Canada: Not all ponzi proceeds are taxable
09 October 2014
Posted by: Authors: Philip Friedlan and Adam Friedlan
Authors: Philip Friedlan and Adam Friedlan (Friedlan Law)
In Roszko v. The Queen (2014 TCC 59), the issue was whether $156,000 received by Mr. Roszko in 2008 from a Ponzi scheme administered by TransCap Corporation was a taxable receipt of interest income pursuant to paragraph 12(1)(c) of the Act. Notwithstanding that the money was purportedly paid as interest on amounts advanced to TransCap by Mr. Roszko and evidenced by interest-bearing promissory notes, the TCC held that in fact there never was a valid loan arrangement between the parties. Mr. Roszko provided TransCap with a series of amounts totalling $800,000 by way of promissory notes between February 2006 and December 2007. Subsequently, an Alberta Securities Commission investigation found that TransCap had perpetrated a fraud on its investors. On this basis, the TCC (per Miller J) held that there never was a valid contract between the parties or any source of income to which the payments to Mr. Roszko could be related.
In an earlier case (Johnson, 2012 FCA 253), the FCA concluded that there can be a source of income from a Ponzi scheme and, on the basis of the decision in The Queen v. Cranswick (82 DTC 6073 (FCA)), that if the investor ultimately receives back more money than he or she initially invested, then there is income from a source. However, Miller J found that the situation in Johnson was very different from that in Roszko.
In Johnson, the FCA found that the relevant contract simply mandated an investment of money on the basis that the money would be invested with a return in certain instalments. In Johnson, the court stated at paragraph 39 that
Ms. Johnson may well have believed that Mr. Lech was going to use the money to earn profits by option trading, because that is what he told her he would do. However, the record discloses no evidence upon which the judge could reasonably conclude that Mr. Lech was under a contractual obligation to Ms. Johnson to generate profits in that manner.
In Roszko, Miller J found (1) that the agreement specifically stipulated how the funds were to be invested, (2) that the funds were not invested in the manner intended, and (3) that the investment itself was a fraud.
Miller J also referred to paragraph 48 of Johnson, where the FCA endorsed the comments of Noël J in Hammill v. Canada (2005 FCA 252): "A fraudulent scheme from beginning to end . . . cannot give rise to a source of income from the victim’s point of view and hence cannot be considered as a business under any definition.” Applying this reasoning to the case at bar, Miller J reasoned that because the purported interest income was a fraud from the outset, the payments that Mr. Roszko received could not be considered income from property to the extent that they did not exceed the original investment. Consequently, the payments were a return of capital.
In addition, Miller J applied the factors set out in Perini Estate v. The Queen (82 DTC 6080 (FCA)) and The Queen v. Sherway Centre Limited (98 DTC 6121 (FCA)), which if met would result in the amounts received by Mr. Roszko being treated as interest. Miller J concluded that those amounts could not be treated as interest because the requirement that the amount received be "a payment for the use of the money” had not been met: TransCap did not use the funds as it had contracted to do. Furthermore, Miller J reasoned that it was questionable whether TransCap could even be considered a borrower, since it simply "took from Peter to pay Paul”; therefore, the amounts received to the extent of the original advances were simply returns of capital.
Miller J also noted that there is a distinction between a finding that income was earned from a fraudulent act or illegal activity (as was the case in Johnson) and a finding that the investment itself is a fraud (the conclusion in Roszko). This distinction is reflected in the following quotation from paragraph 49 of Johnson, which distinguished that case from Hammill:
In other words, the proceeds of an illegal activity in and of themselves can give rise to a taxable source of income, but if the investment itself is fraudulent, the return of funds to the extent of the original investment cannot.
[T]he principle upon which Mr. Hammill was precluded from claiming tax relief for his losses is not applicable to Ms. Johnson. Their circumstances are entirely different, not because she profited from her transactions with Mr. Lech, but because her contractual rights were respected. As a matter of law, the fact that Mr. Lech used the proceeds of his unlawful Ponzi scheme to fund the profits . . . is not relevant in determining the income tax consequences to Ms. Johnson.
Roszko is a welcome decision that may give some comfort to the victims of Ponzi schemes who have received payments only up to the amount of their initial investment and whose contracts had specifically stipulated the manner in which funds transferred would be invested. The case also clarifies the circumstances in which a payment from a Ponzi scheme constitutes a taxable receipt.
This article first appeared on ctf.ca.