Federal Court Of Appeal Finds Payments From Ponzi Scheme Are Taxable As Income

The Federal Court of Appeal (the "FCA") released its reasons in The Queen v. Donna M. Johnson (2012 FCA 253) on October 4, 2012. In that decision, the FCA ruled that payments made to an unwitting participant in a Ponzi scheme were taxable as income. This was a reversal of a decision by the Tax Court of Canada (the "TCC"), which held that the payments were not taxable because they were not from a "source" of income (Johnson v. The Queen (2011 TCC 540, 2012 DTC 1022)). This case is of particular interest because it asks whether those who profit from a Ponzi scheme (while unaware of the underlying fraud) should be taxed on distributions received, and it raises the unsettled issue of whether innocent parties who lose money in such schemes should be allowed to deduct their losses.

The Facts

In 1997, Ms. Johnson, through a friend, took part in an "investment opportunity" offered by Mr. Andrew Lech ("Lech"). Ms. Johnson had never met Lech but knew of him through her church and other connections in her community. After a few months of profitable investments, Lech approached Ms. Johnson directly and offered her the chance to participate directly in an investment plan based on options trading. Ms. Johnson provided capital to Lech by issuing a cheque to him. In return, Lech gave her several cheques, postdated for the next 8 to 10 months, which would return her invested capital over time, with profits included in the final cheque.

According to the trial decision, Lech told Ms. Johnson that he would invest her money in options and pay her the profits, less a commission. Lech also told her that the investments were secure and there was no risk of loss. He further told Ms. Johnson that the profits were tax-free, as the investment was held by his family trust, which paid any tax arising from the investment. Lech went so far as to sign a document declaring that all taxes on the profits were being paid by his family trust, and another document stating that if Lech passed away, payments to Ms. Johnson on the investment were to be funded from his estate.

Unknown to the investors in Lech's scheme, there was no trading in options and no family trust. Lech was, according to the FCA decision, simply shuffling money received from investors through bank accounts to pay other investors. The scheme continued until April 10, 2003, when Lech's bank froze his accounts. A month later, a group of investors, including Ms. Johnson, filed a class action law suit against Lech. A three-year police investigation subsequently led to Lech pleading guilty to a criminal charge of fraud over $5,000. He was sentenced to six years in prison in 2007.

The Minister of National Revenue (the "Minister") subsequently audited the investors involved in Lech's scheme, and found that Ms. Johnson and 31 others had profited from it. The Minister reassessed Ms. Johnson for income tax on the profits she had made in 2002 and 2003. These funds totalled $614,000 in 2002 and $702,000 in 2003. Ms. Johnson appealed to the TCC.

Tax Court of Canada Decision

At trial, the TCC considered whether the profits made by Ms. Johnson were from a source of income, as required by paragraph 3(a) of the Income Tax Act (the "Act"). Ms. Johnson argued that the income was not from a source, relying on the FCA decision in Hammill v. The Queen (2005 FCA 252, 2005 DTC 5397), where a fraudulent scheme was held not to be a "source" of income to the victim of the scheme, because such a scheme could not be considered a "business". In reply to Ms. Johnson, the Crown argued that the income...