Payments from a Ponzi scheme held to be non-taxable

The Tax Court recently released a decision dealing with the issue of whether gains realized by an unwitting participant in a Ponzi scheme are taxable.  In Johnson v. The Queen, 2011 TCC 540, the taxpayer had invested $10,000 with Andrew Lech (“Lech”).  They agreed he would invest the funds in options and pay her profits minus commissions.  The scheme paid the appellant $614,000 in 2002 and $702,000 in 2003.  However, the reality was that Lech was simply shuffling the money around between various accounts and other investors.  Further, Lech told the appellant that his family trust paid all the income tax on the investment and, therefore, the Appellant need not be concerned about paying tax.  Lech’s scheme fell apart in 2003 and he was later sentenced to jail.

The Minister assessed the Appellant for the gains she received from the scheme in 2002 and 2003.  She appealed, saying the payments were not taxable because they were not from a source of income as required by paragraph 3(a) of the Income Tax Act.  The Respondent stated that the gains were income that arose from capital she had invested with Lech, and were not windfalls exempt from tax.

The Court held that the profits from the scheme were not taxable, finding there was precious little connection between the capital invested and the gains received because the gains were taken from other investors and did not arise from any actual investment.  Further, the profits did not arise from the investment agreement with Lech because he had never intended to comply with that agreement.  Finally, the Court applied the criteria from Cranswick and held that the payments were akin to windfalls because they were funds passed on to the appellant through the fraudulent actions of Lech and did not represent a return on invested capital.

The Court also held the Minister was statute-barred from reassessing the Appellant’s 2002 taxation year in any event (although the Court found that the Appellant was careless in respect of her 2003 return, and thus if the Court found that the gains were taxable, her 2003 taxation year would have been open to reassessment).

As of the time of posting, the Crown has not filed an appeal to the Federal Court of Appeal.

It will be interesting to see how US Courts will deal with investors who profited from the Bernie Madoff scandal in 2009.  There has already been some consideration of the issue of the taxation of profits from a Ponzi scheme in earlier US jurisprudence.  In Premji (T.C. Memo. 1996-304) the US Tax Court ruled that an interest payment received from a Ponzi scheme should have been included in the taxpayer’s gross income because the payment was not a return of capital.  See also IRS CCA 200451030.

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