Citation: 2011 TCC 540
Date: 20111124
Docket: 2009-3460(IT)G
BETWEEN:
DONNA M. JOHNSON,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Woods J.
[1]
Around 1997, the appellant, Donna Johnson, began to make
investments with an individual by the name of Andrew Lech. Her returns were
fantastic. Several years later, it came to light that Andrew Lech was not the
trading guru that he had portrayed himself to be.
[2]
The appellant was caught up in a
classic Ponzi scheme, for which Lech received a lengthy prison sentence. A
large number of investors provided funds to Lech, but most of the funds were never invested. Lech
simply shuffled funds among the investors. In the appellant’s case, she
unwittingly received money taken from others.
[3]
There were at least 237 other participants in the Ponzi
scheme, from the United States and Canada. 132 of the participants were audited by the Canada
Revenue Agency. At least 32 participants received more money than they invested
(herein referred to as “up investors”). A significant number were undoubtedly
on the losing end (the “down investors”).
[4]
The appellant, who was one of the
up investors, was assessed under the Income Tax Act with respect to her
gains from the scheme. For the 2002 and 2003 taxation years, she was assessed
in respect of the total amount that she received from Lech less the amount that
she paid to him (the “Net Receipts”). These amounts, which are not in dispute,
are $614,000 and $702,000 for the 2002 and 2003 taxation years, respectively.
[5]
There are two questions to be determined
in this appeal. First, do the Net Receipts constitute income from a source for the
purpose of paragraph 3(a) of the Act? Second, are the
assessments, which were issued after the normal reassessment period, statute
barred?
Factual background
[6]
At all material times, the
appellant lived in Peterborough, Ontario where
Andrew Lech had grown up.
[7]
The appellant worked as a
registered nurse until the 1990s. She also assisted her husband who was a
Baptist minister. Since 1982, the couple have operated a travelling ministry.
[8]
Around 1997, an investment
opportunity was brought to the appellant’s attention by one of her good friends,
Liz Wakeford.
[9]
Ms. Wakeford, who has a real
estate background, had been successful investing with Lech. She offered to act
as an intermediary so that the appellant could do the same.
[10]
The appellant was persuaded to
participate. Although she had never met Lech, she knew of him as a result of
church and other connections in Peterborough. In addition, the appellant trusted Ms. Wakeford’s
judgment about financial matters.
[11]
The first few investments made
through Ms. Wakeford worked out as expected.
[12]
After a few months, the appellant was
approached by Lech directly. He told her about an option trading
strategy and he gave her the opportunity to participate. He said that the money
would be invested in options, and that he would pay her the profit, less a
commission. The appellant was led to believe that the investments were secure,
and that there was no risk of losing the capital.
[13]
After confirming with her bank that
large profits could be made from option trading, the appellant agreed, and she
provided Lech with an initial amount of about $10,000.
[14]
The arrangement worked out well and
the appellant began to deal with Lech on a regular basis, every week or so.
[15]
The mechanics were simple. For
each purported investment, the appellant would provide capital to Lech in the
form of a cheque and simultaneously Lech would provide post-dated cheques to
the appellant which represented repayment of her capital over 8 to 10 weeks,
plus a profit element in the last cheque.
[16]
The arrangement continued until April
10, 2003 when Lech’s bank became suspicious and decided to freeze his
account. The appellant had just provided money to Lech and she was not able to
cash his cheques.
[17]
The percentage returns that the
appellant made in this scheme were not brought out in the evidence. However, the
returns were sizable. It appears that the appellant initially put up
approximately $10,000 and ended up with returns of over $1,300,000 in later
years.
[18]
In an agreed statement of facts
(ASF) that was filed in the criminal proceeding against Lech, it was
stated that just before the collapse of the scheme some investors were paid a
40 percent return over 3 months.
[19]
Lech told the appellant and other
investors that the investments did not have to be reported for income tax
purposes. He said that he was managing a large trust fund belonging to his
family and that the investors’ money was commingled in the trust. He said that
tax had been paid already.
[20]
In 2000, the appellant asked Lech to confirm
this in writing. The following statement was prepared by the appellant and
signed by Lech.
I, Andrew
Lech, declare and certify that all taxes payable for income tax purposes,
for all the investments funded by Donna M. Johnson, have and are being paid
through the Lech family trust account over which I am the financial manager. It
is not necessary for Donna M. Johnson or her immediate family to report and
declare investment income to be taxed again.
[21]
A similar document was prepared by
the appellant and signed by Lech which stated that the appellant’s money was
being held in trust and was payable to her in the event of Lech’s death.
[22]
Other than these statements, no
paperwork was received from Lech involving the arrangement. The appellant kept her own
records. Lech’s story about commingling funds in a family trust likely enabled
him to avoid providing paperwork because the alleged trust was a private family
matter.
[23]
After Lech’s bank
account was frozen in April of 2003, he had a meeting with investors and told
them that their cheques could not be cashed immediately due to a minor administrative
problem at the bank.
[24]
Around this time, a group of
investors started a class action lawsuit against Lech. The appellant became
aware of the potential lawsuit around May 2003 and she was interviewed by the
group’s lawyer in December 2003. She also participated in the lawsuit.
[25]
A police investigation into the
matter lasted approximately three years and the appellant was interviewed by
the police around 2005. Lech pled guilty in 2007.
[26]
A forensic audit of Lech’s
activities uncovered over $45,000,000 that was provided by investors. Virtually
all of the funds were never invested but were simply shuffled between bank
accounts and paid to other investors. Lech was assisted by intermediaries who dealt with many of
the investors.
[27]
After Lech’s bank account was
frozen, the appellant believed that through Lech’s training she had the
knowledge to replicate his option trading strategy. Accordingly, she started purchasing
options on her own in 2003. It appears that the investments were successful for
a time, but in 2008 the appellant’s savings were virtually wiped out.
[28]
The down investors may have had a
claim against the appellant for restitution, but no claim was ever made. (Re
Titan Investments Limited Partnership, 2005 ABQB 637; Den Haag Capital,
LLC v Correia, 2010 ONSC 5339.)
[29]
The investments with Lech were not
reported in the appellant’s income tax returns. She prepared her own return for
the 2002 taxation year. For the 2003 taxation year, she retained an accountant
to assist with reporting her own option trading activity.
[30]
In cross-examination, the
appellant acknowledged that she could not recall mentioning the Lech
investments to the accountant. She testified that she trusted Lech and
believed that the tax had been paid through the trust.
Are Net Receipts income
from a source?
(a) Positions of parties
[31]
The appellant submits that the Net
Receipts are not subject to tax because there is no source of income. Her counsel
referred to the following comment of Noel J. in Hammill v. The Queen,
2005 FCA 252, 2005 DTC 5397:
[28] A
fraudulent scheme from beginning to end or a sting operation, if that be the
case, 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. […]
[32]
Although this comment
refers to a victim of fraud, counsel
suggests that the comment applies to the appellant since she was an unknowing
participant in a fraud.
[33]
The respondent submits that the
Net Receipts have the quality of income from a source in accordance with the
principles described in The Queen v Cranswick, 82 DTC 6073 (FCA). The
argument is summarized at para. 20 of counsel’s written submissions:
In this case, the list of the relevant factors developed in Cranswick
[82 DTC 6073] does not lead to the conclusion that the net amounts received by
the appellant from Lech were windfalls. The appellant provided Lech with capital and she expect [sic] that
money to generate income. The appellant made efforts to receive the payments,
the payments were expected and sought after by the appellant, were made in
consideration of the capital she provided him, and were earned as a result of
the pursuit of gain of both the appellant and Lech.
(b) Analysis
[34]
Pursuant to paragraph 3(a)
of the Act, a taxpayer is subject to tax on income from a source. The
provision reads:
3. The
income of a taxpayer for a taxation year for the purposes of this Part is the
taxpayer’s income for the year determined by the following rules:
(a) determine
the total of all amounts each of which is the taxpayer’s income for the
year (other than a taxable capital gain from the disposition of a property) from
a source inside or outside Canada, including, without restricting the
generality of the foregoing, the taxpayer’s income for the year from each
office, employment, business and property,
[…]
(Emphasis added)
[35]
The approach that should be taken
in applying this provision was described by LeDain J. in Cranswick, at p.
6076.
[…] In the
absence of a special statutory definition extending the concept of income from
a particular source, income from a source will be that which is typically
earned by it or which typically flows from it as the expected return. […]
[36]
Justice LeDain also cited with
approval a list of relevant criteria that had been provided by Mr. Cranswick’s
counsel (the Respondent). It is reproduced from page 6075 of the decision.
(a) The Respondent had no enforceable claim to the
payment;
(b) There was no organized effort on the part of the
Respondent to receive the payment;
(c) The payment was not sought after or solicited by
the Respondent in any manner;
(d) The payment was not expected by the Respondent,
either specifically or customarily;
(e) The payment had no foreseeable element of
recurrence;
(f) The payor was not a customary source of income to
the Respondent;
(g) The payment was not in consideration for or in
recognition of property, services or anything else provided or to be provided
by the Respondent; it was not earned by the Respondent, either as a result of
any activity or pursuit of gain carried on by the Respondent or otherwise.
[37]
The application of these principles
is difficult in this case. On the one hand, the returns by the appellant do have
some characteristics of income from a source in that the appellant’s capital
was provided to Lech and she did receive something in return. On the other
hand, in reality there was very little connection between the capital and the
Net Receipts. Overall, I am not satisfied that there is a sufficient connection
between the capital and the Net Receipts that would justify a conclusion that
the capital is the source.
[38]
First, nothing was actually earned
with the capital. The appellant thought that the capital was being invested but
that was not the reality. The Net Receipts were nothing more than the shuffle
of money among innocent participants. The nature of the Net Receipts should
reflect what they actually were, and not simply what the appellant thought they
were.
[39]
Further, the Net Receipts were not
in satisfaction of the appellant’s agreement with Lech. That
agreement was to pay the appellant the earnings from investing her funds. Lech
had no intention of complying with that agreement.
[40]
In reaching this conclusion, I
have taken into account that the arrangement between Lech and the
appellant was not a loan. The fact that Lech provided post-dated cheques to the
appellant makes it look like a lender-borrower relationship. However, Lech
acknowledged in writing that the arrangement was a trust. In the face of this
documentation, I would not conclude that the arrangement was a loan.
[41]
The conclusion is also reinforced by
the criteria set out in Cranswick.
(a)
Did the appellant have an enforceable
claim against Lech for the Net Receipts? The answer is no. The appellant had a
legal right to have the capital invested on her behalf. She did not have a
legal right to the Net Receipts.
(b) Was there an organized effort on the part of the
appellant to receive the Net Receipts? The answer is no. The appellant made an
effort to receive investment returns, not fraudulently obtained funds.
(c)
Were the payments sought after or
expected? The answer is no. The appellant did not seek or expect fraudulently
obtained funds.
(d) Did the Net Receipts have the foreseeable element of
recurrence? Although payments were made to the appellant over a long period of
time, the appellant was not aware of the nature of the payments. The true
nature of the payments was not foreseeable.
(e)
Was Lech a customary source of
income? For the same reason, Lech was not a customary source of income. He was
a customary source of something, but not income.
(f)
Were the amounts earned or paid as
consideration? Although Lech would not have made the payments to the appellant if
she had not provided funds to him, I do not think that the Net Receipts are
properly described as earned or paid in recognition of this. There was no
bargain on the part of Lech. He did not pay the Net Receipts as consideration.
[42]
I would make a few further
observations. First, I have found that the arrangement between Lech and the
appellant was not a loan. It is not necessary that I consider whether the
returns would be income in that case. That issue should be left for another
day.
[43]
Second, the respondent has not suggested
that the Net Receipts are business income to the appellant. It is acknowledged
that the appellant was not part of the illegal business that Lech engaged in.
[44]
I would also briefly comment concerning
the possible application of the surrogatum principle, although this was
not raised by the parties. This principle has generally been applied where a
taxpayer is paid an amount in lieu of income pursuant to a legal right: Schwartz
v The Queen, 96 DTC 6103 (SCC), para 45. In this case, the surrogatum
principle has no application because the appellant was not paid pursuant to a
legal right.
[45]
For these reasons, I have
concluded that the Net Receipts are not income from a source.
[46]
This is sufficient to dispose of
the appeal. However, I will also briefly consider whether the assessments would
be statute barred if the Net Receipts were income from a source.
Are reassessments statute
barred?
[47]
The appellant did not report the
Net Receipts in her income tax returns and the relevant assessments were issued
beyond the normal reassessment period. Accordingly, the Minister is precluded
from including the Net Receipts in the appellant’s income unless her failure to
report the Net Receipts was a misrepresentation that is due to neglect,
carelessness or wilful default.
[48]
The relevant provision,
subparagraph 152(4)(a)(i) of the Act, provides:
152(4)
The Minister may at any time make an assessment, reassessment or additional
assessment of tax for a taxation year, interest or penalties, if any, payable
under this Part by a taxpayer or notify in writing any person by whom a return
of income for a taxation year has been filed that no tax is payable for the
year, except that an assessment, reassessment or additional assessment may be
made after the taxpayer’s normal reassessment period in respect of the year
only if
(a) the taxpayer or person filing the return
(i) has made any misrepresentation that is attributable to neglect,
carelessness or wilful default or has committed any fraud in filing the return
or in supplying any information under this Act, or
[…]
[49]
As for whether there is a
misrepresentation, the question is whether there has been an error in the
returns. If the Net Receipts have the quality of income, which is assumed for
purpose of this analysis, there was a misrepresentation in omitting the Net
Receipts from the returns.
[50]
The appellant submits that there
can be no misrepresentation because it is debatable whether the Net Receipts
are income or not. I agree that the issue is debatable, but this does not
assist the appellant. At the relevant time, the appellant did not know that the
scheme was fraudulent. She thought that she had earned income from option
trading.
[51]
The next question is whether the
failure to include these amounts in the returns was due to neglect,
carelessness or wilful default.
[52]
I would first observe that the
obligation to properly report income is a bedrock of the tax system. Taxpayers
who are careless in failing to properly report will not have the protection of
the normal limitation period for reassessments.
[53]
The central question here is
whether the appellant was careless in relying on Lech’s statements that the tax
had been paid and that it was not necessary to report the income.
[54]
In my view, there is a crucial
difference between the two taxation years at issue.
[55]
At the time that the 2002 income
tax return was due, Lech’s bank account had just been frozen. Until this time,
I accept that the appellant was not careless in relying on Lech’s statements
that it was not necessary to report the investment returns. She relied on Lech,
who by all accounts was very convincing, and she had the comfort of her fellow
investors from Peterborough who believed the same thing.
[56]
Circumstances had changed substantially
by the time the 2003 tax return was due. By the end of 2003, Lech was no longer
in operation. The bank had stopped cashing his cheques, a class action suit was
in the works and the appellant was interviewed by the lawyer acting for
investors in the class action.
[57]
The appellant testified that the
class action suit, of which she was a part, did not alert her to the fact that
this was an out and out fraud. The investors were suing simply to get their
money back. The appellant testified that she continued to trust Lech and that
she only began to have doubts when she was interviewed by the police in 2005 or
2006. As she stated, Lech had come through for her in the past and therefore
she had good reason to trust him.
[58]
In my view, it was obvious at this
point that there were serious questions that needed answering about Andrew Lech.
The failure of the appellant to more carefully scrutinize Lech, including
his statements about tax, was careless. If the appellant had acted prudently
towards the obligation to properly report income, she would have started asking
questions much earlier.
[59]
I would also comment that the
appellant impressed me as someone who was quite astute in business matters.
Reference may be made to the two written confirmations that the appellant
prepared for Lech to sign. These are relatively sophisticated documents.
[60]
My conclusion is that the
assessment for the 2003 taxation year is not statute barred, whereas the
assessment for the 2002 taxation year is statute barred.
Conclusion
[61]
In the result, the appeal with
respect to assessments for the 2002 and 2003 taxation years is allowed. The
appellant is entitled to her costs.
Signed at Ottawa, Ontario this 24th
day of November 2011.
“J. M. Woods”
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