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Tax Implications for Ponzi Scheme ‘Investors’

Friday, 30 July 2010   (0 Comments)
Posted by: Author: Jonty Sacks
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Tax Implications for Ponzi Scheme ‘Investors’

Not only are you likely to be parted from your money—there could be some unpleasant tax consequences as well

In a developing country where there is high unemployment and low growth in gross domestic product, one would assume that the government would encourage growth in the private sector.However, keeping this in mind,it appears harsh that, where investors are misled into investing in fraudulent pyramid schemes,they will not only lose their capital investment, they will also be taxed on any return on their investment—even if the investor has to repay the amount back in full to the liquidator.

Over and above the tax consequences mentioned, the income derived from the investment must first be subject to income tax in the hands of the scheme, even though there was a fraudulent intention.This reduces the amount recoverable by the investor,resulting in a direct tax burden.

Income tax implications facing investors

In the case of ITC 1814 68 SATC297, the question before the court was whether the amount invested had been incurred in the production of income or whether it was of a capital nature.The appellant invested an amount into a micro lending business, and in addition provided a loan to a trust.

The court ruled that "the appellant did not incur the loss in the pursuit of a micro-lending business, but the said loss was of a capital nature as his loan did not make him a micro-lender, just as a person who invests money in a bank does not become a banker.Moreover, appellant did not in anyway become involved in the management and he had no control or say in how his money would be utilised in the business.”

This court ruling provides that there has to be a nexus between the investment and the management of the business in order to claim the deduction against the income generated by the taxpayer. Thus,due to the court finding that the investment was of a capital nature,the deduction sought was refused.

In order for an investor to been titled to a claim deduction, the expenditure relating to such investments must form part of the carrying on of a "trade” as required by Section 23(g) of the Income Tax Act. In other words, private individuals who make financial investments would not comply with this requirement as they are not in the business of lending money. In conjunction with Section 23(g),Section 11(a) states that losses can only be deducted if it is "actually incurred in the production of income, provided such losses are not of a capital nature”.Due to these schemes being of a fraudulent nature and irregular, it is difficult to show that the losses are not of a capital nature.

Tax implication on the scheme and its effect on investors

In the case of MP Finance Group CC (In Liquidation) v Commissioner, South African Revenue Service [2007] 69 SATC141, the issue before the court was whether the income on the investment could have been received by the appellant as "gross income” within the meaning of Section 1 of the Act.

The liquidators raised the common law defence that the amount received in terms of an illegal scheme is immediately repayable, and thus the amount does not fall within the meaning of"gross income”.The court,however, ruled that the amount paid to an illegal and fraudulent pyramid scheme falls within the definition of"gross income” as defined in the Act, regardless of the transaction's illegal nature or outcome.A similar decision was reached in ITC1789 67 SATC 205.

These decisions have placed substantial additional consequences on the investor.In addition to the loss suffered from the fraudulent scheme, the investor would now be adversely affected by the income tax payable by the scheme for the amount received from the investors.Therefore, even where monies can be recovered, such amounts would first be subject to income tax in the hands of the scheme before the investors can recover their investment.

American approach

The Internal Revenue Service (IRS)published an Internal Revenue Procedure 2009-20 during April 2008. The Procedure provides for an optional "safe harbour treatment” for taxpayers that are"qualified investors” (American citizens) affected by fraudulent schemes.In general, an American citizen will be entitled to claim a deduction for misappropriated funds as a deductible expense if such an investor complies with the provisions of this procedure.The claim is limited to 95% for a qualified investor who is not entitled to any potential third party recovery, or 75% for a qualified investor who is entitled to or intends to be entitled to any potential third-party recovery.Thereafter, parties are required to reduce their claim by any amount recovered and any potential insurance claims.

Australian approach

In the case of Lean v Commissioner of Taxation [2010] FCAFC 1 the Appeal Court considered the effect of the misappropriation of a substantial sum of money belonging to the taxpayer.The money was misappropriated after the taxpayer transferred it to a bank in Hong Kong.The taxpayer claimed deductions totalling AU$4 972 671from his taxable income. The deductions included the sum of  AU$3 287 749 in respect of the misappropriation.

The Commissioner disallowed the deductions and issued a notice of assessment to the taxpayer.The notice of assessment showed an outstanding tax liability, and the Commissioner made a decision affirming his decision to disallow the loss as a deduction.It appears that the court is of the opinion that where money is misappropriated, it is unlikely that a deduction will be allowed.


On comparing the approach of foreign countries, it is unlikely that SARS will adopt the American view, as this approach encourages reckless investments with little or no consequences.However, the taxation of income in the hands of fraudulent schemes where there is no income-producing intention should be reconsidered, as the consequences are detrimental to the development of the private sector.

SARS however does not feel much empathy towards these investors,and this has been the outcome in a number of court cases.This being said, the investor will be liable for income tax, where he or she receives an amount in excess of his contribution, even if the amount has to be repaid to the liquidator in the future.The opposite is also true in this regard: when investors receive a return that is less than their initial investment, they will not be subject to income tax, nor will they been titled to deduct any of their losses.

Source: By Jonty Sacks (Tax breaks)



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