Principal Issues: 1) In this situation, is it possible to request adjustments to tax returns for prior years? 2) What is Rulings’ position with respect to fraudulent investment schemes such as Ponzi schemes, where a taxpayer has included investment income in computing their income for prior tax years?
Position: 1) Yes, but only within the time limits set out in subsections 152(3.1) and 152(4.2). 2) The tax treatment should be determined on a case-by-case basis. Under the present context, the investor may claim a deduction for bad debt pursuant to paragraph 20(1)(p) for investment income reported for prior years.
Reasons: 1) In order to reassess a prior tax year return, the Minister must do so within the normal reassessment period. Outside this period, the Minister could reassess that tax year’s return if the taxpayer makes a request for relief within ten years of the end of the taxation year. 2) Based on a CRA’s administrative position, we consider interest on XXXXXXXXXX to be a "debt" for purposes of paragraph 20(1)(p).
March 27, 2018
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XXXXXXXXXX TSO |
Income Tax Rulings Directorate A. Dagenais, Advocate; M. Fisc., B.A.A. 2017-069194 |
Fraudulent schemes
This memo is a follow-up to the March 17, 2017 conference call where it was agreed that we would share our comments on the Income Tax Rulings Directorate's position on Ponzi schemes.
This follows on a letter from XXXXXXXXXX (footnote 1) ("Representative") to XXXXXXXXXX (footnote 2) in which he asked whether the Canada Revenue Agency ("CRA") would accept requests for adjustments of income tax returns from taxpayers who have been victims of a fraudulent Ponzi scheme.
All legislative references herein are to the provisions of the Income Tax Act (the "Act").
FACTS
The Representative has indicated that he represents XXXXXXXXXX investors who purchased XXXXXXXXXX between XXXXXXXXXX and XXXXXXXXXX.
The Representative stated that some of these investors ("Investors") held these XXXXXXXXXXs. Between XXXXXXXXXX and XXXXXXXXXX, we understand that these Investors included in the computation of their income the interest on these XXXXXXXXXX and that they paid taxes on such interest income.
XXXXXXXXXX
The Representative indicated that in XXXXXXXXXX, a Plan of Arrangement and Compromise under the Companies' Creditors Arrangement Act (footnote 3) was approved. According to the representative, XXXXXXXXXX.
You have brought to our attention a memorandum to the Regional Program Directors and Deputy Directors of Audit that Susan Betts signed on May 5, 2010 (the "Memorandum"). The purpose of that memorandum was to provide guidance for the processing of requests for adjustment from taxpayers who have participated in a fraudulent investment scheme and who require the adjustment of previously filed income tax returns or declarations of loss. We will refer to that memorandum below.
About XXXXXXXXXX Investors (footnote 4) would like to apply for adjustment of their income tax returns for the years XXXXXXXXXX to XXXXXXXXXX in order to obtain a refund of the taxes they paid on the interest that they added to their income for these years. We understand that the Investors for this file are individuals. The Representative is asking the CRA to accept such relief.
OUR MANDATE
You wish to know if you can accept the tax treatment requested by the Representative.
In addition, if the tax treatment is not acceptable, you wish to know what the current position is of our Directorate in the case of fraudulent schemes in light of the Memorandum, more specifically, in the case of a bad debt.
OUR COMMENTS
For the purposes hereof, our comments are based on the summarized facts you have provided to us.
Our comments reflect the administrative position expressed in the Memorandum. We also take into account that that memorandum is still valid. For example, under the heading "Bad Debt", the following is stated:
“For the purposes of this policy, the Canada Revenue Agency (CRA) is prepared to accept amounts that have not actually been received, but that have been reported for income tax purposes and reinvested by the promoter are eligible by virtue of paragraph 20(1)(p).”
Based on this administrative position, we have assumed that the interest on XXXXXXXXXX that an Investor has included in computing the Investor’s income constitutes a "claim" for the purposes of paragraph 20(1)(p). It is not considered as having been added to the principal of the debt.
Furthermore, in referring to the Memorandum, we have assumed that Investors held an investment that they did not believe to be fraudulent and that they did not knowingly participate in a tax avoidance scheme.
Statute-barring period
You asked us if the CRA would accept requests for tax return adjustments for taxpayers who have been victims of a fraudulent Ponzi scheme.
In order for the Minister of National Revenue ("Minister") to reassess an Investor's taxation year, she must do so within the normal reassessment period. Beyond that period, she could reassess for that taxation year, if that Investor seeks relief within 10 years after the taxation year. Outside these periods, the Minister cannot reassess.
Subsection 152(3.1) – Adjustment within the normal reassessment period
In brief, subsection 152(4) provides that the Minister may at any time make an assessment, reassessment or additional assessment of tax for a taxation year, interest or penalties payable by a taxpayer in the "normal reassessment period" applicable to the taxpayer for the year. For an individual, the "normal reassessment period" is set out in paragraph 152(3.1)(b) and is generally three years after the date of sending a notice of initial assessment.
Where an individual wishes to obtain an adjustment to an income tax return already filed for a particular taxation year that is within the normal reassessment period, the individual must apply to the CRA to correct the individual’s income tax return by filing with the individual’s Tax Service’s Office a completed Form T1-ADJ, T1 Adjustment Request, or a signed letter providing all the information regarding the request.
For example, if the CRA sent to a taxpayer on September 1, 2014 an initial notice of assessment for the 2013 taxation year and the taxpayer wished to obtain an adjustment for the 2013 taxation year, the Minister could accept the adjustment request and reassess for the 2013 taxation year before September 1, 2017.
In the present situation, unless otherwise directed by an Investor, the taxation years XXXXXXXXXX to XXXXXXXXXX would no longer be within the normal reassessment period provided for in paragraph 152(3.1)(b). The Minister could therefore not reassess an Investor for those taxation years.
Subsection 152(4.2) – Relief after the normal assessment period
By virtue of the relief provisions in subsection 152(4.2), the Minister may, in certain situations and at the request of a taxpayer, reassess for any taxation year on or before the day that is 10 calendar years after the end of that taxation year,
For example, under the relief provisions, a taxpayer may request an adjustment to the taxpayer’s income tax return for the 2008 taxation year. That application must be made to the Minister by December 31, 2018.
We invite you to refer to Information Circular IC07-1R1 (footnote 5) for more information on the CRA's guidelines for whether or not to grant the relief claimed by a taxpayer for a taxation year.
In this situation, pursuant to subsection 152(4.2), the Minister would not be able to reassess the XXXXXXXXXX to XXXXXXXXXX taxation years unless the Investor has requested it by XXXXXXXXXX.
Application of subsections 152(3.1) and 152(4.2) to this situation
Consequently, the Act does not permit the Minister to accept the tax treatment proposed by the Representative for the refund of taxes paid by an Investor on the Investor’s interest income for the XXXXXXXXXX to XXXXXXXXXX taxation years.
The time limitations in subsections 152(3.1) and 152(4.2) have now expired for the XXXXXXXXXX to XXXXXXXXXX taxation years.
However, those periods have not necessarily been exceeded for more recent taxation years and a taxpayer could obtain relief different from that proposed by the Representative as we will see below.
That relief would be possible if the taxpayer meets the requirements of paragraph 20(1)(p). The following discussion is intended to assist you in determining whether that paragraph can be applied depending on the circumstances.
Paragraph 20(1)(p)
Paragraph 20(1)(p) reads as follows:
“Deductions permitted in computing income from business or property
20 (1) Notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto
[…]
Bad debts
(p) the total of
(i) all debts owing to the taxpayer that are established by the taxpayer to have become bad debts in the year and that have been included in computing the taxpayer’s income for the year or a preceding taxation year, and
(ii) […]”
Income Inclusion
In order for paragraph 20(1)(p) to apply, the Investor must have included in computing the Investor’s income for a taxation year interest received or receivable in XXXXXXXXXX pursuant to paragraph 12(1)(c).
Briefly, under the wording of paragraph 12(1)(c), there is to be included in computing a taxpayer's income any amount received or receivable by the taxpayer in the year as interest to the extent that the interest was not included in computing the taxpayer’s income for a preceding taxation year.
Based on the facts provided to us, the Investors received or were entitled to receive interest on XXXXXXXXXX and reinvested it. That is what the Representative called "fictitious interest".
In our view, that interest was to be added to taxpayers' income under paragraph 12(1)(c) in the year the taxpayers received it or were entitled to receive it.
Deduction in the computation of income
Under paragraph 20(1)(p), a taxpayer may claim a bad debt deduction.
Bad Debts - General Rule
Under paragraph 20(1)(p), a taxpayer may claim a deduction for all debts owing to the taxpayer that are established by the taxpayer to have become bad debts in the year and that have been included in computing the taxpayer’s income for the year or a preceding taxation year.
The term "bad debt" is not defined in the Act. Interpretation Bulletin IT-442R (footnote 6) contains comments from the CRA on the meaning to be given to that expression. Those comments will help you determine whether a debt is a bad debt.
As to determining whether a debt has become irrecoverable, paragraph 6 of Interpretation Bulletin IT-442R (footnote 7) states the following:
“There are no specific conditions that must be met before a debt may be classed as a bad debt. Such a decision should be made only after determined efforts to collect the debt have been unsuccessful or there is clear evidence to indicate that it has in fact become uncollectible. If a debt is merely doubtful of collection, it should not be claimed as a bad debt but should be considered for purposes of a reserve for doubtful debts. The fact that a recovery is made after a debt is written off does not negate the correctness of a claim for a bad debt if the recovery could not reasonably have been foreseen at the time the debt was written off.”
In addition, in determining the "time" when a debt has become uncollectible, paragraph 10 of IT-159R3 (footnote 8) states the following:
“The time at which a debt becomes a bad debt is a question of fact and any decision made must be dependent upon the circumstances in each case. A determination by a creditor that a debt has become bad in a particular taxation year must be supported by all relevant and material facts. Generally, a debt will not be uncollectible at the end of a particular taxation year unless the creditor has exhausted all legal means of collecting it or where the debtor has become insolvent and has no means of paying it. [….]”
Furthermore, paragraph 1.34 of Folio S4-F8-C1 (footnote 9) also states the following:
“The time at which a debt becomes a bad debt is a question of fact. Generally, a debt owing to a taxpayer will be a bad debt at the end of the year if:
- the taxpayer has exhausted all legal means of collecting on it; or
- the debtor has become insolvent and has no means of repaying it.
While there is no legal requirement that in all cases a taxpayer must exhaust all legal means of collecting on a debt before determining that during the year it had become a bad debt, such a determination will generally fall short if it is evident that collection on the debt is reasonably possible but no proactive steps were taken to collect on it.”
In considering the foregoing, the question of whether a debt is uncollectible is a question of fact that must be resolved in the light of all the relevant facts. We are of the view that it is up to an Investor to establish the time from which the debt becomes uncollectible. In addition, we are of the view that it is incumbent upon the Investor to demonstrate, to the satisfaction of the CRA, that the conditions for the application of paragraph 20(1)(p) are satisfied. Consequently, each situation must be considered on a case-by-case basis, depending on the facts of the case.
Effect of Plan of Arrangement and Compromise
The representative told us that a Plan of Arrangement and Compromise under the Companies' Creditors Arrangement Act (footnote 10) was approved in XXXXXXXXXX. XXXXXXXXXX.
The CRA would accept an application for the deduction of interest under paragraph 20(1)(p) in computing a taxpayer's income for the XXXXXXXXXX year if the taxpayer considers that the taxpayer’s debt has become uncollectible in XXXXXXXXXX and the taxpayer fulfills all the conditions for application of that paragraph.
However, as discussed above, other dates prior to the date of approval of the Plan of Arrangement and Compromise could also be accepted by the CRA as the date on which the receivable became uncollectible under the facts specific to each situation.
In the year
Under paragraph 20(1)(p), a taxpayer may claim a bad debt deduction in a taxation year for debts that are established by the taxpayer to have become bad debts in the year and that have been included in computing the taxpayer’s income for the year or a preceding taxation year.
For example, if an Investor determines that the interest on XXXXXXXXXX is a bad debt in the 2017 taxation year, that Investor could claim a deduction for bad debts in the 2017 taxation year in respect of the interest that has been included in computing the Investor’s income for the XXXXXXXXXX to XXXXXXXXXX taxation years.
Moreover, the mere fact that an Investor has not recovered the debts that constitute the interest on XXXXXXXXXX is not sufficient in itself to establish that such debts have become irrecoverable.
Adjustment within the normal reassessment period
If an Investor establishes within the normal reassessment period that a debt became a bad debt in a taxation year, the Minister may make a reassessment of that Investor for that taxation year. Concerning the period specified in paragraph 152(3.1)(b), we refer to the previous section on its requirements.
Adjustment outside the normal reassessment period
Subsection 152(4.2) provides that if an Investor determines that a debt has become irrecoverable in a taxation year outside the normal reassessment period, the Minister may reassess that year if the Investor so requests within the specified periods. We refer you to the previous section respecting these periods.
Year of criminal charges
The Memorandum you brought to our attention is intended to provide guidelines for the processing of claims for taxpayer’s who have participated in a fraudulent investment scheme, including Ponzi schemes.
The Memorandum provides for a "time" when a debt has become uncollectible.
According to the Memorandum, the CRA generally accepts that the "time" when a taxpayer can conclude that the taxpayer’s debt has become uncollectible occurs in the year in which the Crown makes charges against the perpetrator of the fraud (the "Year of Charges").
Thus, where a taxpayer has included investment income in the computation of the taxpayer’s income for the Year of Charges or for years prior to the Year of Charges and that income becomes a debt that has never been recovered by the taxpayer or a third party for the taxpayer’s benefit, the CRA is generally prepared to accept that the taxpayer may claim a bad debt deduction in respect of that debt under paragraph 20(1)(p) in the Year of the Charges.
In this case, if the Year of the Charges is established and the taxation year is not statute-barred, an Investor could claim in that year a deduction for interest on XXXXXXXXXX that the Investor has already included in the computation of the Investor’s income for the XXXXXXXXXX to XXXXXXXXXX taxation years if the interest has never been recovered.
Furthermore, in our opinion, that "time" may vary according to the facts. Thus, there may be situations where a deduction can be claimed before or after the Year of Charges. For example, where a taxpayer is exercising remedies to recover the debt, it may establish that the debt became irrecoverable, pursuant to paragraph 20(1)(p), in a year before the Year of Charges. That deduction would be permitted under paragraph 20(1)(p).
Moreover, the amounts that a taxpayer received directly or that were paid to a third party for the taxpayer’s benefit are obviously not taken into account for the purposes of that deduction.
Non-capital loss
It may happen that the bad debt deduction provided in paragraph 20(1)(p) results in a non-capital loss. That would be the case if the amount of the claim exceeds the net income of the taxpayer otherwise computed without regard to the debt. In such a situation, under paragraph 111(1)(a), that loss could generally be carried back for the 20 taxation years immediately preceding and the 3 taxation years immediately following the year and claimed against any other income of the Investor.
Income exclusion - exceptional circumstances
In the case of fraudulent Ponzi schemes, taxpayers may ask a court to cancel the loan agreement between the parties ab initio (footnote 11).
Because of the ab initio cancellation of the contract, it would be possible to conclude that the taxpayer concerned never received and was never entitled to receive interest income from the said contract. It would then be possible for the Minister to reassess for each taxation year affected by the cancellation of the contract provided that the time limits under paragraph 152(3.1)(b) or subsection 152(4.2) are satisfied.
XXXXXXXXXX. However, we wish to bring that procedure to your attention so that you can distinguish XXXXXXXXXX from other situations where a court has rendered such a cancellation and where the tax treatment may have been different from the one being applied in this case.
Disposition of the principal of the debt
Where the principal of the debt held by an Investor is capital property as defined in section 54, the debt’s disposition for an amount less than the principal will generally result in a capital loss. Paragraph 20(1)(p) will not apply to the principal or to a portion of the principal that has become irrecoverable. Indeed, paragraph 20(1)(p) can only apply to interest that has never been collected.
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise to extend this waiting period), for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca. In such cases, a copy will be sent to you for delivery to the taxpayer.
Best regards,
Roxane Brazeau-LeBlond CPA, CA
Director
Business and Employment Income Division
Income Tax Rulings Directorate
Legislative Policy and
Regulatory Affairs Branch
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 XXXXXXXXXX.
2 XXXXXXXXXX.
3 The Companies' Creditors Arrangement Act, RSC 1985, C-36, as amended.
4 Ibid.
5 CANADA REVENUE AGENCY, Information Circular IC07-1R1, “Taxpayer Relief Provisions”, May 31, 2007.
6 CANADA REVENUE AGENCY, Interpretation Bulletin IT-442R (Archived), “Bad Debts and Reserves for Doubtful Debts”, September 6, 1991.
7 Ibid.
8 CANADA REVENUE AGENCY, Interpretation Bulletin IT-159R3 (Archived), “Capital Debts Established to be Bad Debts”, May 1, 1989.
9 CANADA REVENUE AGENCY, Income Tax Folio S4-F8-C1, “Business Investment Losses”, February 18, 2017.
10 Ibid footnote 3.
11 Voiding ab initio signifies the nullification of a legal act which, when pronounced, applies retroactively and annihilates the act as of its execution.