Federal Court Of Appeal Rules Sham Need Not Be Specifically Plead

• Published date: 20 October 2021
• Subject Matter: Litigation, Mediation & Arbitration, Tax, Trials & Appeals & Compensation, Income Tax
• Law Firm: Borden Ladner Gervais LLP
• Author: Ms Laurie A. Goldbach and Elizabeth Egberts

In a decision rendered verbally from the Bench by Justice Woods on September 16, 2021, the Federal Court of Appeal (FCA) dismissed the Taxpayers' appeal from the Tax Court of Canada's decision in Paletta v The Queen, 2019 TCC 205 (Paletta).

Background

The primary issue under appeal was whether breaches of procedural fairness tainted the Tax Court hearing. Critically, the Taxpayers submitted that they did not have a fair hearing before the Tax Court because the Crown's pleadings did not allow them to know the case they had to meet. Consequently, the Taxpayers argued they could not properly respond to the issue the case ultimately turned on; namely, sham.

In principle, appeals before the Tax Court of Canada ask the Court to determine whether the Minister was correct in fact and law in making the disputed assessment. Generally, a Taxpayer has the burden of demolishing, i.e. disproving, the assumptions of fact that the Minister relied on when rendering the disputed assessment. A Taxpayer will be successful if they prove that it is more likely than not that the assumptions made by the Minister in assessing the Taxpayer were incorrect.¹

Paletta v The Queen

In Paletta, the primary issue before the Tax Court was whether the Taxpayers were right to deduct certain losses and expenses related to film distribution in their 2007 and 2008 taxation years. The deducted film distribution losses and expenses arose from transactions wherein 20^th Century Fox (Fox) sold two of its newly produced films to partnerships, in which the Taxpayers were limited partners, subject to an option agreement to buy the films back. The majority of the deducted losses and expenses related to print and advertising expenses allegedly incurred by the partnerships soon after acquiring the films from Fox. After a short period, Fox exercised its options to reacquire all interests in the films, including those acquired by the partnerships, the arrangement was unwound and the right to the films returned to Fox.

The Minister reassessed the Taxpayers to disallow these losses and expenses on the basis that the transactions described above involved a tax loss scheme that used the appearance of incurring expenses in the distribution of a motion picture to generate a tax deferral and permanent tax savings.

The Tax Court upheld the reassessment of the losses and expenses on the basis that they were not incurred for the purpose of earning income and thus prohibited under paragraph 18(1)(a) of the Income Tax...