FCA's Paletta Ruling & Its Impact On Tax Opinions & Appeals

• Law Firm: Counter Tax Litigators
• Subject Matter: Tax, Income Tax, Tax Authorities
• Author: Peter Aprile and James Roberts
• Published date: 18 April 2023

Navigating FCA's Decision on Straddle Transactions, Income Test, and Penalties

*Thompson Reuters considers the authors "leading tax experts and litigators". The authors agreed to grant TR partial rights to this work. This article first appeared in TR's, Tax Dispute and Resolution Centre.*

In The Queen v. Paletta Estate, 2022 FCA 86, the Federal Court of Appeal held that activity undertaken to generate tax losses does not constitute a source of income or loss for tax purposes. The FCA allowed the Minister's appeal, upheld the gross-negligence penalties, and sent the matter back to the Minister for reassessment.

Background

The Tax Court of Canada allowed Mr. Pat Paletta's estate's appeal. The taxpayer took part in a tax plan that used "straddle transactions" to offset his taxable income between 2000 and 2007.

In general terms, Paletta would enter into a pair of options contracts to buy and sell an amount of foreign currency on a future date. Between the date Paletta entered the contracts and the date Paletta chose to exercise his option, the currency's price would change. As a result, one contract would create a gain, and the other would create a loss.

Paletta exercised the option which created the loss shortly before the end of the taxation year and applied the loss to offset his income. Paletta would then exercise the gain option in the new year and repeat the process. Paletta used the plan, directly and indirectly, to generate over $185,000,000 in losses.

TCC's Paletta Decision

The TCC allowed Paletta's appeal and found he correctly deducted the foreign exchange trading losses in the years under appeal.

The TCC considered several arguments. However, during the hearing, the Minister's primary argument was that Paletta could not claim the losses because the plan was not a business. The TCC disagreed with the Minister. In particular, the TCC stated that Stewart v. Canada governs and if "one's activity is clearly commercial, and that no personal element is involved, there is a source of income."

The TCC found that Paletta engaged in foreign exchange trading to claim non-capital losses to offset his taxable income. However, the TCC found that foreign exchange trading is "by its very nature, a commercial activity" and that there was no personal or hobby element. So, the TCC concluded the trading was a source of income for tax purposes and that Paletta was entitled to deduct the trading losses.

And, in this situation, the TCC held that the Minister did not meet...