When it comes to ponzi schemes, financial advisors are mostly concerned about keeping clients clear of such frauds and, if they somehow are snagged, dealing with the resulting losses.
But a recent decision from the Tax Court of Canada focuses on another problem: what to do when the “investor” reaps large gains. On the tax front, at least, the news is good: hoodwinked clients don’t need to pay taxes on their winnings, which are classed as “windfalls” and not income under the Income Tax Act.
The decision, handed down late last year, means that Donna Johnson, a nurse in Ontario, does not owe the Canada Revenue Agency for taxes on more than $1.3 million she received in 2002 and 2003 from a Ponzi scheme run by Andrew Lech (who is now in jail). The ruling from Justice Judith Woods, which notes that Johnson was completely unaware of Lech’s fraudulent intentions found that, “there was very little connection” between the capital she invested with Lech and her returns.
Woods’ decision acknowledges that Johnson’s returns did have some characteristics of income, in that Johnson provided Lech with capital and received something in return. Among Woods’ reasons for ultimately deciding the returns were not income, as defined by the ITA, were: nothing was earned from the capital (all Johnson’s returns came from other defrauded investors and amounted to a “shuffle of money”); Lech never had any intention of investing the money he collected from his victims; the arrangement was not a loan.
Around 1997, Johnson had heard of Lech through a close friend in Peterborough, Ont., where John-son lives. Lech had contacted John-son and explained he would invest her money through an options-trading strategy. For each investment, Johnson would write a cheque to Lech; he would give her post-dated cheques representing repayment of her capital, with a profit added to the final cheque. Johnson had checked with her bank and was told that, indeed, it was possible to make large gains this way. In 2003, the scheme collapsed. Lech pleaded guilty to fraud in 2007.
Johnson had never declared her earnings because Lech had told her the investments were held in his private family trust and the taxes were already paid. Johnson was audited, along with 132 other victims of the Ponzi scheme, and assessed for gains of $614,000 in 2002 and $702,000 in 2003. (Johnson had continued to trade in options on her own after the scheme had collapsed; she was successful until 2008, when her savings were wiped out.)
The case raises the issue of how the results of Ponzi schemes are treated in both the U.S. and Canada. In a note on the case, Ken Whitelaw, a lawyer with Fraser Milner Casgrain LLP in Edmonton, states: “It will be interesting to see how the U.S. courts will deal with investors who profited from the Bernie Madoff scandal in 2009.” (A U.S. court has ruled that interest payments from a Ponzi scheme are taxable because they are not return of capital.)
But some think the decision is merely the other side of an existing coin, in that the CRA does not permit those who are defrauded under such schemes to deduct their losses because these schemes are not income investments.
Says Ed Mitukiewicz, a chartered accountant with Collins Barrow LLP in Elora, Ont.: “I found it curious that the CRA was now taking the other position and going after this taxpayer, when it would take the exact opposite stance when someone is trying to claim a loss.” IE