Paletta Estate – Federal Court of Appeal Overturns Tax Court on Source of Income Test

In Canada v Paletta Estate (“Paletta FCA”), a unanimous panel of the Federal Court of Appeal (the “FCA”) overturned the decision of the Tax Court of Canada (“Paletta TCC”).  Our blog post analyzing Paletta TCC is found here and contains a description of the background facts.

In brief, Mr. Paletta entered into multiple pairs of contracts to buy and sell an identical amount of foreign currency at slightly different dates in the future.  Based on currency fluctuations, one contract would move into a gain position while the other moved into a loss position.  At the end of the year, Mr. Paletta would close the loss position and, shortly after the start of the next year, he would close the gain position.  Using this strategy, Mr. Paletta claimed approximately $49,000,000 in losses for tax purposes from 2000 to 2007.  The Canada Revenue Agency reassessed Mr. Paletta to disallow these losses.  The reassessments were issued beyond the statute-barred date, and gross negligence penalties were imposed, for each year reassessed.

The Tax Court found, as a factual matter, that Mr. Paletta did not undertake these “straddle” transactions to make a profit.  Rather, they were undertaken solely to generate tax losses.  This was, as the FCA acknowledged, a “crucial” finding of fact.

The principal issue before the FCA was whether commercial activities undertaken solely to generate tax losses can constitute a source of income or loss for tax purposes.  Paletta TCC answered this question in the affirmative; Paletta FCA overturned that decision and ruled it cannot.

In its analysis, the FCA reviewed the Stewart v Canada decision of the Supreme Court of Canada, and Paletta TCC’s discussion of that case.  The main holding of Paletta FCA in this regard is stated at paragraph 36: “where as is the case here, the evidence reveals that, despite the appearance of commerciality, the activity is not in fact conducted with a view to profit, a business or property source [of income or loss] cannot be found to exist.”  The FCA summarized Stewart by stating that its objective “was to reaffirm ‘pursuit of profit’ as the decisive consideration in ascertaining the existence of a business.”  This was based on Stewart’s conclusion that the common law definition of a “business” means an activity taken in the pursuit of profit.

However, Stewart also made the following statements:

…the issue of whether or not a taxpayer has a source of income is to be determined by looking at the commerciality of the activity in question.  Where the activity contains no personal element and is clearly commercial, no further inquiry is necessary. (para. 60)

We emphasize that this ‘pursuit of profit’ source test will only require analysis in situations where there is some personal or hobby element to the activity in question. (para. 53)

Based on these latter statements, it is arguable that Stewart’s “decisive consideration” for the existence of a business is the lack of a personal or hobby element, rather than the presence of a pursuit of profit.  This is the conclusion that Paletta TCC reached when interpreting Stewart.  Paletta FCA nevertheless overturned this decision by following Stewart’s statements that a business requires a pursuit of profit.

Paletta FCA accepted that the “reasonable expectation of profit” test, which was disavowed in Stewart, remains inapplicable in determining whether a source of income exists for tax purposes.  However, the FCA did not comment on the distinction between a reasonable “expectation of profit” and a “pursuit of profit”.  The deciding factor may be the subjective intentions of the particular taxpayer in question, but that can be difficult and time-consuming to prove.

Since Mr. Paletta’s straddle transactions were not undertaken in the pursuit of profit, Paletta FCA concluded that those transactions did not constitute a source of income.  Therefore, any losses Mr. Paletta realized were not deductible for income tax purposes.  The reassessments were thus upheld, and alluding to its statements on Mr. Paletta’s “deceptive” intent, the FCA held that none of taxation years under appeal were statute-barred.

The FCA also upheld the gross negligence penalties assessed in each year, which is particularly notable.  Mr. Paletta had informally discussed his straddle transactions and the resulting losses with lawyers from three different law firms.  Each indicated that his losses should be deductible for tax purposes.  However, the FCA found that Mr. Paletta failed to properly inform those lawyers, and did not obtain a formal, written legal opinion in relation to the subject transactions.

The FCA concluded that those were critical issues because “no minimally competent tax lawyer could have sanctioned Mr. Paletta’s plan to portray his trades as a business”.  This is in spite of the fact that the Tax Court itself concluded that Mr. Paletta’s straddle transactions were acceptable from a tax perspective.  Indeed, Paletta FCA stated that, “the Tax Court’s reasons on this point are not only incorrect, they are implausible.”

In the result, the FCA concluded that the imposition of gross negligence penalties on Mr. Paletta was justified because he was “indifferent or wilfully blind to whether his plan complied with the law or not and was content to assume the risk.”  This is a surprising result, given the high bar for imposing gross negligence penalties under the federal Income Tax Act and earlier findings from the TCC.