Paletta Estate v. The Queen

Paletta Estate v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2021-03-25
Neutral citation
2021 TCC 11
File numbers
2015-2662(IT)G
Judges and Taxing Officers
David E. Spiro
Subjects
Income Tax Act
Decision Content
Docket: 2015-2662(IT)G
BETWEEN:
THE ESTATE OF PASQUALE PALETTA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on August 20 and 21, November 12, 13, 14, 18, 19, 20, 21, 25, 26, 27 and 28, December 2 and 3, 2019 at Toronto, Ontario and March 11, 12, and 13, 2020 at Ottawa, Ontario and written representations received on July 30 and 31, 2020
Before: The Honourable Justice David E. Spiro
Appearances:
Counsel for the Appellant:
Justin Kutyan and Kelly Ng
Counsel for the Respondent:
Suzanie Chua, Rana El-Khoury and Dina Elleithy
JUDGMENT
1. The appeals for the 2000, 2001, 2003, 2004, 2005, 2006, and 2007 taxation years are allowed, with costs to the Appellant, and the reassessments for those taxation years are vacated.
2. The appeal for the 2002 taxation year is allowed, with costs to the Respondent, and the reassessment for that taxation year is sent back to the Minister of National Revenue for reconsideration and reassessment on the basis that:
(a) the gain of $8,030,844.73 from closing out the gain legs in that year shall be taken into account in computing income in accordance with these reasons; and
(b) penalty under subsection 163(2) of the Income Tax Act (the “Act”) shall be reassessed on the basis that the understatement of income that is reasonably attributable to the false statement or omission is $8,030,844.73.
3. The parties shall have 30 days from today’s date to reach an agreement on costs, failing which the parties shall have a further 30 days to serve and file written submissions on costs. The parties shall have a further 10 days to serve and file their written responses, if any. No such submission shall exceed 10 pages in length.
Signed at Ottawa, Canada, this 18th day of February 2021.
“David E. Spiro”
Spiro J.
Table of Contents
I. Overview 1
II. The Losses at Issue 3
III. Witnesses 3
IV. Findings of Fact 4
A. Background 4
(1) The Relevant Foreign Exchange Markets 4
(a) Over-the-Counter Market 4
(b) Exchange-Traded Contracts 5
(2) Forwards, Options and Synthetic Forwards 5
(a) Forwards 5
(b) Options 6
(c) Synthetic Forwards 6
(3) Trading on Margin 6
(4) How Forward Foreign Exchange Contracts Come to an End 9
B. The Chronology 11
(1) Mr. Pat Paletta’s Background 11
(2) Mr. Pat Paletta’s Trading Experience 11
(3) Introduction to the Promoter and the Tax Straddle 12
(4) Role of Tax Lawyers 12
(a) Oral Consultations 12
(b) Third-Party Opinions 13
(5) Annual Target Losses 13
(6) Fees Paid to the Promoter and the Brokerage Firms 14
(7) Mr. Angelo Paletta as Mr. Pat Paletta’s Agent 15
(8) Mr. Hodgins as Mr. Pat Paletta’s Agent 15
(9) Architecture of the Trades 16
(a) Forward Straddle – Representative Example 16
(i) Opening Positions 16
(ii) Modifying Positions 17
(iii) Closing Positions 19
(b) Synthetic Forward Straddle 19
(c) The Loss Legs and Gain Legs for Each Taxation Year 20
(10) Mr. Pat Paletta’s Knowledge of the Trading 21
(11) Review by the Canada Revenue Agency 22
(12) Change of Brokerage Firms 22
(13) The Reassessments 23
C. The $8 Million Understatement of Income for 2002 24
D. The Expert Witnesses 25
(1) The Appellant’s Experts 26
(a) Mr. Simon Bird 26
(b) Mr. Colin Knight 26
(2) The Crown’s Experts 26
(a) Dr. Andrey Pavlov 26
(b) Mr. Richard Poirier 27
(3) Observations on the Expert Reports 28
V. Positions of the Parties 29
A. The Crown’s Argument 29
(1) As Pleaded in the Amended Reply 29
(2) As Argued at Trial 30
(a) No Source of Income 30
(i) Tax Loss Scheme is Not a Business 30
(ii) Sham Forward Foreign Exchange Contracts and Options 30
(iii) Window Dressing 31
(iv) Facts Incompatible with the Existence of a Business 31
(3) Statute-Barred Taxation Years 32
(4) Gross Negligence Penalties 32
B. The Appellant’s Argument 33
(1) Friedberg and the Straddle Trade 33
(2) Stewart and Clear Commerciality 33
(3) Statute-Barred Taxation Years 34
(4) Gross Negligence Penalties 35
VI. Analysis 35
A. Realization of Losses for Tax Purposes 35
(1) Friedberg in the Federal Court – Trial Division (1989) 36
(2) Friedberg in the Federal Court of Appeal (1991) 37
(3) Friedberg in the Supreme Court of Canada (1993) 37
(4) Parliament’s Response to Friedberg (2017) 40
B. The Source Argument and the Stewart Decision 43
C. The Source Argument and Risk 47
D. Sham 48
(1) Lack of Business Purpose 52
(2) Customer Agreements 52
(3) Margin Amounts 53
(4) Irrevocable Letters of Credit 53
(5) Transaction Confirmations/Summaries 54
(6) Closing Out 55
E. Window Dressing 55
F. Ineffective Transactions 56
G. Statute-Barred Taxation Years 57
H. Gross Negligence Penalties 61
VII. Conclusion 66
VIII. Relief Granted 66
Citation: 2021 TCC 11
Date: 20210325
Docket: 2015-2662(IT)G
BETWEEN:
THE ESTATE OF PASQUALE PALETTA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
FURTHER AMENDED REASONS FOR JUDGMENT
Spiro J.
I. Overview
[1] With a view to deferring all or most of the tax that would otherwise have been payable by him under the Income Tax Act (the “Act”), Mr. Pasquale (“Pat”) Paletta entered into a plan designed to generate non-capital losses through forward foreign exchange trading. [1]
[2] The plan involved entering into a set of forward foreign exchange contracts, one long (agreeing to buy a particular currency on a future date) and the other short (agreeing to sell the same currency on a future date). [2] The contracts would almost exactly offset one another.
[3] The contracts did not exactly offset one another because each contract had a slightly different value date (the date on which delivery of the currency was to be made), which created a small positive or negative difference at any particular time between the value of the long leg and the value of the short leg of the straddle.
[4] Toward the end of each year, Mr. Pat Paletta, in consultation with his accountants, would decide on the amount of loss that he wished to realize for income tax purposes for that year (the “target loss”).
[5] Before December 31 Mr. Pat Paletta would close out the loss leg of the straddle, thereby realizing the target loss for that year. He would defer recognition of the corresponding gain leg by keeping it in place until after the beginning of the following year.
[6] Early the following year, the gain leg would be closed out before its value date. The gain realized would be included in computing income for that year. The following year the same trading pattern would be repeated but on a larger scale. Why a larger scale? Because the amount of each year’s target loss necessarily took into account the taxable income that Mr. Pat Paletta expected to receive in that year and the amount of the gain realized from closing out the gain leg carried over from the previous year.
[7] In reassessing, the Minister of National Revenue (the “Minister”) assumed that the forward foreign exchange trading was a sham. On that basis, the Minister disallowed all of the losses claimed by Mr. Pat Paletta for his 2000 to 2006 taxation years. [3] At trial, the Crown argued sham to support an overarching argument that there was no source of income against which the claimed losses could be deducted.
[8] The Minister reassessed after the normal reassessment period in respect of each year. The onus was, therefore, on the Crown to prove that Mr. Pat Paletta made a misrepresentation each year in filing his return that was attributable to neglect, carelessness, or wilful default.
[9] The Minister also assessed gross negligence penalties against Mr. Pat Paletta for the 2000 to 2006 taxation years. The Crown has the onus to prove the facts necessary to sustain those penalties as well.
[10] On the basis of my finding that the forward foreign exchange trading was not a sham and my obligation, as a trial judge, to follow the decisions of the Supreme Court of Canada in Friedberg [4] and Stewart, [5] the Appellant [6] must prevail in these appeals with one limited exception.
[11] The exception is this: the Minister was justified in opening Mr. Pat Paletta’s 2002 taxation year as he was careless or neglectful in understating his income for that year by $8,030,844.73. In addition, he was grossly negligent in understating his income for that year by that amount. Accordingly, the penalty under subsection 163(2) for that year should be reassessed in accordance with these reasons.
[12] Two corporations owned or controlled by Mr. Pat Paletta, Tender Choice Foods Inc. and Paletta International Corporation, participated in the same plan with the same counterparties. The Minister alleges that those corporations deducted over $150 million in losses during the period at issue. [7] Those corporations have instituted appeals as well but they have been held in abeyance pending the determination of this appeal.
II. The Losses at Issue
[13] Mr. Pat Paletta claimed some $55 million in losses for his 2000 to 2006 taxation years and reported just over $6 million in profit for his 2007 taxation year, for a total of almost $49 million in net losses from forward foreign exchange trading during the period at issue:
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 [8]
($5,134,923.14)
2006
($21,236,115.40)
2007
$6,444,216.20
Total:
($48,762,747.11)
III. Witnesses
[14] In addition to four expert witnesses, whose evidence will be described below, the following lay witnesses testified at trial. I found each of them credible:
Angelo Paletta Mr. Pat Paletta’s eldest son
Ralph Baber Former CEO of Union PLC [9]
Graham Wellesley Former CEO of IFX Ltd. and former CEO of ODL Securities Ltd.
Tim Hodgins Mr. Pat Paletta’s forward foreign exchange broker
Stephen Wiseman An accountant at Taylor Leibow LLP
Robert Ban An accountant at Taylor Leibow LLP
Stephen Kleinschmidt Former Canada Revenue Agency (“CRA”) officer
IV. Findings of Fact
A. Background
(1) The Relevant Foreign Exchange Markets
(a) Over-the-Counter Market
[15] Most forward foreign exchange contracts are not traded on any exchange but are entered into directly between two counterparties. This is known as the “Over-the-Counter” or “OTC” market. In this market, value dates (the date on which the terms of the contract must be fulfilled) are infinitely variable—any dates may be chosen by the counterparties—and the OTC market is always open for trading. A forward foreign exchange contract reflects a direct contractual relationship between two counterparties.
[16] The OTC market is dominated by large global banks constituting what is known as the “interbank market”. The interbank market accounts for the largest volume of forward foreign exchange trading in the world. Certain brokerage firms act as intermediaries between the large global banks and smaller entities that are not large enough to deal directly with those banks on the interbank market. Those brokerage firms act as agents for their clients or as counterparties depending upon the needs of the particular client. The counterparties to the trades at issue were such brokerage houses.
[17] All of the forward foreign exchange trading at issue occurred on the OTC market between Mr. Pat Paletta and three brokerage firms based in London, England: Union Cal Limited (or “UCAL”), IFX Ltd. (or “IFX”), and ODL Securities Ltd. (or “ODL”).
[18] All of the evidence adduced is consistent with the Minister’s assumptions that:
UCAL, IFX and ODL were the counter-party to the trades . . . . [10]
. . .
In every forex option or forward contract transaction . . . entered into by the Appellant, UCAL/IFX/ODL was the counterparty. [11]
. . .. . . UCAL/IFX/ODL was . . . the counterparty to any and all contracts that the Appellant entered into with UCAL/IFX/ODL. . . . [12]
(b) Exchange-Traded Contracts
[19] Standard form futures contracts have been developed for trading on exchanges such as the London International Financial Futures and Options Exchange, the Chicago Mercantile Exchange, and the Philadelphia Stock Exchange. [13] Although they are relatively easy to trade, they offer less flexibility than one would find on the OTC market. Exchange-traded futures contracts generally offer a limited number of value dates (generally falling at the end of the month) and have identical terms and conditions. [14] Mr. Pat Paletta did not trade futures contracts on an exchange. Instead, he traded forward foreign exchange contracts directly with the brokerage firms as his counterparties.
(2) Forwards, Options and Synthetic Forwards
(a) Forwards
[20] A forward foreign exchange contract is an agreement between two counterparties to trade a fixed amount of currency at a set rate on a pre‑determined value date. [15] Forward foreign exchange contracts are traded in the OTC market. They are not traded on any exchange. The counterparties agree among themselves on the currencies, the value date, the quantity, and the exchange rate. [16] The future purchaser of a particular currency is holding a “long” position in that currency and the future seller of the particular currency is holding a “short” position in that currency. [17] In a contract such as USD/CAD, if the value of the USD rises beyond the price specified in the contract, the buyer of the USD (the holder of the “long” contract) will make a profit and the seller of the USD (the holder of the “short” contract) will suffer a corresponding loss. [18]
(b) Options
[21] Options are financial instruments with strictly defined terms and conditions. One may buy (long) or sell (short) an option contract. There are two types of option contracts—calls and puts.
[22] A call option gives the holder (the buyer) the right, but not the obligation, to purchase the underlying asset or instrument at a specific price (the “strike price”) on or before the option’s expiration date. The writer or seller of the option has the obligation to sell the underlying asset to the holder if the holder chooses to exercise the option. [19]
[23] A put option gives the buyer the right, but not the obligation, to sell an underlying asset or instrument at a strike price on or before the option’s expiration date. The seller of the option has the obligation to buy the asset or instrument if the holder chooses to exercise the option. [20]
(c) Synthetic Forwards
[24] A synthetic forward is created by using two options to synthesize the effect of a forward. A long call option and a short put option with the same value date and strike price constitute a synthetic long (buy) forward. [21] Similarly, a short call option and a long put option with the same value date and strike price constitute a synthetic short (sell) forward. [22]
(3) Trading on Margin
[25] Margin protects a brokerage firm from the risk of default by its client. It is a form of collateral which offers protection to the brokerage firm against loss. [23] It appears in different forms but typically consists of cash or near cash instruments. Ultimately, it is anything that a brokerage reasonably believes will offer it protection against clients who are unable to cover their losses. [24]
[26] According to the uncontroverted evidence of the CEO of two of the brokerage firms, there is no hard and fast rule with respect to the amount of margin required in the OTC market. [25] Margin amounts on the OTC market are discretionary and negotiable.
[27] Each brokerage firm assesses the value of a particular client’s positions, as well as the firm’s entire position, at the end of each day. This is called “marking to market”. Marking to market is an essential part of assessing risk for any brokerage firm.
[28] When a particular brokerage firm reviewed the financial risk to which it was exposed in respect of Mr. Pat Paletta’s account at the end of each day, it did so on the basis of the net value of all positions in his account. To the extent that a positive net balance existed in the account, no additional margin was required and Mr. Pat Paletta was entitled to withdraw the surplus. To the extent that a negative net balance existed in the account, the brokerage firm was entitled to call for additional margin. Whether it did so or not was a discretionary decision.
[29] The margin required for Mr. Pat Paletta to trade forward foreign exchange contracts started as 5% of the target loss amount in 2000 and 2001 but was negotiated as low as 1% for 2002 and 2005 to 2007.
[30] In 2003 and 2004 the margin required was 0.33% and 0.8% of the target loss, respectively. In those two years the target loss was initially lower. No additional margin was required when the target loss was later increased.
[31] The amount of margin required related directly to the target loss for each taxation year:
Taxation Year
Target Loss
Margin Required
Margin as a % of Target Loss
2000
$6,000,000
$300,000
5%
2001
$8,000,000
$400,000
5%
2002
$10,000,000
$100,000
1%
2003
$15,000,000
$50,000
0.33%
2004
$20,000,000
$160,000
0.8%
2005
$25,000,000
$250,000
1%
2006
$45,000,000
$450,000
1%
2007
$40,000,000
$400,000
1%
[32] Mr. Pat Paletta primarily used irrevocable letters of credit as margin. The fees that Mr. Pat Paletta paid to the Royal Bank of Canada to secure those irrevocable letters of credit ranged from CAN$263 to CAN$3,576. [26] As mentioned above, the margin provided protection to the brokerage firms against the risk of default by Mr. Pat Paletta on his net obligation to them at any particular time. [27]
[33] During the following periods, a negative net balance existed in Mr. Pat Paletta’s trading account, yet no margin call was made by the brokerage firm and, in the last instance, new trades were entered into:
(a) November 30, 2001 to March 29, 2002 [28]
(b) April 2, 2003 to June 19, 2003 [29]
(c) August 19, 2005 to September 13, 2005 [30]
[34] The Minister assumed that the forward foreign exchange trades undertaken by Mr. Pat Paletta “would have resulted in margin calls in a real forex market” [31] yet there were no such margin calls. [32]
[35] The inference that I draw from the discretionary decision made by the brokerage firms not to make margin calls when they were otherwise entitled to do so is that they made a business decision. They were reasonably comfortable with the degree of risk they carried in respect of Mr. Pat Paletta’s account notwithstanding any margin shortfall at any particular time. That inference is based primarily on the evidence of the Crown’s expert on financial risk, Dr. Pavlov, who opined that the amount of risk to which the brokerage firms were exposed was negligible. It, therefore, follows that the margin required by the brokerage firms would have been negligible as well.
[36] The Minister also assumed that the:
[p]rincipal values of the forex option and forward contracts were denominated in the hundreds of millions of dollars, whereas the cost . . . [of] these options and forward contracts was only in the tens of thousands of dollars. [33]
[37] This assumption is technically correct, but its implication is not. The implication is that there was something untoward about trading in the OTC market on margin. Based on the evidence of the CEOs of the brokerage firms and the experts, I find that there was nothing untoward, let alone unusual, about trading on margin in the OTC market.
[38] Similarly, in attempting to justify the assessment of gross negligence penalties, the Minister alleged that:
the purported amount of foreign currency purchased was obviously excessive given the immaterial amount purportedly invested. [34]
[39] Once again, if the amount of risk was negligible, the amount of margin should be negligible as well. According to the Crown’s own theory of the case, the modest amount of margin that was actually required by the brokerage firms in this case would not have been unreasonable in the circumstances.
[40] I find that initial margin was computed as a percentage of the target loss for the year and that margin was maintained at a level that each brokerage firm was comfortable with in light of the negligible exposure to risk created by the net results of Mr. Pat Paletta’s trading.
[41] I also find, based on the evidence of the CEOs of all three brokerage firms, that the transitory margin deficiencies described above were not a cause for concern in light of their overall assessment of risk given their ongoing business relationship with Mr. Pat Paletta and his companies. [35]
[42] In light of the fact that margin is discretionary and negotiable in the context of the OTC market, and that the risk was negligible, the occasional margin deficiency was not a cause for concern to any of the brokerage firms.
(4) How Forward Foreign Exchange Contracts Come to an End
[43] Forward foreign exchange contracts come to an end by (a) delivering to the counterparty the currency contracted for on the value date, or (b) entering into an equal and offsetting position with the counterparty before the value date (known as “closing out” the contract). [36]
[44] Delivery occurs when the counterparties exchange the contracted amounts of each currency on the value date specified in the contract. For example, assume a forward contract selling EUR for USD on January 30, 2002. On the value date, January 30, 2002, the selling (or short) counterparty would deliver the EUR and the buying (or long) counterparty would deliver the USD.
[45] The other method used to bring a forward foreign exchange contract to an end is by entering into the equal and opposite position with one’s counterparty. For example, assume a forward contract to sell EUR for USD on January 30, 2002. At any time before January 30, 2002, the counterparty selling the EUR may enter into an equal and opposite contract with its counterparty to buy the same amount of EUR for USD on the same value date. The original contract has now been “closed out” or terminated. At that time, a gain or loss is crystallized as the contract has been effectively extinguished.
[46] Both methods of bringing forward foreign exchange contracts to an end are equally effective and both are used in the market.
[47] The Minister assumed, quite correctly, that:
[a]ll positions taken by the Appellant could only be closed out by entering into offsetting positions with UCAL/IFX/ODL. [37]
[48] The Minister also correctly assumed that the forward foreign exchange contracts “were never held to performance on [their] specified value dates.” [38] That assumption is consistent with the evidence.
[49] However, when that assumption is read in the context of all the other assumptions made by the Minister, its implication is that there was something wrong, or at least rather suspicious, about not holding forward foreign exchange contracts to their value dates. I am satisfied, based on the evidence of the CEOs of the brokerage firms and the expert evidence, that such contracts may be, and often are, closed out before their value dates. [39]
[50] The Minister further assumed (in an assumption that, at best, is an assumption of mixed fact and law) that all of the forward foreign exchange contracts:
. . . were not (could not have been) actually settled in a legal sense (legitimately extinguished) until their respective value dates. [40]
[51] On the evidence, that assumption is wrong. The assumption discloses a fundamental lack of understanding of how the forward foreign exchange market works and of the fact that such contracts may be closed out before their value dates. [41]
B. The Chronology
(1) Mr. Pat Paletta’s Background
[52] Mr. Pat Paletta immigrated to Canada from a small village in Italy in the 1950s. Starting with almost nothing, he built businesses ranging from meat packing to real estate development. His eldest son, Mr. Angelo Paletta, assumed increasingly important roles in his father’s businesses starting at an early age.
[53] Mr. Pat Paletta left school early. He did not have the benefit of a post‑secondary education. He was, however, very good with numbers. As a self‑made man, he was hands-on with respect to each business and was deeply interested in all aspects of his businesses, including the financial side.
[54] He entrusted all of his accounting and tax matters to his accountants at Taylor Leibow LLP, with whom he met on a weekly basis, mostly on Saturday mornings. During those meetings, Mr. Pat Paletta would discuss not only accounting and tax issues, but business initiatives and strategic planning as well.
[55] Mr. Pat Paletta incorporated various corporations to carry on many of his businesses. However, he operated cattle feedlots as a sole proprietor. [42] He decided to use that sole proprietorship to carry on the trading at issue.
(2) Mr. Pat Paletta’s Trading Experience
[56] In the early 1980s, Mr. Pat Paletta purchased cattle from Australia, New Zealand, and Nicaragua, for which he paid in either USD or the local currency. In addition, he purchased capital equipment from Europe and paid for that equipment in foreign currency. [43] He would generally ask his office manager to call the Royal Bank of Canada to have rates quoted to him, and would then buy or sell currency based on his business needs. [44]
[57] By the early 1990s, Mr. Pat Paletta exported meat to 20 countries and received foreign currency on those sales. Those receipts could be as high as tens of millions of dollars in a year. [45]
[58] Mr. Angelo Paletta testified that Mr. Pat Paletta would occasionally speculate by selling some of his accumulated foreign currency or buying additional currency based on what he had heard in the marketplace. [46] Before the events at issue, that was the extent of his involvement in foreign exchange.
(3) Introduction to the Promoter and the Tax Straddle
[59] Late in 1999, or early in 2000, Mr. Pat Paletta’s accountants recommended a tax plan to him. [47] They suggested that he meet with Mr. David Lewis, who had a tax plan they said was worth considering. Mr. Lewis was a principal at a firm called Affinity Financial. Mr. Angelo Paletta understood that Affinity Financial was a corporation that provided tax avoidance plans to clients. Although there was no evidence of the plan having been reduced to writing, it was understood that the plan was designed to generate non-capital losses through forward foreign exchange trading.
[60] Mr. Pat Paletta and Mr. Angelo Paletta met Mr. Hodgins and the CEO of Union PLC before commencing the trading in 2000. Initially, Mr. Angelo Paletta provided instructions to Mr. Lewis, who would relay those instructions to Mr. Hodgins. In late 2004 or early 2005, Mr. Angelo Paletta stopped dealing with Mr. Lewis and started dealing directly with Mr. Hodgins. [48]
(4) Role of Tax Lawyers
(a) Oral Consultations
[61] While Mr. Pat Paletta was considering Mr. Lewis’s tax avoidance plan, he and his eldest son visited several law firms on a number of unrelated matters.
[62] In mid-2000, before trading commenced, Mr. Pat Paletta and his eldest son were at the law offices of Borden & Elliot LLP in Toronto, where they met with a non-tax lawyer on another matter. They asked whether they could see a tax lawyer. They were introduced to Mr. John Tobin. They had a discussion with Mr. Tobin about the tax plan and asked Mr. Tobin if it was acceptable, if it was legal, and whether it met CRA requirements. Mr. Tobin mentioned the Friedberg case to them. That was the first time they heard of it. Mr. Tobin advised them that the plan was legitimate and met CRA standards. No written opinion was requested.
[63] Toward the end of 2000, before trading commenced, Mr. Pat Paletta and his eldest son were at the law offices of Love & Whalen, where they met with Mr. Jim Love on other tax matters. They had a discussion with Mr. Love about the tax plan and asked for his advice on the status of it, whether it was legal, and whether it met the requirements of the CRA. Mr. Love confirmed that it did and mentioned Friedberg as the leading case. They did not ask Mr. Love for a written opinion.
[64] In the summer or fall of 2001, after trading had commenced, another tax lawyer was consulted. That was Mr. Jack Bernstein at Aird & Berlis LLP, whom Mr. Pat Paletta and his eldest son met on the same basis as they had met Mr. Tobin the year before. In light of a general warning issued by the CRA earlier that summer regarding tax shelter transactions (and passed along to them by their accountants), they wanted to confirm that the tax plan remained sound. They received that confirmation from Mr. Bernstein. Once again, no written opinion was requested.
(b) Third-Party Opinions
[65] While the trading proceeded, Mr. Angelo Paletta was presented with several written opinions relating to the tax plan. They were all addressed to third parties. Mr. Pat Paletta never requested or obtained a written opinion addressed to him in respect of the tax plan. The written opinions were passed along to the Palettas at first by Mr. Lewis and later on by Mr. Hodgins.
[66] Mr. Angelo Paletta testified that while he and his father relied on those opinions, they did not read any of them. They were simply filed away. [49]
(5) Annual Target Losses
[67] Through his eldest son, Mr. Pat Paletta provided to Mr. Lewis (and, in later years, to Mr. Hodgins directly) the target loss amount each year. The target loss amount was the amount of loss that Mr. Pat Paletta, in consultation with his accountants, wanted his trading to generate, enabling him to claim the target loss amount as a non-capital loss on his tax return for that year, thereby eliminating either all or most of his taxable income for the year.
[68] Other than the first year, the target loss amount was arrived at by taking into account the aggregate of the (a) taxable income that Mr. Pat Paletta expected to receive that year and (b) the gains realized from closing out the gain leg carried over from the previous year.
[69] The target loss for each taxation year was as follows:
Taxation Year
Target Loss Amount
2000
$6,000,000
2001
$8,000,000
2002
$10,000,000
2003
$15,000,000
2004
$20,000,000
2005
$25,000,000
2006
$45,000,000
2007
$40,000,000
[70] I find that the sole purpose of the trading each year was the realization of the target loss for that year. The annual fee paid by Mr. Pat Paletta (later negotiated downward on his behalf by Mr. Angelo Paletta) was a percentage of the target loss for the year. The initial margin required by the brokerage firm was a percentage of that year’s target loss. Everything, without exception, revolved around the target loss each year and its realization.
(6) Fees Paid to the Promoter and the Brokerage Firms
[71] The fees paid to each brokerage firm for the trading each year were initially set as a percentage of the target loss requested for that year. However, in later years Mr. Angelo Paletta ignored the amounts called for by that formula, as well as specific fee requests from the brokerages, and would generally pay progressively smaller amounts:
Taxation Year
Target Loss Amount
Fees
Formula
2000
$6,000,000
$210,000
3.5% of the target loss [50]
2001
$8,000,000
$120,000
1.5% of the target loss [51]
2002
$10,000,000
$100,000
1% of the target loss [52]
2003
$15,000,000
$94,000
1% of the first $5,000,000 target loss, then 0.4% for an additional $11,000,000 target loss (despite the target later being reduced to $15,000,000, the fees were not reduced or refunded) [53]
2004
$20,000,000
$106,000
No formula was used. Mr. Angelo Paletta made a payment of $56,000 and later made another payment of $50,000. [54]
2005
$25,000,000
$50,000
No formula was used. Mr. Angelo Paletta made an initial payment of $20,000; another payment of $15,000 was paid later that year, and $15,000 was paid early in 2006. [55]
2006
$45,000,000
$70,000
No formula was used. Initially Mr. Angelo Paletta paid $12,500 (he testified that this was one-half of the amount ODL Securities Ltd. had requested). Later an additional $25,000 was wired, and then another $32,500. [56]
2007
$40,000,000
$20,000
No formula was used. Only the one payment was in evidence. [57]
[72] In the first years of trading, the fees were divided among Mr. Lewis, the particular brokerage firm, and Mr. Hodgins and his father. Later on, after Mr. Angelo Paletta stopped dealing with Mr. Lewis, the fees were divided among the particular brokerage firm and Mr. Hodgins and his father.
(7) Mr. Angelo Paletta as Mr. Pat Paletta’s Agent
[73] Mr. Pat Paletta assigned his eldest son, Mr. Angelo Paletta, the day-to-day responsibility for monitoring the trading undertaken on his behalf by Mr. Hodgins. All email messages in respect of the trading originated from or were sent to Mr. Angelo Paletta as his father did not have his own email account. At all times, Mr. Angelo Paletta acted as his father’s agent with respect to the trading.
(8) Mr. Hodgins as Mr. Pat Paletta’s Agent
[74] The Minister assumed that Mr. Hodgins acted as agent for Mr. Pat Paletta in executing the forward foreign exchange trades undertaken in order to achieve the target loss each year. [58] That assumption is consistent with the evidence. Among the relevant assumptions are:
The Appellant did not give any instructions [i.e. the currency pairs to be traded, the amounts to be traded, whether to enter into “buy” or “sell” positions, the expiry of value dates and the trade prices (bid/ask)] for any of the forex contracts purportedly entered into with UCAL/IFX/ODL and so reflected in their accounts. . . . [59]
Tim Hodgins, at his discretion, entered into and caused to be executed the purported contracts (trades) as needed to create each straddle loss and then subsequently unwind that straddle loss. [60]
[75] On the evidence, the Minister was correct in assuming that Mr. Pat Paletta had given discretionary authority to Mr. Hodgins to undertake whatever trading on his behalf was necessary in order to realize the target loss each year.
(9) Architecture of the Trades
[76] From 2000 to 2003, Mr. Hodgins used synthetic forwards to construct the straddle trades for each trading cycle. Mr. Hodgins would ask the forward foreign exchange desk and the foreign exchange options desk at the brokerage firm for prices on the trades. [61] Although more trades were required when options were used, it was initially less costly for Mr. Hodgins to use options in order to achieve Mr. Pat Paletta’s objective. [62] The synthetic forwards are further explained in paragraphs 93 and 94 below.
[77] For the later trading cycles (2004 to 2007), only forwards were used to construct the straddle. As forwards are easier to explain than synthetic forwards, only forwards are used in the example below.
(a) Forward Straddle – Representative Example
[78] The architecture of the straddle trades used by Mr. Pat Paletta involved a three-step process: opening positions, modifying positions, and closing positions. The process is best illustrated by way of an example using USD/CAD trades.
(i) Opening Positions
[79] Mr. Pat Paletta entered into opening positions with a pair of forward contracts. In the first contract, Mr. Pat Paletta agreed to sell US$80,000,000 for CAD on a value date of April 10, 2006. In the second contract, he agreed to buy the same amount of USD on a value date of May 8, 2006:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/ Loss (CAD)
Closes
A
07-Nov-05
10-Apr-06
Sell
(80,000,000)
1.18330000
94,664,000
n/a
B
07-Nov-05
08-May-06
Buy
80,000,000
1.18243000
(94,594,400)
n/a
(ii) Modifying Positions
[80] As one contract increased in value over time, the other would decrease in value by approximately (though not exactly) the same amount. In this example, the market value of the USD relative to the CAD increased over time, which caused the short (sell) trades to lose value, meaning that Trade A was in a loss position. [63]
[81] Shortly before the end of 2005, Mr. Pat Paletta entered into additional pairs of contracts to modify his original position. In this case, Mr. Pat Paletta entered into trades C and D. Trade C takes exactly the opposite position to Trade A, thereby closing out Trade A and realizing a loss of $711,600. Trade D replaced Trade A, reducing the day count between the two legs from 28 days to 10 days, thereby reducing the risk:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/ Loss (CAD)
Closes
C
15-Nov-05
10-Apr-06
Buy
80,000,000
1.19219500
(95,375,600)
(711,600)
A
D
15-Nov-05
28-Apr-06
Sell
(80,000,000)
1.19155500
95,324,400
n/a
[82] At this point the only two open positions were trades B and D:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/ Loss (CAD)
Closes
B
07-Nov-05
08-May-06
Buy
80,000,000
1.18243000
(94,594,400)
n/a
D
15-Nov-05
28-Apr-06
Sell
(80,000,000)
1.19155500
95,324,400
n/a
[83] Closer to the end of the year, Mr. Pat Paletta entered into additional positions, further modifying his open positions. In this example, Trade F exactly offset Trade B, thereby closing it out and realizing a loss of $1,352,160. Trade E replaced Trade B, reducing the day count between the two legs from 10 days to 6, further reducing the risk:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/ Loss (CAD)
Closes
E
24-Nov-05
02-May-06
Buy
80,000,000
1.16577500
(93,262,000)
n/a
F
24-Nov-05
08-May-06
Sell
(80,000,000)
1.16552800
93,242,240
(1,352,160)
B
[84] At this point the only two open positions were trades D and E:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/Loss (CAD)
Closes
D
15-Nov-05
28-Apr-06
Sell
(80,000,000)
1.19155500
95,324,400
n/a
E
24-Nov-05
02-May-06
Buy
80,000,000
1.16577500
(93,262,000)
n/a
[85] Just before the end of the year, Mr. Pat Paletta entered into two additional modifying positions. In this example, he entered into trades G and H. Trade G was the exact opposite of Trade E, thereby closing out Trade E and realizing an additional loss of $758,000. Trade H replaced Trade E and slightly increased the day count between the two legs from 6 days to 7:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/Loss (CAD)
Closes
G
15-Dec-05
02-May-06
Sell
(80,000,000)
1.15630000
92,504,000
(758,000)
E
H
15-Dec-05
09-May-06
Buy
80,000,000
1.15621800
(92,497,440)
n/a
[86] At this point the only open positions were trades D and H, which carried over into the following year:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/Loss (CAD)
Closes
D
15-Nov-05
28-Apr-06
Sell
(80,000,000)
1.19155500
95,324,400
n/a
H
15-Dec-05
09-May-06
Buy
80,000,000
1.15621800
(92,497,440)
n/a
[87] At the end of 2005, Mr. Pat Paletta realized losses in the amount of $2,821,760, consisting of the loss of $711,600, the loss of $1,352,160 and the loss of $758,000. [64]
[88] The process of entering into an opening position, adding contract pairs and closing the loss legs would be repeated as many times as necessary to achieve the target loss for the year. In 2005, the target loss was $25,000,000, so there would have been a number of opening positions established and then modified in a similar manner until the target loss was reached by year‑end.
(iii) Closing Positions
[89] Finally, early in 2006, the remaining positions (Trade D and Trade H) would be closed out by entering into equal and opposite trades:
Trade
Trade Date
Value Date
Buy / Sell
Amount (USD)
Rate
Price (CAD)
Profit/Loss (CAD)
Closes
I
26-Jan-06
28-Apr-06
Buy
80,000,000
1.14663200
(91,730,560)
3,593,840
D
J
26-Jan-06
09-May-06
Sell
(80,000,000)
1.14633725
91,706,980
(790,460)
H
[90] Although Trade J was the gain leg of the trade, a small loss was realized. The gain from closing out Trade I, however, entirely offset that loss. It was not unusual for some loss to be embedded within the gain leg of the trades, and vice versa. The total gain realized on the closing out of the gain leg in early 2006 was $2,803,380 ($3,593,840 - $790,460