Taxable income – Doug Carroll

E-mail fraud causes tax trouble – One lawyer’s dismal drama

TV’s famous Addams Family may have been creepy and kooky, but the taxpayer in a recently reported case would no doubt have preferred those antics to the true-to-life horror visited on him by another Adams family.

Even the judgment reads like a screenplay, with a cast (as the judge called it) that included a 23-year-old girl whose father had just been assassinated; a security “diplomat”; trans-continental couriers; and a handful of pliable airport officials. Add to that our unsuspecting taxpayer — a Calgary lawyer named “CR” — and things were ripe for a $400,000 fraud.

I’ll come to the tax issue shortly, but first let’s set the stage.

Out of Africa

On Saturday, April 16, 2005, CR received an unsolicited (and as noted by the judge, grammatically challenged) e-mail from one Purity Adams, purporting to be a South African writing from Abidjan, Ivory Coast. Her father had been assassinated after a business trip during which he deposited US$8.5 million in a trunk now held by an Ivory Coast security service. She decided to reach out to a Canadian lawyer to assist her with obtaining the trunk’s release.

CR replied and within 90 minutes received the terms of his engagement. For facilitating the release, he would receive a 10% recovery fee, and act as trustee of the remaining funds for at least 10 years.

Needless to say, Purity belied her namesake.

Within the week, CR had wired over $20,000 to Purity and her beleaguered brother David. A month later the trunk was impounded at the airport and CR sent $200,000 to secure its release. While those funds were in transit, he advanced another $100,000. Military officials caught wind.

On receiving notice in July that the trunk had reached London, CR was asked for another $132,825 to cover freight charges. That’s when he got suspicious. He called the RCMP, and, flew to London. He was intercepted at the airport by New Scotland Yard; rode with two of the conspirators; and managed to call in the bobbies after a sprint across a hotel lobby. One of the men escaped; the other was arrested and later released without a hearing. No money was recovered.

And justice for all?

Despite the international intrigue, CR’s woes were not at an end. In his 2005 tax return, he claimed a $398,995 deduction in determining his income from his law practice. The deduction was denied, so an appeal ensued to the Tax Court of Canada.

To be entitled to a deduction, a taxpayer must have a source of income against which to claim that deduction. The judge sided with CR, agreeing his activities were carried out within the precincts of his practice, and were therefore a legitimate source of income.

Still, CR would have to show that the amount was reasonable in order to be entitled to the deduction, which the judge held could only follow from CR having a reasonable belief in the existence of a container with US$8.5 million in Ivory Coast.

In the end, the judge determined there were simply too many inconsistencies and questions about the story to sustain such a reasonable belief. Deduction was denied.

Ironically, the judgment was released April 3, mere days after the end of Canadian Fraud Awareness Month.

Advisor fraud and investor taxation

At issue

Fraud can rear its ugly head in any area of commercial activity, and the financial advisory field is certainly no exception. Indeed, the highly interpersonal nature of the advisor-client relationship can make it an especially fertile ground for the unscrupulous ‘con’fidence man.

Defrauded individuals may feel doubly victimized when the tax assessment shoe drops, with the potential for particularly harsh results when registered money is involved. Even the judges in the first two cases below suggest that Ministerial discretion may be warranted for these losing taxpayer-litigants.

On the other hand, fraudulent activity can lead to some anomalous results, as the last case demonstrates.

Mignault v. R. 2011 TCC 500

Advisor had Mr. Mignault withdraw $287,920 from his RRSP over four years, with the net $202,794 paid to the advisor’s corporation. It was the last Mr. Mignault saw of those funds.

While the judge acknowledged that Mr. Mignault may have believed that he was only reinvesting within an RRSP, the documents (prepared by the advisor) and his own testimony supported the factual finding of a withdrawal. He was liable for tax on the RRSP withdrawals, with $85,126 already having been withheld.

Penalties for two of the years were also upheld as Mr. Mignault could not show that he met either the objective or subjective standard for a due diligence defense.

St. Arnaud v. R., Braun v. R, Patenaude v. R., 2011 TCC 536

These three taxpayers were not directly connected to one another, but had the same advisor – to their mutual misfortune.

Each taxpayer moved RRSP or RRIF funds into new self-directed accounts to purchase shares of corporations purportedly poised for lucrative initial public offerings. Semi-annual statements were issued for 4 or 5 years before it came to light that the shares were worthless from the start, and otherwise not qualified for RRSP/RRIF investment.

For RRSP and RRIF acquisitions, consideration paid in excess of fair market value is brought into a taxpayer’s income. The judge found that though these taxpayers had done nothing wrong themselves, the purchasing funds “left the sheltered environment and so must, under the scheme of the Act, and its specific provisions, be subject to tax.”

Johnson v. R., 2011 TCC 540

The taxpayer was an innocent participant in a $45 million Ponzi scheme, being one of the ‘up’ investors. She was assessed for amounts she received in excess of what she had provided, totaling $614,000 and $702,000 for the 2002 and 2003 taxation years, respectively.

The scheme of the Income Tax Act requires that income must derive from a source. On the facts, the judge held that while Mrs. Johnson received something, there was an insufficient connection between the capital she provided and her receipts. Thus, as the capital was not a source, the receipts could not be characterized as income. [Ed. note: Case since reversed on appeal]

Practice points – for investor due diligence

Verify the credentials, licensing and professional ‘good standing’ of your advisor and the financial organization he or she represents.
Be aware of what reports and statements you are entitled to receive, be sure that you do receive them, and be careful to store them securely.
Review, respond and act immediately upon correspondence with the Canada Revenue Agency, and be prudent in deciding whether and who to appoint to communicate with CRA on your behalf.

Tax treatment of rebates paid by an advisor

At issue

In some provinces, licensed insurance advisors are permitted to pay a portion of earned commission to the purchaser of a life policy. If an advisor chooses to use this device, there can be tax implications for both advisor and client – and possibly even for parties extending beyond that immediate relationship.

Here are a couple of Canada Revenue Agency rulings and a Tax Court case on the issue.

CRA 2008-0271381E5 – Commission Rebates

The CRA was asked whether a rebate payment served to reduce an advisor’s commission, or if it was instead a deductible expense.

In general, where the advisor has the absolute right to the commission without restriction, the total amount of the commission would be included in income. However, the rebate would generally be a deductible expense so long as it fulfills the Income Tax Act requirements of being incurred for the purpose of earning income and being reasonable.

The recipient of such a payment will be treated as having received an amount that is income from property, the property being the life insurance policy. In fact there is a specific income inclusion section in the ITA for inducements received from someone (ie., an advisor) who has made the payment in the course of earning income.

CRA 2010-0359401C6 – Rebate Paid by an Advisor to a Policyholder

At the 2010 Conference for Advanced Life Underwriting program, the CRA was asked again about this issue. The Agency representatives referred back to the above ruling, reaffirming its position regarding the payor advisor and payee policyholder.

An additional leg of the question inquired whether the payment would reduce the policy’s adjusted cost basis. In response, the representative noted that an election is available for similar payments in respect of capital property. Life insurance is not however capital property, and there is no corresponding provision in the ITA section dealing with the ACB of a life insurance policy.

Lapalme v. R. 2011 TCC 396

A corporation purchased life insurance coverage on each of four brothers who were its shareholders and directors. Shortly thereafter, each received a cheque in his personal name from the advisor’s insurance-licensed corporation, which each claimed as a non-taxable gift. The amounts approximately equaled the respective first year policy premiums.

The court upheld the CRA assessment of a shareholder benefit having been conferred on each of the brothers. Further, it allowed the assessment despite being outside the normal assessment period, finding there to have been misrepresentation in filing the personal returns. Penalties were also upheld, attributable to a finding of gross negligence.

The case did not address what the tax implications may have been to the advisor, who was not present at the hearing.

Practice points

Obviously, verify your provincial rules on the legality of rebating.
Keep in mind the implications and complications if it is contemplated that the payment will be made to someone other than the policyholder.
With respect to advising the client, be aware of CRA’s position as stated in the first cited ruling above that “clients should be notified of the CRA’s position that the rebate received must be included in their income.”