Taxpayers victimized by fraudulent investment schemes ("Fraudulent Investment Schemes") may find some relief by deducting their losses. Recent Canada Revenue Agency ("CRA") administrative statements provide welcome guidance to taxpayers whose investments have been defrauded in a financial scam.

The CRA has ruled consistently that losses incurred from Fraudulent Investment Schemes may be deducted from a taxpayer's ordinary income or capital gains. The taxpayer must have made the investment without the knowledge that it was a Fraudulent Investment Scheme. If so, the taxpayer must then determine whether the loss was a result of carrying on a business or from the disposition of an investment held on capital account.

Determining Whether an Investment Loss is on Income or Capital Account

Determining whether an investment loss resulted from carrying on a business or disposing of an investment that was being held on capital account is a question of fact. To characterize an investment loss, the CRA applies a multi-factorial test. For securities transactions, the CRA considers tests courts have developed based on the taxpayer's "course of conduct" and "intention". Under the "course of conduct" test, the CRA considers these factors to determine whether securities were held on income account:

  1. the frequency of transactions;
  2. the period of ownership;
  3. the knowledge of securities markets;
  4. whether security transactions formed a part of the taxpayer's ordinary business;
  5. the time spent on investigating potential transactions;
  6. whether the purchases were financed by debt;
  7. whether the taxpayer advertised his or her willingness to purchase securities; and
  8. in the case of shares, whether the share purchase was speculative.

In determining whether a taxpayer held debt instruments as an investment on income or capital account, the "course of conduct" test varies slightly. When determining whether debt obligations are held on income account, the CRA considers these factors:

  1. the ownership of a fairly large number of purchased obligations;
  2. the sale of some purchased obligations rather than holding them to maturity;
  3. borrowing a substantial portion of the funds used to purchase debt obligations;
  4. the extent to which the taxpayer advertised his or her willingness to purchase debt obligations;
  5. the amount of time devoted to investigating potential purchases; and
  6. the creation of a partnership to purchase debt obligations.

A combination of several factors may suffice to characterize the activities of a taxpayer as a business. Furthermore, the Income Tax Act ("Act")[1] defines "business" as an "adventure or concern in the nature of trade". Courts have ruled that an "adventure or concern in the nature of trade" can include an isolated transaction, where the course of conduct and intention of the taxpayer align with that of a trader.

A taxpayer's intention to dispose of an investment at a gain is not sufficient to characterize the investment loss as a business loss. Generally, courts treat intention as corroborative evidence of involvement in a business if the "course of conduct" test suggests an "adventure or concern in the nature of trade" and the taxpayer can establish that it was his or her intention to sell the property at the first suitable opportunity.

Deducting Business Investment Losses

The most favorable treatment for some taxpayers may be to characterize a loss incurred from a Fraudulent Investment Scheme as an allowable business investment loss ("ABIL") under paragraph 39(1)(c). An ABIL is one-half of a business investment loss ("BIL") as determined under paragraph 39(1)(c). Characterizing an investment loss as an ABIL is especially attractive because an ABIL for a taxation year may be deducted from all sources of income for that year. An ABIL may be carried back up to three years and forward up to ten years and may be deducted in calculating the taxable income for those years.

The Act, however, restricts the scope of investment losses that qualify as BILs. First, a BIL 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. Second, the disposition must be made to an arm's length person or be deemed to be a bad debt for the purposes of subsection 50(1). Further limitations apply to characterizing an investment loss as a BIL. Where a taxpayer cannot establish that he or she advanced funds to a CCPC that is any of an SBC, a bankrupt that was an SBC at the time of bankruptcy or a corporation that was insolvent and was an SBC, the investment loss will not qualify as a BIL. However, if the investment loss can be characterized as a result of carrying on a business, taxpayers may also consider deducting the loss as a bad debt pursuant to paragraph 20(1)(p).

Deducting Capital Losses

If an investment loss does not qualify as a BIL, the loss may still be deducted as a capital loss against taxable capital gains. If a taxpayer incurs a loss on the disposition of an investment held on capital account, a taxpayer may be entitled to a capital loss under paragraph 39(1)(b), to the extent the initial investment was unable to be recovered. An allowable capital loss ("ACL") for a taxation year, however, may be deducted only from taxable capital gains realized in the year. If the ACLs for a given taxation year exceed the taxable capital gains for that year, the difference is a net capital loss which may be carried back three years and forward indefinitely to be deducted against future taxable capital gains.

Conclusion

While victims of Fraudulent Investment Schemes may never be able to recover their principal, the CRA's guidance helps them to deduct those losses against ordinary income or capital gains. Taxpayers with the unfortunate experience of seeing their investments defrauded in a financial scam should seek legal advice to identify and pursue their best option for available relief.

[1] All statutory references are to the Act.