Tax Court Reaffirms Legitimacy of “Straddle” Transactions and Source of Income Test

Published by Tyler Berg

In Paletta Estate v The Queen, 2021 TCC 11, the Tax Court of Canada allowed the taxpayer’s appeal in respect of “straddle” transactions undertaken in the early-2000s.  In doing so, the Court expressly held that commercial activities undertaken solely in order to generate tax losses constitute a source of income or loss for tax purposes.

Background

In 2000, the taxpayer began entering into transactions involving foreign exchange option contracts.  In general terms, the plan involved the taxpayer entering into contracts with certain brokerage firms to buy and sell an identical amount of foreign currency at slightly different dates in the future.  As the value of the foreign currency fluctuated, one of the contracts would move into an accrued gain position (the “gain leg”) and the other would move into an accrued loss position (the “loss leg”).  Before the end of the taxation year, the taxpayer would “close” the loss leg, thus realizing the loss for tax purposes.  The gain leg would be closed shortly after the end of the taxation year.  Thus, the taxpayer would realize a tax loss in year 1 and a tax gain in year 2.  Such transactions are generally known as “straddle” transactions.1

By repeating these steps numerous times each year, the taxpayer could realize tax losses in each year which would offset both the tax gain realized on the gain leg closed at the start of the year and the taxpayer’s other income earned during the year.  The strategy thereby allowed the taxpayer to defer income tax entirely for many years.

Using the above strategy, the taxpayer claimed an aggregate of nearly $49,000,000 in losses from the foreign exchange option contracts between 2000 and 2007.  The taxpayer earned approximately $38,000,000 in income over these years, but was able to report nil taxable income in five of eight of those years.  Corporations related to the taxpayer allegedly deducted over $150,000,000 in losses using similar transactions during the same period.

In 2014, the Minister of National Revenue (the “Minister”) reassessed the taxpayer’s 2000 to 2007 years.  The Minister’s main argument at trial was that the taxpayer’s trading in foreign exchange contracts did not constitute a “source” of income or loss for the purposes of the Income Tax Act (Canada) (the “Act”), such that the losses claimed by the taxpayer each year were invalid.  The Minister argued that the taxpayer undertook the straddles solely to create tax losses and without an intention to profit, and therefore the transactions did not constitute a business. Further, the Minister argued that the transactions were a “sham” or “window dressing”.  The Minister reassessed each of the years beyond the normal reassessment period and imposed gross negligence penalties in respect of each adjustment.

Analysis

The Tax Court began its analysis by noting that the facts in this case were highly similar to those in Friedberg v Canada, [1993] 4 S.C.R. 93 (“Friedberg”).  In that case, the Supreme Court of Canada held that the “realization” method of accounting, whereby gains and losses are recorded at the time they are realized – rather than, for example, the “mark-to-market” method which involves reporting the accrued gain or loss of an asset at the end of each year, whether realized or not – was acceptable under the Act in relation to straddle transactions.  In other words, the taxpayer’s reporting of the straddle transactions in that case, the subject matter of which were gold futures, was acceptable for tax purposes.

After considering the Minister’s position, the Court in Paletta Estate stated that, “Unhappy as the Minister may be with [Friedberg], there is no basis on which she can avoid its effect on the taxation years at issue.”

The Tax Court next reviewed the Minister’s argument that the taxpayer’s straddle transactions did not constitute a source of income or loss for the purposes of the Act, such that the losses realized were not deductible.  In this regard, it is interesting that the Court found that the sole purpose of the straddle transactions was the deferral of tax payable by the taxpayer.  Indeed, the Court stated: “There can be no doubt but that that straddle trading had no business purpose.  Its only purpose was to allow [the taxpayer] to claim non-capital losses that he could use to offset his taxable income each year.”

The Supreme Court of Canada’s decision in Stewart v Canada, 2002 SCC 46, directly countered the Minister’s position.  In that case, the SCC held that activities which are “clearly commercial…necessarily involve the pursuit of profit” such that “a source of income by definition exists”.  In applying Stewart to Paletta Estate, the Tax Court wrote that, “Forward foreign exchange trading is, by its very nature, a commercial activity”.  This is because such trading does not involve a “personal or hobby element”. That said, the Court did not fully address how such trading could be considered “commercial” when the taxpayer’s intention was to realize net losses each year.

Ultimately, the Court concluded that the taxpayer did have a “source” of loss from his straddle transactions. Thus, the losses realized were deductible for tax purposes.  It followed that the Minister did not meet her onus in relation to the statute-barred years and gross negligence penalties.2

Other notable takeaways from the Court’s decision include:

  • The Court reiterated the high bar for proving the existence of “sham” transactions. After reviewing the replete evidence, it held there was no “fabrication” of documents and the trades in question actually occurred.  There is no “sham” simply because the transactions in question lacked a business purpose and were undertaken solely for tax purposes.
  • The Minister argued that the straddle transactions were “window dressing”, which is a separate doctrine from sham. The Court held that the concept of window dressing is an aspect of the sham analysis – “designed to highlight certain aspects of a sham designed to misrepresent to others the true legal relationship between the parties” – and not a separate doctrine.

Conclusion

Paletta Estate is a well-reasoned and compelling decision.  The specific transactions in issue may be of limited relevance going forward given legislative amendments to the Act in 2017 targeting straddle transactions, but the Court’s thorough analysis regarding business purpose, source of income, sham, and window dressing will undoubtedly be of widespread applicability. The Court’s reaffirmation of Friedberg and Stewart, even in the face of considerable non-capital loss claims, is equally significant.

1 Straddle transactions were addressed by amendments to the Income Tax Act introduced in 2017 (see subsections 18(17) to (23)).

2 There was one exception.  The Court upheld the reassessment and imposition of gross negligence penalties in respect of a gain of approximately $8,000,000 realized by the taxpayer on the gain leg of a straddle contract in 2002.  The Court held that the taxpayer should have realized that this gain was not reported on his 2002 return and that the reassessment and gross negligence penalties were justified.