2018-0753051E5 Treatment of losses and investment income

Principal Issues: Tax implications of losses incurred as a result of a fraudulent investment scheme.

Position: Various implications discussed.

Reasons: See below.

Author: McCullagh, Melanie
Section: 9, 12(1)(i), 20(1)(p), 38(c), 39(1)(b), 39(1)(c), 40(2)(g)(ii), 50(1), 111(1)(a), 111(1)(b), 54 capital property, 111(8) non-capital loss, 125(7) Canadian-controlled private corporation.

XXXXXXXXXX                                2018-075305
                                    Melanie McCullagh
July 17, 2018

Dear XXXXXXXXXX:

Re:  Tax treatment of losses incurred as a result of a fraudulent investment scheme

We are writing in response to your correspondence of February 16, 2018, concerning the tax implications of participating in a fraudulent investment scheme. Specifically, you wish to know whether you can claim an allowable business investment loss in respect of the failed investment and whether the investment income you previously included in income can be reversed. We apologize for the delay in responding.

Our comments

This technical interpretation provides general comments about the provisions of the Income Tax Act (the “Act”) and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC70-6R7, Advance Income Tax Rulings and Technical Interpretations. This and all other publications noted herein are available on the Canada Revenue Agency (CRA) website at canada.ca/cra-forms-publications.

The income tax consequences pertaining to a failed investment where a taxpayer is a victim of a fraud or scam can only be determined following a complete review of all the relevant facts and circumstances of the particular situation. Such a review would normally be conducted by the applicable Tax Services Office during the course of an income tax audit which, if undertaken, would be carried out after the particular taxpayer has prepared and filed an income tax return for the year. As such, we cannot comment on the income tax treatment of your particular situation, as we have only been provided with limited information. We can, however, provide some general information that applies to taxpayers who participated in what reasonably appeared to be a legitimate investment for income tax purposes.

Income inclusion

Income Tax Folio S3-F9-C1, Lottery Winnings, Miscellaneous Receipts, and Income (and Losses) from Crime, sets out the CRA’s position in respect of amounts received from what was determined in a subsequent tax year to be a fraudulent investment scheme.

Paragraph 1.42 of Income Tax Folio S3-F9-C1 explains that an amount paid to a taxpayer that is a return on investment, such as interest, must be included in the taxpayer’s income in the year of receipt. For example, if Mr. A receives $100 in interest in 2015, he must include that amount in income for 2015 even if he subsequently learns in 2017 that he has lost most or all of his total investment.

Where it is determined that no funds were actually invested on behalf of the taxpayer and the amounts paid to the taxpayer came from a different taxpayer’s investment, as is typically the case in a Ponzi or Ponzi-like scheme, this does not change the nature of the transaction for the taxpayer. The amount received by the taxpayer must still be included in income.

There is no provision in the Act that would allow interest income previously received by a taxpayer (and included in income) to be removed from the taxpayer’s income. However, in the case where investment income purportedly earned from a scheme was previously included in the taxpayer’s income, but was not actually received or withdrawn by the taxpayer, the taxpayer may claim a deduction for a bad debt in accordance with paragraph 20(1)(p) of the Act in the year the debt is established to be bad.

More information is provided in paragraph 1.43 of Income Tax Folio S3-F9-C1 and Interpretation Bulletin IT 442R, Bad Debts and Reserves for Doubtful Debts.

Losses from fraud

Paragraph 1.44 of Income Tax Folio S3-F9-C1 explains that the nature of any losses incurred as a result of a fraudulent investment scheme needs to be established in order to determine the correct tax treatment. Specifically, it will need to be determined whether the loss was as a result of carrying on a business or from the disposition of an investment that was being held on capital account.

See paragraphs 9 to 13 of Interpretation Bulletin IT-479R, Transactions in Securities, for a discussion on determining whether an investment is being held on income or capital account.

Capital loss

If a loss is incurred on the disposition of an investment that was being held on capital account, a taxpayer may be entitled to a capital loss pursuant to paragraph 39(1)(b) of the Act to the extent that the taxpayer is unable to recover the amount of their initial investment.

Ordinary allowable capital losses for a tax year may be deducted only from taxable capital gains realized in the year. If the allowable capital losses exceed the taxable capital gains, the difference is a net capital loss which may be carried back three years and forward indefinitely to be deducted only against taxable capital gains.

More information on capital losses and how to apply an allowable capital loss is available in the T4037 Capital Gains guide.

Business investment loss

Unlike ordinary allowable capital losses, an allowable business investment loss (ABIL) for a tax year may be deducted from all sources of income for that year. An ABIL is one-half of a business investment loss determined under paragraph 39(1)(c) of the Act. It can be carried back up to three years and forward up to ten years and deducted in calculating the taxable income of such other years. Generally, an ABIL that is not deducted as a non-capital loss by the end of the carryforward period becomes a net capital loss at the end of the tenth year. This treatment allows the loss to be carried forward indefinitely to be deducted against taxable capital gains beginning in the eleventh year.

A business investment loss is a capital loss that arises from the 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 an SBC. For a capital loss to qualify as a business investment loss, the disposition must be made to an arm’s-length person or deemed to have occurred under subsection 50(1) of the Act (subsection 50(1) is discussed in more detail in the following section).

In circumstances where it cannot be established that funds advanced to an SBC constitute a debt owing to the taxpayer, or where the funds were advanced to a taxpayer that is not a CCPC that is any of: (i) an SBC, (ii) a bankrupt or (iii) a corporation that was insolvent and was an SBC, then, for income tax purposes, the taxpayer’s loss will not qualify as a business investment loss. However, the loss may still qualify as a capital loss under paragraph 39(1)(b) of the Act.

Income Tax Folio S4-F8-C1, Business Investment Losses, provides more information about SBCs and what constitutes an ABIL.

Debts established to be bad debts

Where an amount owing to a taxpayer (other than a debt owing in respect of the disposition of personal-use property) at the end of a taxation year has become a bad debt in that year, subsection 50(1) of the Act provides a mechanism for recognizing the capital loss.

Generally, where a debt is established to have become bad and provided the taxpayer makes an election to have the rules in subsection 50(1) of the Act apply, there will be a deemed disposition of the debt at the end of that year for proceeds equal to nil and a reacquisition of the debt immediately thereafter at a cost equal to nil. Subject to a possible application of subparagraph 40(2)(g)(ii) of the Act (which may deny the capital loss if the debt was not acquired for the purpose of gaining or producing income from a business or property) these rules will result in the bad debt being treated as a capital loss of the taxpayer for the particular taxation year with any future recovery of that debt being treated as a capital gain.

However, the rules in subsection 50(1) of the Act will only apply where, among other things, it can be established that there was a debt owing to the taxpayer. This is a determination that requires a review of all the relevant circumstances and documentation in each particular case.

Further discussion of the CRA’s views with respect to capital debts that become bad are outlined in Interpretation Bulletin IT-159R3, Capital Debts Established to be Bad Debts.

Recovered amounts

Where an amount has been subsequently recovered by a taxpayer, through a legal settlement or otherwise, the following will occur in the year of the receipt:

1.    A recovery of a previously deducted bad debt will be taxable, up to the amount of the previous bad debt deducted;
2.    A recovery of a previously deducted business loss will be taxable, 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.

Other deductions

Other deductions, such as interest expense and carrying charges, that are incurred in respect of an investment but were not previously claimed, may be addressed through an adjustment request using the T1-ADJ T1 Adjustment Request form. Once completed, the form can be sent to the tax centre indicated on the taxpayer’s Notice of Assessment.

Taxpayer relief provisions

Under the taxpayer relief provisions, the CRA may provide interest and penalty relief in situations where a taxpayer has a confirmed inability to pay or is experiencing financial hardship related to a balance owed to the CRA. The CRA will also, in certain cases, accept late, amended, or revoked elections. Such a request must be made within a ten year time limit and, if accepted, are subject to a penalty under subsection 220(3.5) of the Act.

For more information on the taxpayer relief provisions, including the administrative guidelines that the CRA will apply when considering requests for relief and the types of circumstances that may qualify, please consult Information Circular IC07-1R1, Taxpayer Relief Provisions.

We trust these comments will be of assistance.

Yours truly,

Katie Robinson, CPA, CA
Acting Manager 
Business Income and Capital Transactions
Business and Employment Division
Income Tax Rulings Directorate

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