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Illegal Pyramid Schemes: Still Taxable!

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In Mazo v The Queen (2016 TCC 232), the Tax Court of Canada considered the tax consequences applicable to income earned through an illegal pyramid scheme.  

 

Facts - Roberta Mazo participated in a pyramid scheme run by the company Business In Motion International Corporation (“BIMIC”). She profited from the scheme and was subsequently reassessed by the Minister of National Revenue as having unreported income for the 2007, 2008, and 2009 tax years.

The scheme set up by BIMIC required that a participant pay for the right to receive compensation for the recruitment of others, who in turn paid for the same right.  The scheme involved multiple different "pyramids", each with a director of sales at the top, two VPs on the next level, four sales managers on the next level, and eight sales representatives on the bottom.     Once a pyramid had a full set of sales representatives, the director would be paid out; the pyramid would break in two, and all participants would be promoted up a level.  The two new pyramids would then work to recruit eight new participants to fill their bottom level. Participants paid BIMIC about $3,500 to join the bottom of the pyramid and collected money from BIMIC when they reached the top of the pyramid.

In 2011, the RCMP charged BIMIC under the illegal gaming and betting section of the Criminal Code. That same year, a class action suit was brought against BIMIC under the Competition Act, and in 2014 the Federal Court ruled against BIMIC, awarding damages of $6,560,000.

In Mazo’s reassessment, the Minister took the position that BIMIC’s scheme was a multi-level marketing plan and Mazo’s profits should be taxed accordingly.  

Tax Court's Analysis - The Tax Court of Canada ("TCC") disagreed with the Minister’s characterization of the BIMIC scheme.  

The TCC found that the BIMIC scheme was a fraudulent pyramid scheme, noting that in legitimate multi-level marketing plans commissions are paid upon the sale of products, not after the mere recruitment of others.  

Having decided the BIMIC scheme was fraudulent, the TCC drew from prior jurisprudence to conclude that income from a fraudulent scheme was still taxable in the hands of its promoter: see The Queen v Johnson, (2012 FCA 253)  

Hence the TCC reasoned that participants in a fraudulent scheme who make money, “should be subject to tax if their contractual rights were honored” and that Mazo should be taxed if “she received what she bargained for”: (at para 18).

Applying this reasoning, the TCC found that there was no evidence to suggest that Mazo knew that the BIMIC scheme was pyramid scheme.  Rather, the evidence showed that she agreed to join what she believed was a sales organization that would pay her commissions for recruiting new salespeople.  Since she did recruit new people and was paid for doing so, the TCC held that the payments she received, less any expenses, were business income in Mazo’s hands.

The Minister had argued that the participants in the BIMIC scheme bought goods and services and were therefore not eligible for deductions for the amounts paid to join the scheme.  

The TCC disagreed with this, finding that the amounts that Mazo spent to buy into the pyramids were amounts she laid out to earn the revenue she earned as a sales director, and were properly deductible as such. 

The Court also held that Mazo’s business expenses should be deductible from any income she earned.  

Commentary - The case demonstrates that while multi-level marketing plans are legitimate business pursuits, people venturing towards this type of business model should beware of illegal pyramid schemes.  Worry not about plans where commissions are paid upon the sale of products, but stay away from schemes that pay for the recruitment of others (with no legitimate products to be found).

The case also serves as a reminder that whether one's business operations are legitimate multi-level marketing businesses, or fraudulent pyramid schemes, the CRA will be entitled to their appropriate taxes.

Taxpayers you must be prepared to accurately report business revenues and calculate taxable income as both sets of activities are effectively taxed in Canada.

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