Case challenges tax picture for those hit by scandal

Last month, the Ontario Securities Commission announced that the five mutual fund companies implicated in late-trading and market timing activities back in 2003 have been given an additional two years to distribute any remaining settlement monies to affected investors.

Coincidentally, the taxation of the settlement amounts received by mutual fund investors who held units in their registered plans has also resurfaced in a recent tax case decided this spring (Lavoie v The Queen, 2009 TCC 293).

Russell Lavoie lives in Waterloo, Ontario and owned units of various mutual fund trusts, including units in Franklin Templeton Mutual Funds (“Franklin Templeton”) and AIC Mutual Funds (“AIC”) in his RRSP.

Both Franklin Templeton and AIC were among several of the mutual fund companies investigated in the United States in 2003 for abusive trading practices, specifically, late trading and market timing activities. Following U.S. investigations, the Ontario Securities Commission in cooperation with the Investment Dealers Association of Canada (now IIROC) and the Mutual Fund Dealers Association of Canada, began an inquiry into potential late trading and market timing activities in the Canadian mutual fund industry. As a result of the investigation, the Ontario Securities Commission concluded AIC and Franklin Templeton were among a number of companies “that failed to protect the best interests of their funds … (and) acted contrary to the public’s interests by neglecting to implement appropriate measures to protect their mutual funds against the harm associated with frequent trading market timing activities.”

The OSC reached settlements with five mutual fund companies, including AIC and Franklin Templeton, and had them make payments to unitholders of its mutual funds who’d suffered harm from the market timing activities of the fund company. AIC paid nearly $60 million while Franklin Templeton paid nearly $50 million to affected investors. In total, the five Canadian mutual fund companies disbursed over $200 million to their affected investors.

According to the approved settlements, investors who held affected mutual funds inside of registered plans, such as RRSPs or RRIFs, would receive payments directly as opposed to being paid to the plans themselves.

In September 2005, Lavoie received three cheques from AIC and Franklin Templeton totaling approximately $313. While this hardly seems worth going to tax court over, the case is clearly one of principle and the judge acknowledged that the “case is significant not only to Lavoie, but also to a large number of other taxpayers who received payments as a result of these agreements because they held units of the mutual funds managed by the fund managers (the managed funds) within their registered retirement savings plans (RRSPs).”

Lavoie cashed the cheques but failed to include the $313 in his tax return for 2005. He was reassessed by the CRA in 2007 and, responded that in his opinion, the payments are not income from a source, and thus are a windfall and non-taxable.

Not surprisingly, the CRA objected to the windfall argument. It maintained that since the amounts were paid in compensation for the harm caused to Lavoie’s fund holdings in his RRSPs by the market timing transactions sanctioned by the fund managers, the amounts are akin to monies received “as benefits out of or under (an RRSP)” and therefore taxable.

Lavoie’s main argument was based on an old case (The Queen v Cranswick, 82 DTC 6073) in which a voluntary payment offered by the majority shareholder and parent company of a corporation to a minority shareholder “… in the hope of avoiding controversy or potential litigation on behalf of minority shareholders …”, but not “… by reason of any enforceable claims … by shareholders …” was found to be a windfall. The case delineated seven criteria that help determine whether an amount is a windfall. Unfortunately for Lavoie, for various reasons the judge felt the payment by the fund companies did not meet the Cranswick criteria and therefore was not a windfall and was fully taxable.

Interestingly, however, the judge did say Lavoie could have handed the payments he personally received over to his RRSP trustee to be added to the RRSP’s assets, even though he didn’t have any RRSP contribution room available. Presumably, this would have had the effect of deferring the tax on the payments until ultimate withdrawal. Lavoie has appealed this decision to the Federal Court of Appeal. We’ll keep you posted as the matter grinds its way through the courts.

Jamie Golombek, CA, CPA, CFP, CLU, TEP, is managing director, tax and estate planning, with CIBC Private Wealth Management in Toronto. Jamie.Golombek@cibc.com