Principal Issues: [TaxInterpretations translation] What is the tax treatment of the capital invested and subsequently lost by an individual in a fraudulent scheme?
Position: Generally, at the time the income was reported by the investor, it was a return on the investor’s investment that had to be included in computing the investor’s income.
Reasons: The investor may claim, in respect of such amounts, a bad debt deduction under paragraph 20(1)(p) in the year of discovery.
Financial Strategies and Financial Instruments Roundtable, 5 October 2012
2012 APFF Conference
Question 21 -- Tax treatment of income from fraudulent investments
In recent years, significant fraud has occurred against investors who have injected bona fide sums into financial products (such as mutual funds or limited partnerships) or investment companies, who were supposed to invest the money for the purpose of producing income on behalf of the investors. The Earl Jones, Norbourg, Norshield and Madoff cases are more well-known examples among many others in which good-faith investors have been deceived by unscrupulous promoters.
At the 2009 APFF Conference Roundtable, the CRA responded in part to a specific question on this subject:
[TaxInterpretations translation] In order to determine the tax treatment that must be accorded to the capital invested and subsequently lost by an individual as part of a "Ponzi scheme", it is necessary to determine whether the individual, by reason of the individual’s investing activities, carried on a business or acquired securities or other investments that will result in a capital gain or loss on disposition.
Generally, where an individual does not carry on a business in such a situation and has acquired securities or other investment, the CRA is generally of the view that the loss suffered by the individual can be characterized as a capital loss.
If a taxpayer has included investment income in computing the taxpayer’s income for a previous year, the taxpayer may be entitled to claim, depending on the facts and circumstances of the situation, a deduction if such income has not been received.
However, since the Act contains several legislative provisions dealing with different types of losses, the manner in which these provisions will apply will depend on the facts of each situation.
On reading the CRA's response, it would seem that if the investor has already received income, there does not appear to be any tax adjustments for income already declared in the past, even if the amount of income "received" was simply added to the capital invested with the fraudster. The capital loss would, however, potentially be higher given that a higher "capital" has been left with the "fraudster" manager. However, note that an article published in La Presse June 29, 2011 by the journalist Francis Vailles, dealt with investors who lost huge sums in the Mount Real case. As his article contains information that seems interesting, we quote below some paragraphs from his reporting.
"The Canada Revenue Agency (CRA) intends to treat Mount Real investors fairly," said spokeswoman Kareen Dionne.
On Monday, La Presse published a story about Mount Real's fraud victims who say they have trouble recovering taxes paid unduly on their investments.
Victims saw the interest on their investments accumulate on their statements until 2005, when Mount Real was placed under government receivership. However, that interest proved to be fictitious and investors lost everything. The taxes should not have been paid on this fictitious interest. As a general rule, the tax authorities allow fraud victims to claim losses on the tax returns for the previous three years or the following 20 years.
In the Earl Jones case, victims have benefited from a special provision in the Income Tax Act that gives the Minister the discretion to extend the time, said Kareen Dionne.
The reassessment period has been extended to 10 years rather than 3 years. This extension will allow Earl Jones' victims to recover a large portion of the unduly paid taxes, about $3 million."
As a result, there appears to be a different approach by the CRA in the event that reported investment income turns out to be "fictitious". There is therefore no need for the investor to claim a deduction for bad debts in respect of the investment income already declared by the taxpayer in previous years where the taxpayer becomes aware of the fraud but rather a need to amend the taxpayer’s tax returns from previous years where the fictitious revenues were reported in order to back them out from the taxpayer’s income.
Question to the CRA
Can the CRA confirm the accuracy of our findings with respect to the "fictitious" investment income already reported by the investor whether credited to the portfolio or still to be received by the investor?
CRA Response
To begin with, the general position of the CRA in this type of situation is to not allow the investor to amend the investor’s tax returns for prior years in which the "fictitious" income was declared to exclude it from income. Unless there are exceptional circumstances leading to a contrary conclusion, the CRA is generally of the view that at the time the income was reported by an investor, it was a return on the investor’s investment that was to be included in computing the investor’s income.
Subsequent facts may reveal that the investor has been the victim of fraud and that the investor will not recover all or part of the capital invested or income that the investor has already declared. In general, the CRA agrees that the time when it can be concluded that the investor will not recoup all or part of the capital invested or income occurs in the year in which the Crown charges the fraud perpetrator. ("year of discovery").
Where an investor has declared income in respect of an investment in years prior to the year of discovery and such income has not been paid to the investor directly or to a third party for the benefit of the investor, the CRA is generally prepared to accept that the investor may claim, in respect of these amounts, a bad debt deduction under paragraph 20(1)(p) in the year of discovery. The amounts that the investor received directly or that were paid to a third party for the benefit of the investor are obviously not taken into account for the purpose of this deduction. To the extent that a bad debt deduction resulted from a loss other than a capital loss, such loss, pursuant to paragraph 111(1)(a), generally could be carried back three years and carried forward 20 years and claimed against any other income of the investor.
To the extent that an investor was successful in recovering an amount that previously resulted in a deduction pursuant to paragraph 20(1)(p) under the rules previously set out, the investor would then be deemed to have received, in the year of receipt of that amount, a recovery of a bad debt previously deducted, that was taxable by virtue of paragraph 12(1)(i) up to the amount of the deduction previously accorded under paragraph 20(1)(p).
Alexandro Pace
(613) 952-1506
October 5, 2012
2012-045319