Tag: Distribution

Ponzi distribution taxable after all – Appeal court reverses trial decision

Several recent high-profile Ponzi schemes have stolen fortunes and unfairly tainted the financial advisory profession. In truth, it’s inappropriate to call the perpetrators of these schemes advisors, since they’re pursuing their own selfish interests, not those of their investors, whose trust they’ve betrayed. 

To add insult to injury for victims, losses incurred in a Ponzi scheme are rarely deductible when calculating income tax.

In a surprising decision in 2011, a trial judge determined one innocent Ponzi scheme investor who had a net-positive result would not be taxed on the gain. The finding was overturned by the Federal Court of Appeal (FCA) last September, but the fight may not be over yet.

Anatomy of a fraud

In 1997, a mutual friend introduced DMJ to Andrew Lech, who said he was the financial manager for a family trust. Lech offered to combine DMJ’s money with the trust’s funds, purportedly to invest in options contracts on an ongoing basis. 

On numerous occasions between 1997 and 2003, DMJ gave Lech a cheque in exchange for eight-to-10 postdated cheques of his own, with the last one representing DMJ’s gains. To sweeten the deal, Lech gave written assurance that any associated taxes would have been paid by the trust, so DMJ didn’t have to report any income on her tax return.

The scheme came to a screeching halt in April 2003 when the police froze Lech’s bank accounts. Forensic auditors determined that from 2001 to 2003 alone, almost $50 million had passed through Lech’s hands. 

A civil class-action suit, a criminal case, and regulatory action by the Ontario Securities Commission followed. In 2007, Lech was convicted of fraud and sentenced to six years in prison — on top of the three he spent in pre-trial custody. 

The Queen v. DMJ

The CRA audited 132 of the participants in the scheme and concluded 32 — including DMJ — profited from their involvement. To be clear, it was not alleged DMJ was involved in the fraud; the authorities said she profited innocently.

In 2007 DMJ was reassessed by the CRA for income of $614,000 in 2002 and $702,000 in 2003.

DMJ appealed the reassessments, but conceded during the legal proceedings that these sums accurately reflected the gains she received from Lech. However she contended that no income was actually generated over the course of the transactions, and therefore there was no legal basis for the CRA to assess her for tax on those receipts.

At trial in November 2011, the judge found the gains were not sufficiently connected to DMJ’s original capital to treat them as coming from a taxable income source. In the judge’s words, “nothing was actually earned with that capital. … The Net Receipts were nothing more than the shuffle of money among innocent participants.”

Effect of a scheme on taxation

As noted, the Crown was successful in its appeal to the FCA in September 2012. The appeal judgment emphasizes that “whether a Ponzi scheme is a source of income to a particular person, whether innocent or not, is a question that must be answered on the basis of the facts relating to that person.” 

According to the FCA, when the relationship between two parties is based on fraud, there can be no source of income. In this case, however, DMJ received a contracted return from Lech in a business relationship. The manner in which Lech generated the funds for those returns was irrelevant, even if it was through an unlawful Ponzi scheme. 

DMJ has applied for leave to appeal to the Supreme Court of Canada. It is docket 35090 on the SCC website.

Five tax principles for building better portfolios

Successful portfolio building is most often achieved – and repeated – when chosen strategies rest upon time-tested foundations.  

Such investment strategies in turn should incorporate or at least consider tax implications, given that almost half of investment returns can be lost to taxes. As the old adage goes, “It’s not how you make out; it’s what you take out.”

Here then are five tax principles that should underlie every client portfolio. Individually and in combination, these principles can help investors to achieve some absolute tax savings and otherwise defer the incidence of tax to a later date.

1. Cash preservation due to tax deferral

According to the concept of time value of money, a dollar received today is preferred to one to be received in future, all else being equal. Similarly, delaying an expense – such as a tax payment – keeps more cash available to an investor for the present and allows the potential for continuing gain in investment value until that payment comes due. 

2. Less recognition through lower distributions

Income is generally a desirable thing, but for a mutual fund investor not seeking current income, it can be frustrating to receive unwanted distributions. Apart from having to redeploy those distributions – often right back into the same investment vehicle – there is current tax to be paid on that realized income and thus less money continuing to be invested.

3. Tax-preferred income with capital gains and dividends 

It is not uncommon for novice investors to assume that investment income, like employment income, is fully taxable. Isn’t it as simple as totalling up your income and applying the appropriate tax rate to find out how much you owe? In truth, there is an important distinction as to the type of income before you apply that tax rate – such as one-half taxable capital gains and possibly lower effective rates on dividends.

4. Rebalance holdings without triggering taxation 

It is important for an investment portfolio to be responsive to changing needs, whether prompted by market forces or investor circumstances. Within registered accounts like RRSPs and RRIFs, rebalancing may be undertaken without fear of triggering taxes. For non-registered accounts, however, dispositions generally trigger unrealized capital gains – except where a structure like a mutual fund corporation is used to defer that taxation.

5. Easing recognition via controlled drawdown 

Retirees’ views on investment income taxation may be anchored in the registered investment world, specifically RRIFs. As registered accounts are held in pre-tax form, withdrawals are fully taxable. On the other hand, non-registered investments originate from after-tax funds and each withdrawal is normally a combination of non-taxable capital and one-half taxable capital gains – and it is even possible to have the early distribution of the non-taxable capital from some investment structures like mutual funds.