{"id":2435,"date":"2022-06-14T09:41:28","date_gmt":"2022-06-14T16:41:28","guid":{"rendered":"https:\/\/www.thor.ca\/blog\/?p=2435"},"modified":"2022-06-14T09:41:28","modified_gmt":"2022-06-14T16:41:28","slug":"paletta-estate-federal-court-of-appeal-overturns-tax-court-on-source-of-income-test","status":"publish","type":"post","link":"https:\/\/www.thor.ca\/blog\/2022\/06\/paletta-estate-federal-court-of-appeal-overturns-tax-court-on-source-of-income-test\/","title":{"rendered":"Paletta Estate \u2013 Federal Court of Appeal Overturns Tax Court on Source of Income Test"},"content":{"rendered":"

In Canada v Paletta Estate<\/em><\/a> (\u201cPaletta FCA<\/em>\u201d), a unanimous panel of the Federal Court of Appeal (the \u201cFCA\u201d) overturned the decision<\/a> of the Tax Court of Canada (\u201cPaletta TCC<\/em>\u201d).\u00a0 Our blog post analyzing Paletta TCC<\/em> is found here<\/a> and contains a description of the background facts.<\/p>\n

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.\u00a0 Based on currency fluctuations, one contract would move into a gain position while the other moved into a loss position.\u00a0 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.\u00a0 Using this strategy, Mr. Paletta claimed approximately $49,000,000 in losses for tax purposes from 2000 to 2007.\u00a0 The Canada Revenue Agency reassessed Mr. Paletta to disallow these losses.\u00a0 The reassessments were issued beyond the statute-barred date, and gross negligence penalties were imposed, for each year reassessed.<\/p>\n

The Tax Court found, as a factual matter, that Mr. Paletta did not undertake these \u201cstraddle\u201d transactions to make a profit. \u00a0Rather, they were undertaken solely to generate tax losses. \u00a0This was, as the FCA acknowledged, a \u201ccrucial\u201d finding of fact.<\/p>\n

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.\u00a0 Paletta TCC<\/em> answered this question in the affirmative; Paletta FCA<\/em> overturned that decision and ruled it cannot.<\/p>\n

In its analysis, the FCA reviewed the Stewart v Canada<\/em><\/a> decision of the Supreme Court of Canada, and Paletta TCC<\/em>\u2019s discussion of that case.\u00a0 The main holding of Paletta FCA<\/em> in this regard is stated at paragraph 36: \u201cwhere 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.\u201d\u00a0 The FCA summarized Stewart<\/em> by stating that its objective \u201cwas to reaffirm \u2018pursuit of profit\u2019 as the decisive consideration in ascertaining the existence of a business.\u201d\u00a0 This was based on Stewart<\/em>\u2019s conclusion that the common law definition of a \u201cbusiness\u201d means an activity taken in the pursuit of profit.<\/p>\n

However, Stewart<\/em> also made the following statements:<\/p>\n

\u2026the 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.\u00a0 Where the activity contains no personal element and is clearly commercial, no further inquiry is necessary. (para. 60)<\/p>\n

We emphasize that this \u2018pursuit of profit\u2019 source test will only require analysis in situations where there is some personal or hobby element to the activity in question. (para. 53)<\/p>\n

Based on these latter statements, it is arguable that Stewart<\/em>\u2019s \u201cdecisive consideration\u201d for the existence of a business is the lack of a personal or hobby element, rather than the presence of a pursuit of profit.\u00a0 This is the conclusion that Paletta TCC<\/em> reached when interpreting Stewart<\/em>.\u00a0 Paletta FCA<\/em> nevertheless overturned this decision by following Stewart<\/em>\u2019s statements that a business requires a pursuit of profit.<\/p>\n

Paletta FCA<\/em> accepted that the \u201creasonable expectation of profit\u201d test, which was disavowed in Stewart<\/em>, remains inapplicable in determining whether a source of income exists for tax purposes.\u00a0 However, the FCA did not comment on the distinction between a reasonable \u201cexpectation of profit\u201d and a \u201cpursuit of profit\u201d.\u00a0 The deciding factor may be the subjective intentions of the particular taxpayer in question, but that can be difficult and time-consuming to prove.<\/p>\n

Since Mr. Paletta\u2019s straddle transactions were not undertaken in the pursuit of profit, Paletta FCA<\/em> concluded that those transactions did not constitute a source of income. \u00a0Therefore, any losses Mr. Paletta realized were not deductible for income tax purposes. \u00a0The reassessments were thus upheld, and alluding to its statements on Mr. Paletta\u2019s \u201cdeceptive\u201d intent, the FCA held that none of taxation years under appeal were statute-barred.<\/p>\n

The FCA also upheld the gross negligence penalties assessed in each year, which is particularly notable. \u00a0Mr. Paletta had informally discussed his straddle transactions and the resulting losses with lawyers from three different law firms. \u00a0Each indicated that his losses should be deductible for tax purposes.\u00a0 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.<\/p>\n

The FCA concluded that those were critical issues because \u201cno minimally competent tax lawyer could have sanctioned Mr. Paletta\u2019s plan to portray his trades as a business\u201d.\u00a0 This is in spite of the fact that the Tax Court itself concluded that Mr. Paletta\u2019s straddle transactions were acceptable from a tax perspective.\u00a0 Indeed, Paletta FCA<\/em> stated that, \u201cthe Tax Court\u2019s reasons on this point are not only incorrect, they are implausible.\u201d<\/p>\n

In the result, the FCA concluded that the imposition of gross negligence penalties on Mr. Paletta was justified because he was \u201cindifferent or wilfully blind to whether his plan complied with the law or not and was content to assume the risk.\u201d\u00a0 This is a surprising result, given the high bar for imposing gross negligence penalties under the federal Income Tax Act <\/em>and earlier findings from the TCC.<\/p>\n","protected":false},"excerpt":{"rendered":"

In Canada v Paletta Estate<\/em><\/a> (\u201cPaletta FCA<\/em>\u201d), a unanimous panel of the Federal Court of Appeal (the \u201cFCA\u201d) overturned the decision<\/a> of the Tax Court of Canada (\u201cPaletta TCC<\/em>\u201d).\u00a0 Our blog post analyzing Paletta TCC<\/em> is found \n","protected":false},"author":49,"featured_media":0,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[30,41,15,16],"tags":[],"class_list":["post-2435","post","type-post","status-publish","format-standard","hentry","category-current-tax-cases","category-income-tax-act-ita","category-tax-audits","category-tax-litigation"],"_links":{"self":[{"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/posts\/2435","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/users\/49"}],"replies":[{"embeddable":true,"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/comments?post=2435"}],"version-history":[{"count":2,"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/posts\/2435\/revisions"}],"predecessor-version":[{"id":2437,"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/posts\/2435\/revisions\/2437"}],"wp:attachment":[{"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/media?parent=2435"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/categories?post=2435"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.thor.ca\/blog\/wp-json\/wp\/v2\/tags?post=2435"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}