Canada v. Paletta Estate

Canada v. Paletta Estate
Court (s) Database
Federal Court of Appeal Decisions
Date
2022-05-17
Neutral citation
2022 FCA 86
File numbers
A-83-21
Notes
A correction was made on May 24, 2022 Reported Decision
Decision Content
Date: 20220517
Docket: A-83-21
Citation: 2022 FCA 86
CORAM:
NOËL C.J.
RENNIE J.A.
LASKIN J.A.
BETWEEN:
HER MAJESTY THE QUEEN
Appellant
and
THE ESTATE OF PASQUALE PALETTA
Respondent
Heard at Toronto, Ontario, on April 4, 2022.
Judgment delivered at Ottawa, Ontario, on May 17, 2022.
REASONS FOR JUDGMENT BY:
NOËL C.J.
CONCURRED IN BY:
RENNIE J.A.
[BLANK]
LASKIN J.A.
Date: 20220517
Docket: A-83-21
Citation: 2022 FCA 86
CORAM:
NOËL C.J.
RENNIE J.A.
LASKIN J.A.
BETWEEN:
HER MAJESTY THE QUEEN
Appellant
and
THE ESTATE OF PASQUALE PALETTA
Respondent
REASONS FOR JUDGMENT
NOËL C.J.
INTRODUCTION
[1] Pasquale Paletta (Mr. Paletta) passed away a few months before his appeal to the Tax Court of Canada could be heard. The appeal was continued by his estate (the Estate) and heard over a period of eighteen days. The Tax Court per Spiro J. (the Tax Court) allowed the appeal. But for Mr. Paletta’s failure to include a relatively small part of the amounts in issue in one taxation year, the Estate’s appeal was entirely successful.
[2] During his 2000 through 2007 taxation years, Mr. Paletta generated income from a variety of sources approximating 38 million dollars in the aggregate. Almost all of that income ($37 million) was offset by losses that he generated in the course of forward foreign exchange trading (forward FX trading) activities. The first question to be addressed in this appeal is whether the Tax Court properly held that these trading activities gave rise to a source of income in the form of a business despite having found that the trades were not made for profit. If so, the appeal cannot succeed.
[3] If not, the Court will have to decide whether the Minister of National Revenue (the Minister) could reassess the years in issue beyond the normal reassessment period pursuant to subparagraph 152(4)(a)(i) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the Act) and apply the 50% penalty pursuant to subsection 163(2) against Mr. Paletta on the basis that he was grossly negligent in representing his losses as business losses even though they were not.
[4] For the reasons that follow, I would allow the appeal, set aside the Tax Court’s conclusion that Mr. Paletta’s forward FX trading activities gave rise to a source of income and confirm that the Minister could reopen the taxation years in issue and apply the penalty assessed for the 2000 through 2006 taxation years.
[5] As in most cases involving elaborate tax plans, the facts are not easy to sort out. The panel is grateful to the Tax Court for its meticulous, detailed and accurate marshalling of the evidence and the crucial factual findings that were made. These have greatly facilitated our task in disposing of this appeal.
BACKGROUND
A. The straddle transactions
[6] At a high level, the plan involved Mr. Paletta entering into pairs of contracts with certain brokerage firms to simultaneously buy and sell the same amount of foreign currency at different but closely proximate dates in the future (value dates). As the value of currency fluctuates over time, one of the contracts would move into a gain position and the other would move into a loss position. Before the end of the taxation year, Mr. Paletta would realize the loss leg, thereby crystallizing the loss for tax purposes. The gain leg would be crystallized at the beginning of the next taxation year. Using this strategy, Mr. Paletta “straddled” the offsetting contracts by realizing a loss in the first year and the corresponding gain in the subsequent year.
[7] Mr. Paletta repeated these steps each of the years in question, in order to realize target losses in an amount sufficient to offset both the gain realized on the gain leg closed at the start of the year and his income from other sources earned during the year. This effectively allowed Mr. Paletta to defer paying tax indefinitely.
[8] Two other corporations owned or controlled by Mr. Paletta implemented the same strategy, this time generating target losses exceeding $150 million. Their respective appeals are being held in abeyance pending the outcome of the present appeal (Reasons, para. 12).
B. The reassessments in issue
[9] The reassessments were issued in 2014, well after the expiration of the normal reassessment period. By these reassessments, the Minister denied the trading losses claimed by Mr. Paletta for the 2000 through 2006 taxation years and assessed the 2007 taxation year, only to deny the loss carry-over of prior years’ losses from these activities, while leaving the reported gain for that year untouched. Gross negligence penalties were applied for all years in which trading losses were claimed. The following table reflects the trading losses claimed and refused (Reasons, para. 13):
Taxation Year
Claimed Losses/Gains
2000
($6,184,460.89)
2001
($2,150,917.06)
2002
($10,007,726.00)
2003
($6,198,247.76)
2004
($4,294,300.06)
2005
($5,134,923.14)
2006
($21,236,115.40)
2007
$6,444,216.20
Total:
($48,762,747.11)
C. The for-profit theory
[10] The position of Mr. Paletta during the objection stage and of the Estate before the Tax Court was that the forward FX trading was conducted for profit and that the losses were business losses.
[11] Mr. Paletta’s forward FX trades were done in pairs of offsetting forward contracts (forward-forward swaps). He also traded using a combination of options, but to the extent that he did, the options would only replicate the financial return of a forward-forward swap, albeit synthetically. In their pleadings, Mr. Paletta and the Estate after him simply took the position that the trades were made for profit. The precise contention, as revealed during the trial, was that Mr. Paletta intended to profit from the movement in the interest rate differential (i.e., the difference between the interest rate payable on one currency and receivable in the other).
[12] Expert evidence was submitted in support of this idea. One of the experts who testified on behalf of the Estate acknowledged that the value dates of the legs making up Mr. Paletta’s swaps were very close to one another, typically, only a few days. However, he explained that this was not unusual because Mr. Paletta traded using extremely large notional amounts (in the hundred millions of dollars, billions in the aggregate). Although the returns were very small, he explained that the extent of the returns was commercially proportional to the risk which was also very small, and opined that “trading appears to have been carried out with the intention of making a profit overall” (Rebuttal Report of Colin Knight to Expert Report of Richard Roland Poirier, subpara. 20(iv); see also paras. 20-26, 102-116, 186, 194, 242-260: Appeal Book, Vol. 16, pp. 5825-5827, 5843-5845, 5860, 5862, 5874-5877).
[13] The Tax Court rejected this theory outright. It held, based on its assessment of the evidence, including the trading pattern over the seven-year period and the fee structure, that Mr. Paletta had no intention to make profits, whether large or minimal.
[14] Specifically, the forward-forward swaps were not entered into to speculate on the interest rate differential, but rather to take advantage of the currency movements in order to create the huge losses and the corresponding gains that had to be generated in order to meet the target loss every year, while effectively hedging all currency risk. The slight economic gains and losses derived from the exposure to the interest rate differential were merely incidental and bore little connection with the gains and losses that Mr. Paletta realized for tax purposes, as evidenced by the following table (Reasons, para. 96):
Trading Cycle
Losses
Gains (Realized the Following Taxation Year)
Net Difference (Economic Profit/Loss)
2000
($5,974,460.89)
$5,974,660.32
$199.43
2001
($8,063,011.19)
$8,030,844.73
($32,166.46)
2002
($9,907,726.75)
$9,912,321.58
$4,594.82
2003
($16,011,042.22)
$16,026,804.80
$15,762.58
2004
($20,467,060.00)
$20,313,547.00
($153,513.00)
2005
($25,231,920.00)
$25,212,680.00
($19,240.00)
2006
($46,485,910.00)
$46,422,000.00
($63,910.00)
2007
($39,998,730.00)
N/A
N/A
[15] To enter into his trades, Mr. Paletta paid fees totalling $770,000, calculated as a percentage of the target loss that he communicated to his brokers for execution through his son Angelo (Reasons, paras. 70-72). In all but one year, the fees paid exceeded the economic gain or loss derived from the swap. Through the achievement of the target loss year after year, Mr. Paletta was able to claim trading losses in an amount sufficient to erase the quasi-totality of his other income (Reasons, paras. 97-100). Although Mr. Paletta decided to “show” a gain of more than $6 million in 2007, this was not inconsistent with his tax avoidance plan since he had cumulated losses from previous trading that were sufficient to offset this trading gain (Reasons, para. 98; see also para. 7, n. 3).
D. The findings of fact
[16] In rejecting the Estate’s for-profit theory, the Tax Court made a number of findings of fact that need to be emphasized because they are crucial to the outcome of the appeal. The Tax Court found that “the sole purpose of the trading each year was the realization of the target loss for that year” and that “[e]verything, without exception, revolved around the target loss each year and its realization” (Reasons, para. 70). It further found that “no one seeking to make money would engage in the trades undertaken by Mr. Paletta” (Reasons, para. 134) and that there was no commercial or economic reason for those trades (Reasons, para. 128). The Tax Court rejected the opinion offered by Mr. Paletta’s expert to the effect that the trading appears to have been carried out with the intention to make a profit “overall” (Reasons, para. 140), repeating that “the only purpose of his trading was tax avoidance” (Reasons, para. 142).
[17] The Tax Court further found that “the only trading strategy used by Mr. Paletta was one designed to ensure immediate loss realization and indefinite gain deferral for tax purposes” (Reasons, para. 143). The Tax Court also found that Mr. Paletta and his son knew from the onset the three basic elements of the plan (Reasons, paras. 101 and 263):
1. Before the end of the year, the loss legs of the straddle would be closed out so as to realize the target loss for the year;
2. Shortly after the start of the next taxation year, the corresponding gain legs would be closed out and realized–they both understood that those gains must be included in computing income for the next taxation year; and
3. The target loss for the next taxation year would be sufficient to shelter (a) the gains realized earlier in the taxation year and (b) the taxable income that Mr. Pat Paletta anticipated receiving in that year.
(Emphasis in the original; footnote omitted)
[18] The Tax Court later added that “[t]here can be no doubt but that the straddle trading had no business purpose”. Instead, “[i]ts only purpose was to allow Mr. Pat Paletta to claim non-capital losses that he could use to offset his taxable income each year” (Reasons, para. 227).
E. The application of the law to the facts
[19] Despite having found that Mr. Paletta did not trade for profit or for commercial reasons, the Tax Court held that his trading activities gave rise to a business. Specifically, the Tax Court found that the fact that Mr. Paletta’s trading activities could at all times yield negligible gains and losses together with the fact that these activities were by their nature commercial and had no personal element, left it no choice but to hold that a source of income existed. According to the Tax Court, “Stewart instructs us clearly that the source analysis in such circumstances must end there” (Reasons, para. 204; referring to Stewart v. Canada, 2002 SCC 46, [2002] 2 S.C.R. 645 [Stewart]).
[20] The Tax Court added that the Supreme Court in Walls v. Canada, 2002 SCC 47, [2002] 2 S.C.R. 684 [Walls SCC] confirmed that an intent to profit was not a prerequisite in order for a business to exist when it held that Mr. Walls was engaged in a business, despite the fact that the activity in question was not undertaken for profit and was entirely devoted to the avoidance of tax (Reasons, para. 202). The Tax Court’s theory that Stewart and Walls SCC could be so read was developed without the assistance of the parties as both argued their case at trial on the basis that an intent to profit had to be present before a business could be found to exist.
[21] Although the other arguments raised by the appellant (the Crown) – sham, window dressing, legally ineffective transactions – were ancillary to the source analysis, the Tax Court devoted a good part of its reasons to these issues. The Tax Court made clear that Mr. Paletta correctly represented the legal rights and obligations flowing from his forward FX trading and that the evidence did not support the Crown’s contention that the documentation had been fabricated (Reasons, paras. 225 and 255). The Tax Court also relied on the decision of the Supreme Court in Friedberg v. Canada, [1993] 4 S.C.R. 285, 160 N.R. 312 [Friedberg] to hold that Mr. Paletta could use the realization method to report his trading gains and losses (Reasons, para. 191).
[22] The Tax Court then addressed whether Mr. Paletta made any misrepresentations that would warrant the reopening of statute-barred years and the application of gross negligence penalties. Given the finding that the forward FX trading activities gave rise to a source of income, the Tax Court centred its analysis on whether Mr. Paletta fully reported the gains derived from that source. It found that Mr. Paletta failed to include the gain leg of his trades in his 2002 return thereby making an $8 million understatement of income. The Tax Court went on to find that this understatement was attributable to “conduct tantamount to intentional acting” (Reasons, para. 269) and confirmed that the 2002 taxation year could be reopened in order to assess the understated amount and apply the gross negligence penalty for that year. All the reassessments were otherwise vacated.
[23] The Tax Court concluded its analysis by explaining that although this outcome was not the one it would have liked, binding precedents of the Supreme Court obliged it to reach the result that it did (Reasons, para. 271).
POSITION OF THE PARTIES
A. The Crown
[24] The Crown’s sole contention in this appeal is that the Tax Court could not hold that Mr. Paletta’s forward FX trading activities gave rise to a business given its finding that Mr. Paletta did not intend to profit from his trades. According to the Crown, the Tax Court, in confirming the existence of a business despite this finding, misconstrued binding case law, in particular the pronouncements of the Supreme Court in Stewart, Walls SCC, Friedberg and Stubart Investments Ltd. v. the Queen, [1984] 1 S.C.R. 536, 10 D.L.R. (4th) 1 [Stubart] (Memorandum of the Crown, paras. 26-73).
[25] The Crown submits that had the Tax Court held that Mr. Paletta’s trading losses were not incurred in the course of a business, as it should have, it would then have determined whether, in claiming his losses as business losses, Mr. Paletta made a misrepresentation attributable to neglect or wilful default. The Crown asks that we examine the evidence as it pertains to this issue and make the necessary findings of fact (Memorandum of the Crown, paras. 76-77).
[26] In this respect, the Crown submits that no experienced businessperson in the position of Mr. Paletta could reasonably believe that the trading activities gave rise to a business given that they were conducted for the sole purpose of avoiding tax. According to the Crown, Mr. Paletta’s behaviour in that regard rises to the level of wilful blindness and gross negligence thereby allowing for the reassessment beyond the normal reassessment period and the application of the penalty (Memorandum of the Crown, paras. 78-98).
B. The Estate
[27] The Estate, for its part, accepts the Tax Court’s conclusion that Mr. Paletta’s trading activities were not conducted for profit. It argues, however, that the Tax Court correctly held that these activities nevertheless gave rise to a business for purposes of the Act. In this respect, it focuses on paragraph 53 of Stewart and stresses that an intent to profit is irrelevant in light of that decision (Memorandum of the Estate, paras. 40-45). Specifically, Mr. Paletta’s trades bear the hallmarks of commerciality in that they were subject to risk, and were made in a market full of large global banks, in a manner consistent with industry norms and through regulated entities subject to oversight (Memorandum of the Estate, para. 39). Relying on the Tax Court’s reading of Stewart and of the relevant case law, the Estate submits that this is where the analysis should end (Memorandum of the Estate, paras. 32-38 and 46-71).
[28] In the event that Mr. Paletta’s trading activities did not give rise to a business, the Estate submits that Mr. Paletta acted as a reasonable person would in reporting his trading losses as business losses (Memorandum of the Estate, paras. 72-81). In this respect, the Estate refers to a series of steps taken by Mr. Paletta with the assistance of his son, Angelo, which show that he handled the issue with care and was neither neglectful nor careless (Memorandum of the Estate, paras. 82-92).
ANALYSIS
[29] As the trial unfolded before the Tax Court and the evidence was presented and appreciated, it became apparent to the Crown that the lead arguments raised in support of the reassessments -- sham, window dressing, ineffective transactions -- could not be supported, but that its alternative argument -- Mr. Paletta’s forward FX trading activities did not give rise to a source of income -- could. By the time of final argument, this became the sole ground, all others being relegated to a secondary role in support of the source argument (Reasons, para. 48). Before us, the Crown’s case rests exclusively on the source issue.
A. The source issue
[30] The concept of source of income is fundamental to the Act. There can be no taxation without income and, absent a specific rule (Division C), there can be no income without a source. Tax in turn can only be determined after income has been computed for the year. The foundational rule for the computation of income is set out in section 3. Section 3 reads in part:
3 The income of a taxpayer for a taxation year for the purposes of this Part is the taxpayer’s income for the year determined by the following rules:
3 Pour déterminer le revenu d’un contribuable pour une année d’imposition, pour l’application de la présente partie, les calculs suivants sont à effectuer :
(a) determine the total of all amounts each of which is the taxpayer’s income for the year (other than a taxable capital gain from the disposition of a property) from a source inside or outside Canada, including, without restricting the generality of the foregoing, the taxpayer’s income for the year from each office, employment, business and property,
a) le calcul du total des sommes qui constituent chacune le revenu du contribuable pour l’année (autre qu’un gain en capital imposable résultant de la disposition d’un bien) dont la source se situe au Canada ou à l’étranger, y compris, sans que soit limitée la portée générale de ce qui précède, le revenu tiré de chaque charge, emploi, entreprise et bien;
[31] Pursuant to section 9 of the Act, the income derived from a business or property source is the “profit” derived therefrom, i.e.: the revenues less the expenses incurred to earn them (Russel v. Town and County Bank, (1883), 13 App. Cas. 418 at 424, cited in (PC) MNR v. Anaconda American Brass Ltd., 55 D.T.C. 1220; [1955] C.T.C. 311 (J.C.P.C.). The “loss” from a business or property is the result of the reverse equation. Because they are the reverse side of the same coin, the existence of a “profit” or “loss” for tax purposes is subject to the same conditions. In this respect, it is useful to note that no court has ever held that a “profit” or “loss” can arise under section 9 in the absence of an intent to profit, subject to the Tax Court’s unique reading of Stewart and Walls SCC. Section 9 reads in part:
9 (1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.
9 (1) Sous réserve des autres dispositions de la présente partie, le revenu qu’un contribuable tire d’une entreprise ou d’un bien pour une année d’imposition est le bénéfice qu’il en tire pour cette année.
(2) . . . , a taxpayer’s loss for a taxation year from a business or property is the amount of the taxpayer’s loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source with such modifications as the circumstances require.
(2) […], la perte subie par un contribuable au cours d’une année d’imposition relativement à une entreprise ou à un bien est le montant de sa perte subie au cours de l’année relativement à cette entreprise ou à ce bien, calculée par l’application, avec les adaptations nécessaires, des dispositions de la présente loi afférentes au calcul du revenu tiré de cette entreprise ou de ce bien.
Unless Mr. Paletta’s trading gains and losses emanate from a source in the form of a business, they do not come within section 9 and can neither be included nor deducted in the computation of his income pursuant to section 3.
i. Standard of review
[32] The outcome of this appeal turns on the Tax Court’s reading of various decisions that were binding on it. Identifying the legal principles established by these decisions gives rise to questions of law with respect to which the Tax Court is entitled to no deference.
ii. Stewart and Walls SCC
[33] Despite finding that Mr. Paletta did not trade for profit, the Tax Court held that the trading losses that he claimed originated from a business. The Tax Court explained that the decisions of the Supreme Court in Stewart and Walls SCC “obliged” it to hold that the trading activities gave rise to a source of income (Reasons, para. 271). The Tax Court read these decisions as authority for the proposition that where an activity appears to be inherently commercial, it is a source of income even where the activity is not in fact carried on for commercial reasons or with a view to profit. With respect, this is not what Stewart and Walls SCC stand for.
[34] The Supreme Court in Stewart was focused on doing away with the reasonable expectation of profit test (the REOP test). This test originally had a specific statutory underpinning, but became, over time, a broad-based test used in all kinds of situations to determine if an activity gave rise to a source of income or whether the taxpayer is engaged in a personal endeavour, typically in the form of a hobby (Moldowan v. The Queen (1977), [1978] 1 S.C.R. 480, 77 D.L.R. (3d) 112). The Court was particularly concerned by the fact that, in applying this test, judges were using hindsight and often second-guessing the business acumen of the taxpayers concerned, a role for which they were ill-equipped and no better positioned than those whose business decisions they were assessing (Stewart, paras. 44-47). More fundamentally, the REOP test, which has no statutory foundation as a stand-alone test of general application, had overtaken the long accepted common law definition of business which simply requires that the activity be undertaken in the pursuit of profit (Stewart, para. 38 citing Smith v. Anderson (1880), 15 Ch. D. 247 (C.A.), at p. 258; Terminal Dock and Warehouse Co. v. M.N.R., [1968] 2 Ex. C.R. 78, [1968] C.T.C. 78, aff’d [1968] S.C.R. vi, 68 D.T.C. 5316).
[35] The Supreme Court therefore devised a simple two-step test focused on the pursuit of profit that had withstood the test of time remarkably well until the decision under appeal was released:
Is the activity of the taxpayer undertaken in the pursuit of profit, or is it a personal endeavour?
If it is not a personal endeavour, is the source of income a business or property?
Where the activity contains no personal element and is clearly commercial, no further inquiry is necessary (Stewart, para. 60).
[36] Stewart teaches that, in the absence of a personal or hobby element, where courts are confronted with what appears to be a clearly commercial activity and the evidence is consistent with the view that the activity is conducted for profit, they need go no further to hold that a business or property source of income exists for purposes of the Act. However, where as is the case here, the evidence reveals that, despite the appearances of commerciality, the activity is not in fact conducted with a view to profit, a business or property source cannot be found to exist.
[37] The Tax Court read Stewart differently. It held that the Stewart test effectively did away with the pursuit of profit as a prerequisite for the existence of a business, and that as Mr. Paletta was engaged in what it viewed as a clear commercial activity with no personal element, it was bound to hold that a business existed despite the absence of any profit motive.
[38] This reading is incompatible with what the Supreme Court actually said in Stewart. Not only did Stewart not oblige the Tax Court to hold that there was a source of income in these circumstances, but it required the Tax Court to come to the opposite conclusion. In Stewart, the Supreme Court made it clear that the test being devised was consistent with the traditional common law definition of “business”. The word “business” is given an inclusive and expansive meaning under the Act (subsection 248(1)), but is left otherwise undefined. As in such circumstances, the private law -- the common law on the facts of Stewart -- fills the gap, the Supreme Court explained that the Stewart test gave effect to the common law definition of “business” (Stewart, para. 51):
Equating “source of income” with an activity undertaken “in pursuit of profit” accords with the traditional common law definition of “business”, i.e., “anything which occupies the time and attention and labour of a man for the purpose of profit”: Smith, supra, at p. 258; Terminal Dock, supra. . . .
[39] Yet, the Tax Court read Stewart as requiring it to equate “source of income” with an activity that is not undertaken in “pursuit of profit” and to provide for a result that conflicts, rather than accords, with the common law definition of “business”. This turns Stewart on its head. Contrary to what the Tax Court believed, it could not hold that Mr. Paletta was engaged in a commercial activity in the face of evidence establishing that he had no intention to profit. The objective of the Stewart test, which was to reaffirm “pursuit of profit” as the decisive consideration in ascertaining the existence of a business, precludes the possibility that this test could be construed so as to require the recognition of a business in the face of evidence that establishes that profits are not being pursued.
[40] Even if Stewart cannot be read as the Tax Court proposes, the Estate submits that the companion case to Stewart, Walls SCC, can, and indeed must. In this regard, the Estate first relies on the findings of fact made by the Federal Court at trial (at the time, the Federal Court, Trial Division) in Walls v. R., [1996] 2 C.T.C. 14, 96 D.T.C. 6142 [Walls FC] to the effect that the activity in that case was undercapitalized and unable to produce a profit (Memorandum of the Estate, paras. 60 and 61). It submits that the Supreme Court’s conclusion in Walls SCC that a business exists despite these findings confirms that an intention to profit is no longer an essential element.
[41] In advancing this argument, the Estate omits to point out that the trial court’s findings on which it relies were made in applying the REOP test, that is through the use of hindsight, and by second-guessing the business judgment of the partners (Walls FC, paras. 14-16). The Supreme Court was not bound by these findings as this is the very approach that was proscribed in Stewart.
[42] In Walls SCC, the Supreme Court was illustrating the application of the Stewart test. The case involved the tax-motivated purchase of partnership interests in a storage park operation acquired by the partnership as a going concern. In holding that the partners were engaged in a business, the Court wrote (Walls SCC, para. 22):
Although the respondents in this case were clearly motivated by tax considerations when they purchased their interests in the Partnership, this does not detract from the commercial nature of the storage park operation or its characterization as a source of income for the purposes of s. 9 of the Act. It is a well-established proposition that a tax motivation does not affect the validity of transactions for tax purposes: Backman v. Canada, [2001] 1 S.C.R. 367, 2001 SCC 10, at para. 22; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; Canada v. Antosko, [1994] 2 S.C.R. 312; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, at p. 540. . . .
[43] By this decision, the Supreme Court confirmed the decision of the Federal Court of Appeal (at the time, the Federal Court, Appeal Division) in Walls v. the Queen, [2000] 1 C.T.C. 324, 2000 D.T.C. 6025 [Walls FCA]. Walls FCA reversed Walls FC, applying Tonn v. Canada, [1996] 1 C.T.C. 205, 96 D.T.C. 6001 (F.C.A.), a decision that sets out the approach that foreshadowed the advent of the Stewart test. The important point made in both Walls FCA and Walls SCC is that the partnership “purchased and maintained an ongoing commercial operation” that continued to operate exactly as it had before (Walls SCC, para. 21; Walls FCA, para. 1).
[44] The purpose of the exercise in Walls SCC was to highlight the failings of the REOP test and show the contrasting result obtained under the Stewart test. Applying the Stewart test, the Supreme Court held that the operation was a commercial activity, a conclusion that could only be reached if the evidence was consistent with the partners’ claim that they intended to profit from this activity.
[45] The Estate makes the distinct but related argument that Walls SCC must be read as holding that an activity that is “solely” devoted to the reduction of one’s tax is a business for purpose of the Act. It makes this submission, based on its understanding of the facts in Walls SCC (Memorandum of the Estate, para. 62-63). This understanding appears to be predicated on the Tax Court’s assertion that the activity in Walls SCC was “entirely tax motivated” (Reasons, paras. 201-202). I do not believe that to be the case. A closer look at the trial decision in Walls FC and the subsequent appeals is necessary in order to make this demonstration.
[46] Applying the REOP test, the Federal Court in Walls FC found that the partners had no expectation of profit and therefore were not engaged in a business. Although it could have stopped there, it went on to find that the partners were not engaged in a business on the ground that the “sole” reason for the existence of the partnership operation was to allow the partners to avoid paying taxes (Walls FC, para. 18). Applying the dictum of this Court in Moloney v. the Queen, [1992] 2 C.T.C. 227, 92 D.T.C. 6570 [Moloney], to the effect that an activity aimed at reducing one’s tax cannot, by itself, give rise to a business, the Federal Court held that this was another reason for holding that the partners were not engaged in a business (Walls FC, para. 19).
[47] In the appeals that ensued, neither the Supreme Court nor the Federal Court of Appeal accepted the Federal Court’s finding that the “sole” reason for the existence of the partnership was tax avoidance. The Supreme Court found that the activity was “clearly” tax motivated - not “exclusively” tax motivated – a qualification that left ample room for the Court’s ultimate conclusion that the partners were engaged in a commercial activity and hence a business (Walls SCC, para. 22). Likewise, the Federal Court of Appeal previously found that the partners’ decision to invest in the storage park operation was driven “in part” by favourable tax considerations (Walls FCA, para. 1, as cited in Walls SCC, para. 16).
[48] Before concluding my analysis of Walls SCC, I note that the Supreme Court in that case cites its earlier decision in Backman v. Canada, 2001 SCC 10, [2001] 1 S.C.R. 367 [Backman]. Backman illustrates the point that activities devoted solely to the avoidance of one’s tax cannot give rise to a business under the Act. Although the case focused on whether a partnership had been validly constituted under the applicable partnership legislation, the decision is instructive because, as is the case for a business, partners must have an intent to profit in order for a partnership to exist. In Backman, the presumptive partnership was found not to have been validly formed because the partners did not have a view to profit. In coming to that conclusion, the Court adopted the following observation made in Lindley & Banks on Partnership, 17th ed. (London: Sweet & Maxwell, 1995), pp. 10 and 11 (Backman, para. 23):
. . . if a partnership is formed with some other predominant motive [other than the acquisition of profit], e.g., tax avoidance, but there is also a real, albeit ancillary, profit element, it may be permissible to infer that the business is being carried on "with a view of profit." If, however, it could be shown that the sole reason for the creation of a partnership was to give a particular partner the "benefit" of, say, a tax loss, when there was no contemplation in the parties' minds that a profit . . . would be derived from carrying on the relevant business, the partnership could not in any real sense be said to have been formed "with a view of profit".
(My emphasis)
[49] The same logic applies here. It is also apparent, given the reasoning in Backman, that the Supreme Court would have found that the partnership in Walls SCC was not validly constituted had it been of the view that the sole reason for the partnership operation in that case was tax avoidance.
[50] In the end, Walls SCC establishes that a commercial activity does not cease to be a business because it is pursued with an intent to profit as well as an intent to avoid tax. It does not stand for the odd proposition that an activity devoted exclusively to the avoidance of one’s tax can be a business, and hence a source of income under the Act.
iii. Moloney is the applicable precedent
[51] The Supreme Court in Walls SCC went on to explain why the facts in that case bore no resemblance to those in Moloney. In the words of the Supreme Court, the activity in Moloney was no more than “a circular scheme . . . set up for the sole purpose of obtaining tax refunds with no intention on the part of the taxpayer to carry on the business of marketing a speed reading course . . .” and “a sham set up to appear as though it was commercial in nature where in fact the only activity actually engaged in was that of obtaining tax refunds”. The Court went on: “[h]ere, in contrast, the Partnership purchased and maintained an ongoing commercial operation” (Walls SCC, para. 21).
[52] As the facts in both Moloney and the present case show, an attempt to pass off as a business an activity that is aimed exclusively at avoiding one’s tax, will always involve a form of deception because such an activity, if presented for what it is, cannot be viewed as a business.
[53] In Moloney, the deception took the form of a sham. In the present case, the Tax Court properly found that the forward FX trading transactions were not shams; they were real and legally effective. However, a sham is not the only way in which tax authorities can be misled. Borrowing the phrase used in Walls SCC to describe the activity in Moloney, Mr. Paletta’s activity was no less “set up to appear as though it was commercial in nature when in fact the only activity actually engaged in was that of [avoiding tax]” (Walls SCC, para. 21). Whether avoiding one’s tax is viewed as a personal endeavour, a hobby or placed in a category of its own, it is not a commercial activity pursuant to the test set out in Stewart, and applied in Walls SCC. That said, where the sole purpose of an activity is the avoidance of one’s tax, there is no reason to resort to the Stewart test because such an activity is irreconcilable with the existence of a business.
[54] In filing his tax returns for the years in issue, Mr. Paletta represented that he was engaged in a multi-million dollar – sometimes billion – “foreign currency trading” business, when in fact he was not (see for example the “Statement of Business Activities” in Mr. Paletta’s tax return for the 2002 taxation year: Appeal Book, Vol. 9, p. 3347). He maintained throughout that he made those trades for profit. The deception was so pervasive that it was not brought to light until all the evidence was in after an eighteen-day trial and months of deliberation. I will come back to this in assessing Mr. Paletta’s state of mind in filing his tax return for the years in issue.
iv. Friedberg
[55] The Tax Court pointed to Friedberg as the other Supreme Court decision that obliged it to hold that Mr. Paletta had a source of income despite the fact that he had no intention to profit (Reasons, paras. 10 and 271). Mr. Friedberg was engaged in the gold futures trading business. The only issue before the Supreme Court was whether Mr. Friedberg had to report his gains from that source using the mark-to-market method rather than the realization method.
[56] Mr. Friedberg’s use of the realization method allowed him to decrease his tax burden by realizing the loss in the first year and the matching gain in the subsequent year, the same way Mr. Paletta did. The contention of the Crown in Friedberg was that the mark-to-market method of reporting provided a more accurate reflection of the profits realized from Mr. Friedberg trading activities and that, based on subsection 245(1) of the Act, as it then read, the use of the realization method had the effect of “artificially” reducing his income. The Supreme Court disagreed. It held that Mr. Friedberg reported his losses and gains when they actually occurred and that it was open to him to report his income using the method of his choice.
[57] The Tax Court found, in the present case, that Mr. Paletta “used essentially the same tax plan [as did Mr. Friedberg]” (Reasons, para. 171). Respectfully, the plan was not the same. Mr. Friedberg used the same straddle trading strategy to defer paying tax on the gains realized in the course of his trading activities, but that is where the comparison ends. Specifically, there is no suggestion that Mr. Friedberg did not intend to profit from his trading activities and that he did not have a source of income.
[58] Indeed, the evidence in Friedberg went the other way. As was found by the Federal Court of Appeal in disposing of the Crown’s earlier appeal (The Queen v. Friedberg, [1992] 1 C.T.C. 1, 92 D.T.C. 6031, para. 25), Mr. Friedberg traded in gold futures “primarily to earn profits from his speculation”. This finding was in no way disturbed when the Supreme Court subsequently dismissed the Crown’s appeal from the decision of the Federal Court of Appeal. The Tax Court’s lengthy analysis of Friedberg does not allude to this fundamental difference (Reasons, paras. 173-196). While the Tax Court referred to various publications that were critical of Friedberg and of Parliament’s failure to counter the tax base erosion concerns arising from this decision unti