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O Tannenbaum, O Tannenbaum...The Tax Implications of Ponzi Schemes

29 February 2012   (0 Comments)
Posted by: Author: Johan Van Der Walt
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O Tannenbaum, O Tannenbaum...The Tax Implications of Ponzi Schemes

"O TANNENBAUM" (English version: "O Christmas Tree") is a Christmas carol of German origin.The song lyrics are said to date back to 1550.The best known version was written in 1924 by a Leipzig organist and composer.The words of the carol include:"You give us so much pleasure"—whether that applies in the South African context is another question.

The term "Ponzi scheme" comes from Italian-born Charles Ponzi(1882-1949), con artist and swindler in the USA and Canada.He later told the New York Times:"I landed in this country with $2.50 in cash and $1 million in hopes, and those hopes never left me."His original 1919 operation,based on the arbitrage of international reply coupons for postage stamps, was the first to become known throughout the USA. In seven months, 30 000 people invested approximately $10million in "Ponzi notes".Then everything unravelled. Mr Ponzi was convicted of mail fraud in 1920 and spent time in federal and state prisons.He was deported to Italy in 1934, carrying a suitcase with no money.He died in the charity ward of a Brazilian hospital in Rio de Janeiro aged 66. In his last interview he said: "Even if they never got anything for it, it was cheap at that price. Without malice afore thought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over."

SARS is currently pursuing investors who participated in SA's own Ponzi scheme ran by Barry Tannenbaum, last residing in Runaway Bay, Gold Coast,Australia. [Runaway Bay is described thus: "... primarily a waterfront suburb, with most home shaving canal access.The homes along the canal vary from large mansions ..."]

According to the Financial Mail (12 June 2009) Tannenbaum "...may have created the country's greatest Ponzi scheme", duping approximately 400 investors from SA, the USA, Qatar, and Australia.But what are the tax consequences relating to a Ponzi scheme?Suffice to say that SARS’ current approach to Ponzi scheme tax implications (both with regard to the Ponzi scheme operator and the participants) relies heavily on the case of MP Finance Group CC (in liquidation) v C:SARS 69 SATC141.

In MP Finance, the SCA in 2007 decided that the amounts paid by participants to entities operated by Marietjie Prinsloo had been "received" within the meaning of the Income Tax Act, 58 of 1962.The amounts therefore constituted income received and were duly taxable in the hands of MP Finance Group CC, the recipient of the participants' monies.The MP Finance case dealt primarily with the tax implications from the perspective of the Ponzi scheme operator.As stated by the SCA: "The sole question as between the scheme and fiscus is whether the amounts paid to the scheme in the tax years in issue came within the literal meaning of the Act.Unquestionably they did.

They were accepted by the operators of the scheme with the intention of retaining them for their own benefit.Notwithstanding that in law they were immediately repayable, they constituted receipts within the meaning of the Act …

What matters is that what they took in was income received and duly taxable."But what about the tax implications from the perspective of the Ponzi scheme participant? One commentator feels that "the MP Finance decision could probably be challenged constitutionally by the investors on the basis that they are being unlawfully deprived of their property by the State …, namely,that tax is being collected from the swindlers who are insolvent, at the expense of and to the detriment of the depositors in that it reduces the available amount in the insolvent estate for repayment to the depositors."Could the "extrapolation" of MP Finance to Ponzi scheme participants (as opposed to the Ponzi operator) be problematic?Might well be.

The Canadian Tax Court very recently had an opportunity to consider the Ponzi scheme tax implications from the participant's perspective.The following will be music to the ears of Tannenbaum Ponzi scheme participants.Johnson v The Queen 2011 TCC540 was decided in Ontario, Ottawaon 24 November 2011.In about1997, Donna Johnson (a nurse)started making investments with one Andrew Lech.Introduction to Lech's scheme was by word-of-mouth through a trusted and persuasive intermediary.Returns were fantastic.Subsequently Lech's image as option trading guru was shattered. He went to jail for along time.In classic Ponzi style,Lech had simply been shuffling funds between investors.Johnson had unwittingly received money taken from fellow investors.

The Canadian Revenue Authority (CRA) audited 132 participants. At least 32 investors received more than they invested(the "up investors").The remainder were net losers (the "down investors").As an "up investor" Johnson was assessed with respect to her gains under the scheme.She was effectively taxed on the total amount received from Lech(approximately CA$1.3 million over the years) less the amount she had paid to him (approximately CA$10 000) (the so-called "Net Receipts").To add insult to injury,Lech had also told investors that no tax reporting was required seeing that tax had already been paid in the large trust fund where investors' money commingled.

Johnson's case was that the pay-outs she received were not taxable because they were not from a source of income as required by Paragraph 3(a) of the Canadian Income Tax Act. The CRA argued that the gains were income that arose from capital Johnson had invested with Lech, and were not windfalls exempt from tax.

Judge Woods decided as follows: "... the returns by the appellant [Johnson] do have some characteristics of income from a source in that the appellant's capital was provided to Lech and she did receive something in return.On the other hand, in reality there was very little connection between the capital and the Net Receipts.Overall, I am not satisfied that there is a sufficient connection between the capital and the Net Receipts that would justify a conclusion that the capital is the source"

"First, nothing was actually earned with the capital.The appellant thought that the capital was being invested but that was not the reality.The Net Receipts were nothing more than the shuffle of money among innocent participants.

The nature of the Net Receipts should reflect what they actually were, and not simply what the appellant [i.e. Johnson] thought they were"

"Further, the Net Receipts were not in satisfaction of the appellant's agreement with Lech.That agreement was to pay the appellant the earnings from investing her funds.Lech had no intention of complying with that agreement."The Toronto Tax Court held that the pay-outs Johnson got from the Lech scheme were not taxable in her hands.In coming to this conclusion, Judge Woods applied the principles described in The Queen v Cranswick 82 DTC 6073(FCA). It meant that the funds passed on to Johnson through the fraudulent actions of Lech wereak in to windfalls and did not represent a return on invested capital.

It is unsure whether the CRA will appeal to the Federal Court of Appeal.The significance of the Johnson case (despite it being Canadian) is that it determines the tax implications in respect of the Ponzi scheme pay-outs from the perspective of the Ponzi scheme participant, whereas the local MP Finance case considered same only from the Ponzi operator's side.SA participants in the Tannenbaum Ponzi scheme should be circumspect and take proper advice before engaging with the authorities on this, since MP Finance might be more limited than it is made out to be.Could this be a case of "it ain't over till the fat lady (in Bloemfontein) sings"?

Source: By Johan Van Der Walt (Tax breaks)


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