is that Ms. Johnson was careless in omitting to include the payments in her income for 2002.
– Sas Ansari, JD LLM PhD (exp)
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