There is a fundamental principle in the Canadian tax system that states whether a person or a business should pay tax upon receiving a fund is determined by the “source” of the money.
The source, as I understand it, can be categorized into 4 groups:
- employment income
- business income
- capital gain
- windfall
The first 3 groups are considered “income” by the CRA and thus are taxable. Having said that, the tax rate calculations vary, for example:
- when a rental property is sold, the capital gain will be taxed but there is a 50% discount from CRA
- when a business invests in the stock market, its capital gain could be taxed at a higher rate as it is considered the “passive income” of the business
The group, windfall money, is normally not regarded as “income”, hence it is not taxable. But how to define if money received is a windfall? The court will run a 7-step test (7 questions) based on a 1982 Canadian Authority. The answers to all 7 questions must all be “no” to qualify the money as a windfall.
Now, assuming I’m the payee of the money, the 7 questions are:
- whether I had an enforceable claim to the payment
- whether I made an organized effort to receive the payment
- whether I had a customary or specific expectation of receiving the payment
- whether I had a reason to expect that the payment would recur
- whether the payment was from a source that is not a customary source of income for me
- whether the payment was in consideration for or in recognition of property, services or anything else provided or to be provided by me
- whether the payment was earned by me as a result of any activity or pursuit of gain carried on by me and was not earned in any other manner
After giving it some thought, I’d say there are only 3 behaviours that could set the money non-taxable:
- My great-aunt gifted me some real estate and cash.
- I hit the jackpot with a 649 lottery win or had a lucky streak at the casino.
- Last week at the zoo, a kid fell into the tiger enclosure, and after I saved him, his dad gave me a cool million in cash.
In fact, there typically are only 2 forms, gifting and gambling.
That’s why the most “popular” way of money laundering is to go through the casinos: someone brings $10,000 cash to the casino, plays a couple of games, then cashes out with a cheque from the casino. By doing so, it seems 2 birds can be killed by one stone:
- The Canadian governmental organization Fintrac could lose trace of the money source
- CRA has to treat the money windfall, thus it’s not taxable
To prove the casino method could work, in 2008, 3 CBC News journalists brought $30,000 cash which was sponsored by CBC to several casinos in BC. They successfully laundered $24,000 without getting caught. The full story can be found here.
However, things changed. Nowadays the legislation and legal enforcement have kept up with the following means:
- It is not a problem for the bank to deposit cheques issued by casinos, but the casino rule is now that only the winning money can be realized on a cheque, while the “principal” will be returned to the gambler in whatever format of its origin when brought in
- The dealers at the casinos are well trained; as soon as someone wants to make a 4-digit bet, the person is required to register with the casino with their IDs.
Let’s go back to the 1982 authority. The story was straightforward. In a private company, the majority shareholder wants to sell some of the company’s assets to make some good profits, but a minority shareholder does not like this idea. To prevent the minority shareholders from making a big deal of the matter so the deal could fall through, the majority shareholders offered to make a payment to the minority shareholder. After the minority shareholder received the money, they did not pay tax for that. CRA disagreed and came to collect the tax. They ended up going to court. In court, the judge went to the 7 questions and it appeared all the answers were likely to be a “no”, thus the judge held that the compensation was not “an income” of the minority shareholder who therefore was not required to pay tax on it. R v Cranswick [1982]
Okay now let’s bring up an interesting topic, the Ponzi scheme, which is a fraudulent investing scam promising high rates of return with little risk to investors:
- A Ponzi scheme is a fraudulent investing scam which generates returns for earlier investors with money taken from later investors.
- Eventually, a Ponzi scheme would bottom out when the flood of new investors dries up and there isn’t enough money to go around. At that point, the scheme unravels.
A woman named Donna Johnson, who worked as a nurse and retired in the 90s, was a “wise and prudent investor” described by CRA. She has been wealthy, an example is that she and her husband built a church in Peterborough and became famous in the community. Beginning in the late 1990s, Donna began putting her money in the hands of a man named Andrew Lech, who managed a number of family trusts and was good at trading stock options.
For the first few years, Andrew’s return on investment was surprisingly high. In 2002-2003 alone, Donna earned more than 1 million USD from Andrew.
When the size of funds Andrew managed reached hundreds of millions level, the Ponzi scheme was exposed, and Andrew was sentenced to 6 years in prison in 2007.
However, Donna was the beneficiary of this Ponzi scheme unlike many other scam victims. Just because she made herself in the early stage, Andrew gave her a super high return to spread the word and make it bait for more people.
After consulting with a lawyer, Donna decided not to file a tax return on the money she made. CRA found that the 2 parties argued, and went to the Tax Court of Canada (TCC) when no agreement was reached. In court, the judge surprisingly found that her earnings could not be classified into the first 3 categories of “sources” mentioned above; also, the answers to the seven questions all appeared to be “no” “. As a result, the judge had to conclude that the money Donna received from the scammer was not considered ordinary income; thus it would not be taxed. Johnson v. The Queen [2011]
The MNR (Minister of National Revenue) did not like this decision so they appealed to the Federal Court of Appeal (FCA). The judge of FCA had the following 2 statements:
- Donna entered into a series of agreements with Andrew to receive a profit on her investments with him, and she received what she bargained for;
- The fact that Andrew used the proceeds of his unlawful Ponzi scheme to fund the profits he was contractually obliged to pay Donna was not relevant in determining the income tax consequences to Donna of her transactions with Andrew.
The Federal Court of Appeal, therefore, allowed the MNR’s appeal and held that the reassessments were valid, which means the payments were income from a source pursuant to Income Tax Act s. 3(a); thus they are taxable. Minister of National Revenue (MNR) v. Johnson [2012]
In summary, whether or not to pay taxes on the money you receive depends on the “source”. Other than the pure windfall from lottery or gambling, it is very difficult to convince CRA that the money received is tax-free. At last, let’s end this blog article with a gambling-related case. A dealer named Cheng Xia worked in a BC casino; after gaining some tax knowledge, he claimed that the tips he received from gamblers were tax-free. CRA did not agree and stated the tips were his daily income. In his reply to CRA, he said: “it’s all because of the source! The tips I receive were all from the happy casino winners, they are surely windfall to them. Don’t you CRA always quote the “Attribution Rule” and trace back to the nature of the original money? When you want to charge tax, you follow this rule and state the original income was taxable, so why don’t you follow the same idea to trace back when the original money was not an income?! CRA was speechless for a while so the 2 parties had to go to court. In the end, the judge ruled that the whole thing Mr Xia said was just unreasonable. Xia v Canada [2005]
