{"id":2253,"date":"2021-02-25T23:18:05","date_gmt":"2021-02-25T23:18:05","guid":{"rendered":"https:\/\/www.thor.ca\/blog\/?p=2253"},"modified":"2021-02-25T23:18:05","modified_gmt":"2021-02-25T23:18:05","slug":"tax-court-reaffirms-legitimacy-of-straddle-transactions-and-source-of-income-test","status":"publish","type":"post","link":"https:\/\/www.thor.ca\/blog\/2021\/02\/tax-court-reaffirms-legitimacy-of-straddle-transactions-and-source-of-income-test\/","title":{"rendered":"Tax Court Reaffirms Legitimacy of \u201cStraddle\u201d Transactions and Source of Income Test"},"content":{"rendered":"

In Paletta Estate v The Queen<\/em><\/a>, 2021 TCC 11, the Tax Court of Canada allowed the taxpayer\u2019s appeal in respect of \u201cstraddle\u201d transactions undertaken in the early-2000s.\u00a0 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.<\/p>\n

Background<\/u><\/p>\n

In 2000, the taxpayer began entering into transactions involving foreign exchange option contracts.\u00a0 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.\u00a0 As the value of the foreign currency fluctuated, one of the contracts would move into an accrued gain position (the \u201cgain leg\u201d) and the other would move into an accrued loss position (the \u201closs leg\u201d).\u00a0 Before the end of the taxation year, the taxpayer would \u201cclose\u201d the loss leg, thus realizing the loss for tax purposes.\u00a0 The gain leg would be closed shortly after the end of the taxation year.\u00a0 Thus, the taxpayer would realize a tax loss in year 1 and a tax gain in year 2.\u00a0 Such transactions are generally known as \u201cstraddle\u201d transactions.1<\/sup><\/p>\n

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\u2019s other income earned during the year.\u00a0 The strategy thereby allowed the taxpayer to defer income tax entirely for many years.<\/p>\n

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. \u00a0The 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.\u00a0 Corporations related to the taxpayer allegedly deducted over $150,000,000 in losses using similar transactions during the same period.<\/p>\n

In 2014, the Minister of National Revenue (the \u201cMinister\u201d) reassessed the taxpayer\u2019s 2000 to 2007 years.\u00a0 The Minister\u2019s main argument at trial was that the taxpayer\u2019s trading in foreign exchange contracts did not constitute a \u201csource\u201d of income or loss for the purposes of the Income Tax Act<\/em> (Canada) (the \u201cAct\u201d), such that the losses claimed by the taxpayer each year were invalid.\u00a0 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 \u201csham\u201d or \u201cwindow dressing\u201d.\u00a0 The Minister reassessed each of the years beyond the normal reassessment period and imposed gross negligence penalties in respect of each adjustment.<\/p>\n

Analysis<\/u><\/p>\n

The Tax Court began its analysis by noting that the facts in this case were highly similar to those in Friedberg v Canada<\/em><\/a>, [1993] 4 S.C.R. 93 (\u201cFriedberg<\/em>\u201d).\u00a0 In that case, the Supreme Court of Canada held that the \u201crealization\u201d method of accounting, whereby gains and losses are recorded at the time they are realized \u2013 rather than, for example, the \u201cmark-to-market\u201d method which involves reporting the accrued gain or loss of an asset at the end of each year, whether realized or not \u2013 was acceptable under the Act in relation to straddle transactions.\u00a0 In other words, the taxpayer\u2019s reporting of the straddle transactions in that case, the subject matter of which were gold futures, was acceptable for tax purposes.<\/p>\n

After considering the Minister\u2019s position, the Court in Paletta Estate <\/em>stated that, \u201cUnhappy as the Minister may be with [Friedberg<\/em>], there is no basis on which she can avoid its effect on the taxation years at issue.\u201d<\/p>\n

The Tax Court next reviewed the Minister\u2019s argument that the taxpayer\u2019s 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.\u00a0 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.\u00a0 Indeed, the Court stated: \u201cThere can be no doubt but that that straddle trading had no business purpose.\u00a0 Its only purpose was to allow [the taxpayer] to claim non-capital losses that he could use to offset his taxable income each year.\u201d<\/p>\n

The Supreme Court of Canada\u2019s decision in Stewart v Canada<\/em><\/a>, 2002 SCC 46, directly countered the Minister\u2019s position.\u00a0 In that case, the SCC held that activities which are \u201cclearly commercial\u2026necessarily involve the pursuit of profit\u201d such that \u201ca source of income by definition exists\u201d.\u00a0 In applying Stewart<\/em> to Paletta Estate<\/em>, the Tax Court wrote that, \u201cForward foreign exchange trading is, by its very nature, a commercial activity\u201d.\u00a0 This is because such trading does not involve a \u201cpersonal or hobby element\u201d. That said, the Court did not fully address how such trading could be considered \u201ccommercial\u201d when the taxpayer\u2019s intention was to realize net losses each year.<\/p>\n

Ultimately, the Court concluded that the taxpayer did have a \u201csource\u201d of loss from his straddle transactions. Thus, the losses realized were deductible for tax purposes.\u00a0 It followed that the Minister did not meet her onus in relation to the statute-barred years and gross negligence penalties.2<\/sup><\/p>\n

Other notable takeaways from the Court\u2019s decision include:<\/p>\n