Photo by Tima Miroshnichenko
In Canada v. Paletta, the Federal Court of Appeal clarified that, in order for a business to exist, there must be an intention to earn a profit. Absent such intention, there is no business and therefore no “source of income”.
In cases dealing with source of income, a taxpayer can take a position on either side of the issue. The taxpayer can either argue that there isn’t a source of income or that there is a source of income.
A taxpayer would argue that there is no source of income if he doesn’t want the amount that he received to be taxed. Generally, if an amount is not “income”, it is not taxable unless a provision of the Income Tax Act states otherwise. For instance, in a net worth assessment, if the Canada Revenue Agency or Revenu Quebec notice deposits into a bank account and the taxpayer can prove that those deposits came from family members, they are not income and therefore not taxable.
In other instances, however, a taxpayer may want to argue that there is indeed a source of income. In these instances, the taxpayer typically has losses from an alleged business that he hopes to use to offset his income from other sources. The issue then becomes whether there is a real business. It is not unusual for a start-up to incur losses in its first years of operation or for a business to go through some difficult years due to a range of factors. In these situations, since there is a source of income, the losses incurred are legitimate and can be used to offset the taxpayer’s income from other sources. This situation is to be contrasted with that of a taxpayer enjoying a hobby and deciding to turn that hobby into a “business”. The façade of a business cannot be used to indirectly finance a hobby.
Whether a business existed is the starting point for this case. From 2000 to 2007, Mr. Paletta generated significant income from various sources totalling approximately $38M. However, almost all of that income was offset by losses “generated” in the course of forward foreign exchange trading activities, resulting in minimal income taxes payable for those years. The FCA described Mr. Paletta’s modus operandi as follows:
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.
Not surprisingly, when the CRA caught wind of the situation, they reassessed Mr. Paletta. Since the reassessments were issued beyond the normal reassessment period (3 years for individuals), the CRA had to prove that Mr. Paletta made misrepresentations in his tax returns that were “attributable to neglect, carelessness or wilful default”. In addition to reassessing Mr. Paletta for taxes owing, the CRA also levied gross negligence penalties.
Tax Court of Canada
Before the TCC, Mr. Paletta argued that his trading activities were conducted for profit and that the losses he incurred were business losses. When asked about his intention to profit, Mr. Paletta clarified that he intended to profit from the movement in the interest rate differential (as explained by the FCA, “the difference between the interest rate payable on one currency and receivable in the other”).
The TCC did not buy this excuse and found that the trading activities “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”. The TCC stated that there could “be no doubt but that the straddle trading had no business purpose” and that its only purpose was to allow Mr. Paletta “to claim non-capital losses that he could use to offset his taxable income each year”.
However, despite having found that Mr. Paletta did not carry out the trades for profit, but solely for tax avoidance, the TCC stated that it had no choice but to hold that a source of income existed because it was bound by a precedent from the Supreme Court of Canada. The precedent the TCC was referring to is the case of Stewart v. Canada wherein the SCC elaborated a two-step approach to determining whether a source of income exists. According to the TCC’s reading of Stewart, if there is no personal element to a taxpayer’s undertaking, the analysis stops there and that undertaking is necessarily a business. In this instance, since there was no personal element involved, and even though Mr. Paletta’s sole intention in carrying on the trades was to avoid taxes, the TCC felt bound to conclude that Mr. Paletta’s trading activities gave rise to a business. Since Mr. Paletta carried on a business, the losses that he claimed in relation to that business were valid. The TCC felt reinforced in this view by Walls v. Canada, another SCC decision, which, according to the TCC, indicated that an activity entirely devoted to the avoidance of tax and not undertaken for profit could nonetheless constitute a business.
Federal Court of Appeal
The Crown could not let the TCC decision stand because it upended the longstanding common law meaning of “business” which was defined as “anything which occupies the time and attention and labour of a man for the purpose of profit” [emphasis added]. It argued that the TCC made an error of law in concluding that Mr. Paletta carried on a business despite its finding that he did not intend to profit from his trades.
The FCA agreed with the Crown and confirmed that Stewart did not intend to overrule the common law definition of “business”, which requires an intention to earn a profit: “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.” The FCA later added: “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.” The FCA interpreted Stewart as reaffirming that the “pursuit of profit” was the decisive consideration in ascertaining the existence of a business and commented that the TCC decision effectively turned Stewart “on its head”.
Once this issue was decided, the FCA turned to whether the CRA could reassess Mr. Paletta beyond the normal reassessment period and whether it was correct in assessing Mr. Paletta gross negligence penalties. Since the threshold for the gross negligence penalties is higher, a determination that Mr. Paletta was liable for the gross negligence penalties would also prevail over the issue of whether the CRA was statute-barred from reassessing him.
The FCA formulated the question as follows: “[W]hether Mr. Paletta, in representing that his losses were incurred in the course of a business even though they were not, acted knowingly or in circumstances attributable to gross negligence.”
Here, Mr. Paletta advanced six defences:
1. Due to his limited education and understanding of tax matters, Mr. Paletta relied on the advice of his long-standing accountants when they introduced the forward FX trading opportunity to him. He also drew comfort from his prior experience with a similar deferral strategy with his cattle inventory;
2. Mr. Paletta acted as a reasonable person would in obtaining the verbal opinion of tax experts, all of whom comforted him in his belief that his plan was sound;
3. Mr. Paletta did not require formal opinions because he put a lot of faith in the word of lawyers and because his financial exposure resulting from the forward FX trades was minimal;
4. Mr. Paletta did, in fact, obtain written legal opinions on the forward FX trading strategy throughout the course of trading; although these opinions were not addressed to him;
5. Mr. Paletta could also take comfort from the audit conducted by Canada Revenue Agency (CRA; formerly the Canada Customs Revenue Agency) in 2004, which concluded that no further action was required;
6. In any event, Mr. Paletta could reasonably believe that he had a source of income despite the fact that he did not intend to profit from his forward FX trading activities and that tax avoidance was his sole motivation, in light of the reasons of the Tax Court which agreed with this view.
The FCA rejected his defences one by one. The FCA found it hard to accept that Mr. Paletta did not know what he was doing. He was a successful businessman and entered into a sophisticated scheme that allowed him to avoid paying significant taxes. Mr. Paletta set his mind on this scheme and relied upon tangential advice that favoured the outcome he was aiming for. Even after he was warned that his plan could prove to be problematic, he did not seek a formal legal opinion. Feeding lawyers incomplete facts and relying upon “verbal” opinions proffered only after a cursory discussion is insufficient. The FCA concluded that Mr. Paletta “was indifferent or wilfully blind to whether his plan complied with the law or not and was content to assume the risk.” It is worth noting that earlier in its judgment, the FCA made the following observation, which was prescient of its decision to come: Attempts “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.”
Mr. Paletta was a wealthy man who could afford to pay for legal advice. He sought advice that corroborated his position while refraining from going further to seek complete clarity. The FCA did not accept Mr. Paletta’s defences because they sounded more like excuses than real steps that a diligent and wilful taxpayer would have taken.
It is to be noted that two other corporations that Mr. Paletta owned or controlled implemented the same tax strategy. Combined, they generated target losses of over $150M. Their appeals were held in abeyance pending the outcome of Mr. Paletta’s appeal.
 2022 FCA 86. Note: Mr. Paletta passed away a few months prior to his appeal being heard before the Tax Court of Canada. Therefore, his estate continued the appeal.
 2002 SCC 46.
 2002 SCC 47.
 Para. 71.
 Para. 52.