In Canada v. The Estate of Pasquale Paletta, the Federal Court of Appeal (FCA) unanimously sided with the Minister of National Revenue (Minister) in finding that a plan involving foreign exchange straddle contracts did not give rise to a source of income under subsection 9(1) of the Income Tax Act (the Act) and, therefore, Paletta was not entitled to deduct losses from the foreign exchange trading.
Pasquelle Paletta, year over year, entered into offsetting forward exchange contracts – one long and the other short. He straddled the contracts by crystalizing a loss position before the end of one tax year and realizing a gain at the beginning of the next. The result of these transactions was almost $49 million in net losses from 2000 to 2007, which the Minister denied for a number of reasons, the primary reason being that Paletta did not conduct the foreign trading activity in pursuit of profit and, therefore, it was not a source of income.
The Tax Court of Canada (TCC) found that Paletta’s sole purpose for purchasing the straddles was to avoid income taxes, and there was no pursuit of profit. However, the TCC cited the Supreme Court of Canada’s decision in Stewart v. Canada (Stewart) to conclude that, because foreign exchange straddling is a commercial activity, it must be a source of income under the Act, notwithstanding the tax motivation.
The FCA disagreed, overturning the TCC’s decision on the basis that the TCC misinterpreted Stewart. The FCA clarified that Stewart reaffirmed the principle that a pursuit of profit is the decisive consideration in ascertaining the existence of a business, and that a business cannot exist without a pursuit of profit. The FCA applied this principle to the factual finding that Paletta had no intention to profit from the trading, and thereby held that the foreign exchange trading was not a commercial activity and, therefore, not a source of income. As such, the FCA denied the losses.
The FCA also determined that the Minister was justified in (i) reassessing Paletta’s tax returns after the expiry of the normal reassessment period and (ii) imposing gross-negligence penalties. The FCA cited that, although Paletta had informally consulted with tax lawyers as to the validity of the plan, he had withheld the fact that he did not have a pursuit of profit with his trading activity and had not sought a fully- informed legal opinion on its legitimacy. The court equated his inaction in this regard to indifference or willful blindness.
In light of this decision, taxpayers who engage in similar hedging strategies and have sustained consistent loss balances will need to grapple with the deductibility of their losses on the basis of whether a profit motive can reasonably be considered to exist.