Australia: Ask an expert: Greg Gaunt on Ponzi schemes and fraudulent undertakings

Charles (Carlo) Ponzi was born in Italy in 1882 but migrated to the United States in 1903 (reputedly having gambled away his life savings on the trip across).

The scheme he concocted in the early 1920s and which made him famous to this day, involved the purchase of discounted postal reply coupons in other countries and redeeming them for face value in the United States. He apparently offered investors a profit of 50% within 45 days or 100% within 90 days. In reality he was only able to pay early investors from funds obtained from later investors. The scheme ran for over a year and the cost to investors was reputed to be around US$20m.

Ponzi was convicted on mail fraud charges and imprisoned. He was later imprisoned for a second time on larceny convictions and, at the end of the second term of imprisonment, was subsequently deported back to Italy. There does not seem to be any doubt that Ponzi never considered that his scheme, like others that he came up with subsequently, had any chance of success. He was simply a swindler.

While he wasn't the first to have thought of such a scheme, his name has been forever associated with such a fraudulent undertaking.

Following the Ponzi scheme conducted by Bernard Madoff, the IRS, in the United States, issued Revenue Ruling 2009-09, dealing with "Theft Loss deductions". At its simplest, the ruling allows taxpayers to claim an ordinary deduction (not a capital loss) equal to 95% of their net loss in the year that such theft is discovered – net loss calculated as the sum of the amount invested and amounts previously reported as income, less any amounts recovered.

In Australia there is no equivalent to Revenue Ruling 2009-09. While there is provision under the Income Tax Act Assessment Act of 1997 for the deduction of "theft losses", that is only where;

  • The taxpayer discovers the loss in the income year,
  • The loss was caused by the theft or stealing... of the taxpayer's employee or agent,
  • The money was included in the taxpayer's assessable income for that income year or for an earlier year.

The case of Lean v Commissioner of Taxation 2010 [FCAC] 1 made it clear that the money misappropriated must be the same money as was included in the taxpayer's assessable income. That provision is, therefore of little, if any, assistance in this case.

One of the difficulties which arises in any consideration is whether a "scheme" was intended as a Ponzi scheme at the outset (i.e. it was an absolute sham from the outset) or subsequently evolved into a Ponzi scheme (or akin to a Ponzi scheme) as the original plan (with some possible, original merit or justification in the eye of the misguided proponent) suffered setback and began to unravel.

In the Canadian case of Roszko v The Queen (201 TCC 59), the Tax Court of Canada held that moneys paid out of a fraudulent scheme were not taxable as interest income. The Crown had argued in this case that money repaid to the taxpayer was property income in the form of interest.

The Tax Court found, however, that the returns were a return of capital. In the Roszko case moneys invested were to be applied in a specific manner but were actually invested in a different fashion, without the knowledge of the investor. The Tax Court also found that;

  • it could distinguish this case, on its facts, from an earlier case (Johnson v The Queen (2012 FCA 253)), which reached the conclusion that there can indeed be a source of income in a Ponzi scheme,
  • the case was more like Hammill v The Queen (2005 FCA 252) where the court held that a fraudulent scheme from beginning to end cannot give rise to a source of income from the victim's point of view.

There is no clear case law in Australia that can be used as guidance. As matters stand, therefore;

  • in circumstances where it was absolutely clear from the outset that a scheme was fraudulent from beginning to end (a la Hammill v The Queen in Canada), then perhaps it could be argued that any repayment could only be of a capital nature,
  • in most circumstances, however, where the Ponzi nature of the scheme only arises subsequently, it may well be difficult to characterise any payment, however characterised at the time of payment, as a capital repayment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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