Category Archives: Gross Negligence Penalties

Taxation of Pyramid Schemes – Sas Ansari

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Taxation of Pyramid Schemes

Mazo v The Queen, 2016 TCC 232

At issue was the income tax treatment of amounts received by a participant in a pyramid scheme that is not the developer or mastermind behind the scheme.

FACTS

The Appellant was involved in a pyramid scheme, prohibited by the Competition Act, called Business In Motion International Corporation (for a class action against corp see Cuzzetto v. Business In Motion International Corporation et al,  2014 FC 17).  The scheme was structured to create the appearance that participants were buying goods and services when all they were doing was buying a spot at the bottom of the pyramid.

NOTE: The Minister, despite a clear finding in the FC in the class action that this was a clear case of a pyramid scheme, maintained the position that the corporation was a multi-level marketing company that was selling goods and services (para 10).  The Court stated that this position was clearly wrong and could “see no reason for the Minister to take such a position other than to artificially inflate the tax the Minister can assess” (para 10). However, the DoJ lawyer, Larissa Benham, handled the difficult position the Minister placed her in with professionalism (para 11).

ANALYSIS

The Court referred to previous decisions dealing with the tax treatment of fraudulent scheme [for a paper on this see HERE]. These cases show that income from a Ponzi scheme in the hands of a participant are income where the contractual rights are respected, but losses from a fraudulent scheme that was never a business are not non-capital losses (para 13).

Should profits from a pyramid scheme be treated the same way as Ponzi schemes?

The similarities between the two are (para 15):

  • both are illegal;
  • both rely on a continuous stream of new participants injecting new cash to sustain withdrawals of a few at the top;
  • both inevitably collapse under their own weight, leaving victims suffering losses; and
  • Both present an illusion of people making money, with few extracting more than they put in.

The key differences between the two are (para 16):

  • Participants in a Ponzi scheme believe they are making an investment, thereby generating profits, don’t realize there is no investment; BUT
  • Participants in a pyramid scheme may not realize the full nature of the scheme but are aware at some level that they are being paid using money that comes from those participants below them, such that is clear to everyone that without new people at the bottom there are no profits at the top.

The court held that “it would generally be more appropriate to characterize the income received by a participant in a Ponzi scheme whose contractual rights have been honoured as property income and the income received by a participant in a pyramid scheme whose contractual rights have been honoured as business income” (para 17).

In this case, the participants were being defrauded from the start by walking into a scheme that was doomed to failure but certain to put money in promoters’ pockets (para 18).  If participants’ contractual rights were honoured – if they got what they bargained for – they are taxable on those amounts (para 18).

The Appellant was found not to have bargained for a pyramid scheme (para 19), but to join a sales organization that would result in commissions for recruiting sales people (para 20). As such, the payments, net expenses, were business income in the Appellant’s hands.

The Court “reluctantly” agreed with the MInister’s position in how to calculate profits, but stated that if another set of facts were to come before the courts, the method may well not be accepted. Rather, the income should be the amounts the participant actually extracted from the scheme (para 28).

Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

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Duties and Obligations of Taxpayers – Sas Ansari

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Duties and Obligations of Taxpayers

Mallette v The Queen2016 TCC 27

What are the obligations of a taxpayer who is acting, purportedly, on professional advice but turns out to have been the victim of a fraud? [for an in-depth analysis of tax consequences for victims of fraud see HERE].

FACTS

The taxpayer claimed non-existent business expenses on the basis of fraudulent advice provided by Fiscal Arbitrators and Fireslander Financials.  The fraudsters prepared the taxpayer’s tax returns claiming large fictitious business losses.

The CRA reassessed the taxpayer and penalized him pursuant to 163(2) of the ITA.  The taxpayer appealed the application of gross negligence penalties.

ANALYSIS

 The Court identified the Canadian tax system as both “self-reporting and self-assessing”, relying on the honesty and integrity of taxpayers.  This system imposes on the taxpayer a duty to “report his taxable income completely, correctly and accurately no matter who prepares the return” (para 16, emphasis added).  Taxpayers must be vigilant in ensuring completeness and accuracy of the information in returns, and are solely responsible to the CRA – Northview Apartments Ltd. v. Canada (Attorney General), 2009 FC 74, at para 11.

The Supreme Court of Canada set out the responsibilities and duties of taxpayers in R. v. Jarvis, 2002 SCC 73, stating that:

  • taxpayers have an obligation to pay the tax on their taxable income according to the rules in the ITA;
  • taxpayers must estimate their annual income tax payable;
  • taxpayers must disclose their estimate to the CRA in their returns;
  • The ITA imposes penalties on person who fail to file their returns (s 162) or that fail to report the required amounts, or who are complicit or grossly negligent in making false statements or omissions (s 163); and
  • taxpayers must be forthright and honest in their reporting obligations.

The penalties are there to protect the integrity of the system and to encourage taxpayers to exercise care and accuracy in the preparation of their return no matter who prepares them (para 18). In order for gross negligence penalties under subsection 163(2) to apply, two elements must be established by the Crown:

  1. a false statement in the return; and
  2. knowledge of or gross negligence in the making of, participating in, assenting to, or acquiescing in the making of, that false statement.

There was no question so to false statements contained in the returns. The claims had no foundation in fact.

The taxpayer also reviewed his returns and knew that he didn’t have business expenditures of such magnitude. He knew that this information was simply not true. This is sufficient to impose gross negligence penalties.

Even if the taxpayer honestly believed in the legitimacy of the tax savings scheme, he still knew he had not incurred the magnitude of expenses claimed that year.  He never supplied the tax preparer with any information to allow for such a calculation and knew that this was a made-up number (para 22).  Even if the taxpayer didn’t “knowingly [make], participated in, assented to or acquiesced in the making of, such a false statements”, he is liable if he is grossly negligent.

Negligence is “the failure to use such case as a reasonably prudent and careful person would use under similar circumstances.  Gross negligence involved greater neglect reaching the level of intentional acting or indifference as to whether the law is complied with or not – Venne v. Canada, [1984] F.C.J. No. 314 (QL). In Farm Business Consultants Inc. v. Canada, [1994] T.C.J. No. 760 (QL).  The Court stated, at para 24:

… the words “gross negligence” in subsection 163(2) imply conduct characterized by so high a degree of negligence that it borders on recklessness. In such a case a court must, even in applying a civil standard of proof, scrutinize the evidence with great care and look for a higher degree of probability than would be expected where allegations of a less serious nature are sought to be established …

Gross negligence includes “wilful blindness” which involves a party who “has his suspicion aroused but then deliberately omits to make further inquiries, because he wishes to remain in ignorance ” – R. v. Hinchey, [1996] 3 S.C.R. 1128.  Thus, a person has become aware of the need for inquiry fails to make the inquiry because of the wish not to know the truth, preferring to stay ignorant.  The Federal Court of Appeal in Panini v. Canada, 2006 FCA 224 said (see also Canada v. Villeneuve, 2004 FCA 20):

43 . . . the law will impute knowledge to a taxpayer who, in circumstances that dictate or strongly suggest that an inquiry should be made with respect to his or her tax situation, refuses or fails to commence such an inquiry without proper justification.

In distinguishing between regular and gross negligence, the following factors must be considered, each factor weighed in context to see what the overall picture emerging is:

  • the magnitude of the omission in relation to the income declared;
  • the opportunity the taxpayer had to detect the error;
  • the taxpayer’s education and apparent intelligence;
  • genuine effort to comply.

See DeCosta v. The Queen, 2005 TCC 545, at paragraph 11; Bhatti v. The Queen, 2013 TCC 143, at paragraph 24; and McLeod v. The Queen, 2013 TCC 228, at paragraph 14 – In Torres v. The Queen, 2013 TCC 380, paragraph 65, the factors were non-exhaustively summarized:

a)         Knowledge of a false statement can be imputed by wilful blindness.

b)         The concept of wilful blindness can be applied to gross negligence penalties pursuant to subsection 163(2) of the Act . . . .

c)         In determining wilful blindness, consideration must be given to the education and experience of the taxpayer.

d)         To find wilful blindness there must be a need or a suspicion for an inquiry.

e)         Circumstances that would indicate a need for an inquiry prior to filing . . .  include the following:

i)          the magnitude of the advantage or omission;

ii)         the blatantness of the false statement and how readily detectable it is;

iii)        the lack of acknowledgment by the tax preparer who prepared the return in the return itself;

iv)        unusual requests made by the tax preparer;

v)         the tax preparer being previously unknown to the taxpayer;

vi)        incomprehensible explanations by the tax preparer;

vii)       whether others engaged the tax preparer or warned against doing so, or the taxpayer himself or herself expresses concern about telling others.

f)         The final requirement for wilful blindness is that the taxpayer makes no inquiry of the tax preparer to understand the return, nor makes any inquiry of a third party, nor the CRA itself.

The court identified the ‘red flags’ present as (para 33):

  • the fee structure being a percentage of refunds obtained and being exorbitant in respect of filling out a few forms;
  • the tax preparer was previously unknown to the taxpayer and he was not allowed to deal with the directly;
  • the tax preparer was not mainstream but managed to come up with an amazing tax savings scheme;
  • an internet search not producing negative information on the preparer is not the same as having information of legitimacy of the scheme;
  • the link of investments with tax return obtained is a strange relationship that should have caused the taxpayer to question the investment-savings scheme;
  • the tax savings scheme was specious and utterly preposterous, being the theory that a person can be separated from his SIN to create two separate entities for tax purposes;
  • the numbers were not based on any information provided by the taxpayer, raising the need to investigate how they were determined;
  • The tax advantage was significant and would have returned all taxes paid over the past years to him;
  • The return included blatantly false statements of fact and were easily detectable;
  • Unusual requests made by the tax preparer including:
    • using the word “per” before his signature on a personal return,
    • having to write his name in block letters,
    • statement of agent activities having to be in blue ink,
    • not providing CRA with his phone number,
    • not speaking directly to the CRA,
    • not filing electronically
    • not using direct deposit
    • forwarding all CRA correspondence to the preparer
  • The return not acknowledging that a tax preparer has prepared the return in box 490
  • The preparers address being in a strange format;
  • Failure to make inquiries of the CRA or other tax professionals

The court distinguished this case from others where taxpayers relied on professionals (Lavoie c. La Reine, 2015 CCI 228), or where honest mistakes or confusion resulted in the misstatement (Hine v. The Queen, 2012 TCC 295).  Taxpayers can not avoid penalties for gross negligence by putting blind faith in tax preparers without taking steps to verify the correctness of the information in their returns (Gingras v. Canada, [2000] T.C.J. No. 541 (QL); Laplante v. The Queen, 2008 TCC 335).  The taxpayer’s signature that the returns are truthful is an obligation not avoided by relying on tax professionals.

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