3 July 2014 Internal T.I. 2014-0531171M6 - Fraudulent Investment Schemes

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Basic tax rules concerning fraudulent investment schemes.

Position: See letter below.

Reasons: See letter below.

Fraudulent Investment Schemes – Basic Tax Rules

This document provides information for situations where taxpayers are involved in a fraudulent investment scheme ("Scheme") including ponzi or ponzi-like schemes. Operators of these schemes entice investors by offering what appear to be consistently high returns on investments made with them. In reality, the returns are purely fictitious and the operator uses the invested money to pay returns to earlier investors with any excess funds being used personally by the operator. When the source of new investment money runs out, the Scheme falls apart and investors are left with little or nothing.

These rules apply to taxpayers who had what reasonably appeared to be a legitimate investment for income tax purposes. This is not intended to apply to taxpayers who knowingly participated in a Scheme for tax avoidance purposes. In cases where a taxpayer did not report the investment income, it would be a question of fact, based on the information provided to the Canada Revenue Agency ("CRA") as to whether they "knowingly participated" in a Scheme.

Recently, a number of situations have occurred where taxpayers were involved in fraudulent Schemes. In some situations, taxpayers have lost all of their investment as well as not being able to collect the investment income they reported in prior year tax returns. In all situations, the treatment of the losses will depend on the facts of each particular case and the responsibility rests with the taxpayer to provide sufficient documentation in order to support their claim that an investment existed for tax purposes.

Income Inclusion

Amounts paid to taxpayers that are a return on their investment should be included in the taxpayer's income. For example, if Mr. A receives $100 in interest in 2010, he must include that amount in income for 2010 even if he learns in 2013 that he has lost all or most of his total investment.

Where it is determined that no funds were actually invested on behalf of the taxpayer and the amounts paid to them came from a different taxpayer's investment (i.e. Ponzi scheme), this does not change the nature of the transaction for the taxpayer. Therefore, the amount received by the taxpayer must still be included in income.

The Old Age Security pension, GST/HST credit, medical or donation credits of the taxpayer may change depending on the adjustments necessary related to a Scheme.

Bad Debt

A taxpayer may claim a deduction for a bad debt pursuant to paragraph 20(1)(p) to the extent that investment income purportedly earned from a Scheme, that was not considered to have been received or withdrawn by the taxpayer, was previously included in the taxpayer's income.

The deductibility of the bad debt is subject to the following comments:

1. Invest income withdrawn

Where the taxpayer received payments of the purported investment income from the Scheme, the cumulative total of such payments will reduce the amount of the bad debt deduction otherwise allowable under paragraph 20(1)(p).

2. Investment income constructively received

Investment income is considered to have been received whether it was received in cash or otherwise for the taxpayer's benefit. In the latter case, to the extent of any payments made on the taxpayer's behalf, the investment income is considered to have been constructively received and will not give rise to a bad debt deduction under paragraph 20(1)(p).

3. Investment income not previously reported as income

Where in prior years a taxpayer failed to report investment income believed to have been earned under a Scheme, the taxpayer is not entitled to claim a deduction for a bad debt or a capital loss notwithstanding that such amounts were not previously received or withdrawn by the taxpayer.

4. Timing of recognition of the bad debt deduction

The bad debt should generally be recognized in the year of discovery, being the year in which charges are laid by the Crown against the fraud perpetrator. However, a deduction may be claimed at such earlier time as the debt is otherwise established to have become "bad", pursuant to paragraph 20(1)(p), which is a question of fact.

Losses

The nature of any losses needs to be established to determine whether the losses have the character of a business loss or a capital loss, and, if a capital loss, whether the loss is a business investment loss.

Capital loss

A taxpayer may claim a capital loss pursuant to paragraph 39(1)(b) to the extent that the taxpayer is unable to recover the amount of their initial investment in the Scheme.

Generally, a capital loss must be recognized in the year in which any charges are laid by the Crown. The loss may be recognized earlier depending on the particular circumstances, such as:

• The perpetrator of the fraud (the "principal") was either petitioned or assigned into bankruptcy;
• The principal made a proposal under the Bankruptcy and Insolvency Act;
• The principal applied for creditor protection under the Companies' Creditors Arrangement Act; or
• The principal was petitioned into receivership by a secured creditor under a receiving order.

A taxpayer may carry back three years or carry forward indefinitely any net capital loss pursuant to paragraph 111(1)(b). A net capital loss may only be applied against a taxable capital gain.

Business investment loss

Pursuant to paragraph 39(1)(c), a business investment loss ("BIL") is a capital loss from a disposition of a share of a corporation that is a small business corporation ("SBC"), or a debt owing to the taxpayer by a Canadian controlled private corporation ("CCPC") that was a SBC. Therefore, a BIL is only available if the investment was shares or a debt of a CCPC that was a SBC. Usually, Ponzi scheme losses relate to debt, not shares.

Under subsection 125(7), a CCPC is a special type of private corporation that is also a Canadian corporation. In order to qualify as a CCPC it must not be controlled, directly or indirectly in any manner whatever, by public corporations, non-residents or a combination of the two.

In general terms, a SBC is a CCPC that meets specific criteria relating to the use of its assets.

Allowable business investment loss

Pursuant to paragraph 38(c), one-half of the BIL is an allowable business investment loss ("ABIL").

An ABIL may be deducted from all sources of income in the year in which it arises. Generally, an ABIL that cannot be deducted in the year it arises becomes part of the non-capital loss pool of the taxpayer for a period of ten years pursuant to subsection 111(8) which may be carried back three years or carried forward ten years pursuant to paragraph 111(1)(a). At the expiration of the ten year period, the ABIL loses its non-capital loss character and becomes a capital loss which may be carried back three years or carried forward indefinitely pursuant to paragraph 111(1)(b).

Other Deductions

Other deductions, such as interest expense and carrying charges, not claimed in the past may be addressed through a T1 Adjustment Request form ("T1-ADJ") to be completed by the taxpayer and forwarded to the tax centre indicated on their Notice of Assessment.

Recovered Amounts

Where funds have been subsequently recovered by the taxpayer from a Scheme, through a legal settlement or otherwise, the taxpayer will be treated as follows in the year of the receipt:

1. A recovery of a previously deducted bad debt will be taxable pursuant to paragraph 12(1)(i), up to the amount of the previous bad debt deducted pursuant to paragraph 20(1)(p);
2. A recovery of a previously deducted business loss will be taxable pursuant to section 9 of the Act, up to the amount of the previous business loss deduction; and
3. A recovery of a previously deducted capital loss, including a business investment loss, will be taxable as a capital gain, to the extent of any excess computed in (1) or (2) above.

Taxpayer Relief Provisions

There may be situations where a taxpayer requests relief pursuant to certain provisions of the Act. In these particular situations (usually involving hardship), the CRA would need to consider adjusting prior tax returns. These situations are dealt with on a case by case basis.

Maryann Hikspoors
2014-053117
July 3, 2014