Tax Issues for Victims of Fraud

Although not equal in size to Bernie Madoff's $50 billion-plus Ponzi scheme in the United States, we here in Canada are not immune to fraudulent activity. From the alleged mis-dealings of the Pigeon King in Southwestern Ontario, to the Manna scheme in B.C., and the Earl Jones fiasco in Montreal, many Canadian taxpayers have suffered significant losses. Having suffered a permanent loss of capital, these individuals will hope to recover some of their losses through the tax system.

In some of these fraud cases, the Canadian taxpayers reported income in prior years that was, in reality, just a fictional amount they had thought was income. Under the current fairness provisions of the Income Tax Act, investors in this situation should be able to go back and request adjustments for the past ten years to recover taxes paid on this fictional income. 

Unfortunately, obtaining tax assistance on the lost capital may be a greater problem. In the United States, the Internal Revenue Service (IRS), issued a specific ruling in March, 2009 dealing with the tax treatment of losses arising from Ponzi schemes. Under normal U.S. rules, such losses would be treated as ordinary investment losses, for which deductions are capped at $3,000 per year. The recent IRS ruling allows these losses to be treated as a "theft loss," permitting a deduction against any type of income of up to 95% of the investment. There is, however, no relief for U.S. taxpayers who invested through retirement plans such as a 401(k).

As yet, the Canada Revenue Agency (CRA) has not made any formal ruling regarding any similar tax relief for Canadian taxpayers. In July, 2009, however, Jean-Pierre Blackburn, the Minister of National Revenue, issued a statement in respect of the alleged (now proven) fraud situation surrounding financial advisor Earl Jones. Mr. Blackburn encouraged affected taxpayers to contact the CRA to discuss their situations, promising that CRA agents "will work together with affected individuals to resolve any problems on a case-by-case basis."  He went on to mention the fairness policies and the ability to waive or cancel penalties and interest, but stopped short of announcing any specific relief. The end result is that affected Canadian taxpayers must look for relief within the current rules.

In order to maximize tax assistance, any loss must be claimed and allowed as a business loss, which may be deducted against any source of income. Alternatively, a capital loss claim will provide for a deduction of one-half of the actual loss against taxable capital gains. If there are no capital gains in the current year, such a loss may be carried back three years to recover tax paid on capital gains in those years,  and carried forward indefinitely. The Canadian jurisprudence typically favours the CRA  in disputes about such loss claims. For example, in Heppner v. R. (2008 DTC 2001), a taxpayer sought to deduct approximately $300,000, which he claimed to have invested and lost in a Nigerian fraud scheme. The Minister disallowed the deduction on the basis that there was no legitimate source of income from which to deduct the loss. The Tax Court agreed, ruling such losses are only deductible if they are "incurred in the course of a bona fide business."

For some taxpayers, part of their original investment involved loans that were allegedly made to earn above market rates of interest. These investors sometimes argue that such loans were part of a money-lending business and the losses are thus fully deductible. Here again, the jurisprudence does not favour the taxpayer. In Ellaman Holdings Inc. v. M.N.R. (87 DTC 480), the taxpayer had purchased interests in a number of different mortgages that went into default. The taxpayer sought to deduct his losses from other income as fully deductible business losses. The Minister disallowed the claim and the Tax Court agreed, ruling that the taxpayer, "did not conduct its management of this portfolio as a money lender would."

It would appear that, barring any last minute relief from the CRA, the best result for which Canadian victims of fraud can hope is a recovery of tax on fictional income and a capital loss on funds invested. 

For further information, please contact your Collins Barrow advisor.

Ed Mitukiewicz is a Tax Partner in the Elora, Ontario office of Collins Barrow.