Ponzi distribution taxable after all

Several recent high-profile Ponzi schemes have stolen fortunes and tainted the advisory profession.

But it’s inappropriate to call the perpetrators advisors, since they’re pursuing their own selfish interests, not those of clients.

To add insult to injury for victims, losses incurred in a Ponzi scheme are rarely deductible when calculating income tax.

In a surprising decision in 2011, a trial judge determined one innocent Ponzi scheme investor who had a net-positive result would not be taxed on the gain. The finding was overturned by the Federal Court of Appeal (FCA) last September, but it looks like the fight may not be over just yet.

Anatomy of a fraud

In 1997, a mutual friend introduced DMJ to Andrew Lech, who said he was the financial manager for a family trust. Lech offered to combine DMJ’s money with the trust’s funds, purportedly to invest in options contracts on an ongoing basis.

On numerous occasions between 1997 and 2003, DMJ gave Lech a cheque in exchange for eight-to-10 postdated cheques, with the last one representing DMJ’s gains. To sweeten the deal, Lech gave written assurance that any associated taxes would have been paid by the trust, so DMJ didn’t have to report any income on her tax return.

The scheme came to a screeching halt in April 2003 when the police froze Lech’s bank accounts. Forensic auditors determined that from 2001 to 2003 alone, almost $50 million had passed through Lech’s hands. A civil class-action suit, a criminal case, and regulatory action by the Ontario Securities Commission followed.

In 2007, Lech was convicted of fraud and sentenced to six years in prison — on top of the three he spent in pretrial custody.

The Queen v DMJ

The CRA audited 132 of the participants in the scheme and concluded 32 — including DMJ — profited from their involvement. To be clear, it was not alleged DMJ was involved in the fraud; the authorities said she profited innocently.

In 2007 DMJ was reassessed by the CRA for income of $614,000 in 2002 and $702,000 in 2003. DMJ appealed the reassessments, but conceded during the legal proceedings that these sums accurately reflected the gains she received.

However, she contended that no income was actually generated over the course of the transactions, and therefore there was no legal basis for the CRA to assess her for tax on those receipts.

At trial in November 2011, the judge found the gains were not sufficiently connected to DMJ’s original capital to treat them as coming from a taxable income source.

In the judge’s words, “nothing was actually earned with that capital. … The Net Receipts were nothing more than the shuffle of money among innocent participants.”

Effect of a scheme on taxation

As noted, the Crown was successful in its appeal to the FCA in September 2012.

The appeal judgment emphasizes that “whether a Ponzi scheme is a source of income to a particular person, whether innocent or not, is a question that must be answered on the basis of the facts relating to that person.”

According to the FCA, when the relationship between two parties is based on fraud, there can be no source of income.

In this case, however, DMJ received a contracted return from Lech in a business relationship. The manner in which Lech generated the funds for those returns was irrelevant, even if it was through an unlawful Ponzi scheme. DMJ has applied for leave to appeal to the Supreme Court of Canada. It is docket 35090 on the SCC website.

Doug Carroll, JD, LLM (Tax), CFP, TEP, is vice president, tax and estate planning, at Invesco Canada.