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Application of the Friedberg principles confirmed in recent FX straddle case

On February 19, 2021, the Tax Court of Canada released its decision in The Estate of Pasquale Paletta v Her Majesty the Queen, 2021 TCC 11 (Paletta Estate) regarding the treatment of losses arising from foreign exchange trading. Justice Spiro allowed the appeal, holding that the Appellant prevailed by adducing the evidence necessary to demolish the Minister’s assumptions that the foreign exchange trading did not give rise to a source of income and was a sham.


With a view to deferring otherwise payable income tax, Mr. Pasquale Paletta, along with two related corporations, Tender Choice Foods Inc. and Paletta International Corporation, entered into a series of foreign exchange contracts referred to as “straddle transactions.” By way of the straddle transactions, Mr. Paletta would enter into a set of nearly offsetting 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). As the contracts would have differing dates on which the currency was to be delivered (known as the ‘value date’), small positive or negative differences existed between the value of the long leg and the value of the short leg of the straddle.

Towards the end of each tax year, Mr. Paletta would close out his loss position and realize a loss for tax purposes. Mr. Paletta would then close out the corresponding gain position in the beginning of the next tax year. Those gains were included in Mr. Paletta’s income for that year. By doing so, the losses and gains would “straddle” the taxation year-end. This series of straddle transactions was repeated over a series of years resulting in continued tax deferral. For the taxation years under appeal, Mr. Paletta claimed approximately $55 million in losses for his 2000 to 2006 taxation years and reported just over $6 million in profit for his 2007 taxation year.

The Minister of National Revenue reassessed Mr. Paletta’s 2002 to 2006 taxation years, disallowing the losses claimed on the basis that the forward foreign exchange trading was a sham. The Minister reassessed each of the tax years outside of the normal reassessment period on the basis that Mr. Paletta made a misrepresentation each year in filing his return that was attributable to neglect, carelessness, or wilful default. The Minister also assessed gross negligence penalties for each of the reassessed years. However, the Minister did not seek to apply either the General Anti Avoidance Rule or the tax shelter rules to the straddle transactions.

Over the course of the trial, the Crown shifted her arguments. While her pleadings relied primarily on the argument that the trades were a sham, she made a single over arching point in presenting her final argument: that Mr. Paletta’s trading was not a source of income. While the Minister’s other arguments were considered in the course of the decision, Justice Spiro considered them ‘relegated to a secondary role in support of the Crown’s source argument.’

Issues considered

Fundamentally, the Crown argued that the trading was not a source of income because a tax loss scheme is not a business. As Mr. Paletta’s predominant motive was the pursuit of tax losses, he did not incur those losses from carrying on a business.

As a part of this argument, the Crown submitted that the trade documentation was fabricated and assumed that the trading was a sham. The Crown further argued that the trades were ‘window dressing’, only undertaken to give the impression that Mr. Paletta was carrying on a business.

Finally, the Crown argued that the facts were incompatible with the existence of a business because (a) The target loss amount each year was a preordained amount, (b) There was a lack of risk in these trades and this differs from the amount of risk normally associated with forward foreign exchange trading, and (c) The trades were legally ineffective.

The Appellant argued that the exchange trading was a source of income, that there was no sham, and that all of the transactions were legally effective. Crucial to the holding in this case was Justice Spiro’s determination that each of the expert witnesses and lay witnesses adduced by the Appellant was credible.

Realization of losses for tax purposes - Friedberg

Justice Spiro agreed with the Appellant, holding that the forward exchange trades were not a sham and that each of the transactions was legally effective. Specifically, Justice Spiro applied the law as outlined in the seminal Friedberg case.1 In Friedberg, the Supreme Court of Canada held the realization method of accounting was acceptable under the Act. The Court further held that, under the realization method, a trader will realize a loss for the year by closing out the loss leg of a straddle and any such loss is not diminished by the value of any related gain leg not closed out in the year.

Justice Spiro noted that the Minister’s assumptions in Paletta Estate displayed a fundamental disagreement with the Supreme Court’s decision in Friedberg that a straddle trader’s tax loss may exceed their economic loss. Justice Spiro held that he and the Minister were constrained by the jurisprudence:

Friedberg stands for the proposition that straddle traders may report the results of their trades for tax purposes on a basis that does not reflect the true economic results of such trades. Unhappy as the Minister may be with that decision, there is no basis on which she can avoid its effect on the taxation years at issue.

Although the specific anti-avoidance rule introduced in 2017 may very well override the decision of the Supreme Court of Canada in Friedberg (and that question will have to be answered some other day), that does not allow the Minister to reassess pre-2017 taxation years as though Friedberg had never been decided. Those amendments changed the law on a prospective basis. They did not change the law retroactively or retrospectively.

No source of income

Justice Spiro found that the evidence adduced at trial proved the Minister’s assumption that Mr. Paletta entered into the forward foreign exchange trades for tax deferral purposes. However, he also held that the absence of business purpose does not necessarily mean there was no source of income. Instead, applying the Supreme Court’s holding in Stewart, Justice Spiro confirmed that, provided one’s activity is clearly commercial and involves no personal element, there is a source of income.

In Walls, the Supreme Court held that the Stewart test also applies even where the activity in question was entirely tax motivated. In finding that a source of income existed in Paletta Estate, Justice Spiro held that:

Forward foreign exchange trading is, by its very nature, a commercial activity. In addition, there would always be a positive or negative difference between the value of the loss leg and the value of the gain leg at any particular time. There was no personal or hobby element involved as far as Mr. Pat Paletta was concerned. On that basis, the first test in Stewart is satisfied. The Court’s decision in Stewart instructs us clearly that the source analysis in such circumstances must end there.

Regarding the Crown’s argument that there was no risk associated with the trades and thus no source of income, Justice Spiro held that this argument was inconsistent with the Minister’s own assumption that there was, in fact, a small economic loss associated with the trades. The Crown later tried to argue that the small economic loss was insufficient to constitute a source. Dismissing the Crown’s argument as contrary to the current state of the law set out by the Supreme Court in Stewart, Justice Spiro confirmed there is no such ‘sufficiency’ test in Canadian tax law.

Sham and window dressing

As sham is a serious allegation, Justice Spiro noted that it deserved analysis regardless of whether the Crown argued it as a primary argument or in support of a lack of source argument. The sham doctrine can only apply where the evidence shows the parties misrepresented their arrangements in an attempt to achieve a tax benefit, which would be denied if the true nature of the arrangements were properly disclosed. Following recent case law on sham, Justice Spiro examined the evidence to determine whether the transaction documents truly reflected the parties’ intent.

While the Crown’s pleadings did not make it clear whether the Minister assumed that the trading documents were fabricated, and that this fabrication constituted sham, or that the lack of business purpose in and of itself constituted sham. Regardless, Justice Spiro held that the Crown’s argument failed on both counts. The former argument was factually incorrect and the latter was legally unsustainable.

At trial, the Crown brought no evidence on the fabrication of the trades while the Appellant adduced credible evidence proving that each counterparty to Mr. Paletta’s over the counter trades were bona fide brokerage firms and that each of the trades were actually completed. Crucial was Justice Spiro’s holding that:

The theoretical possibility of fabrication does not satisfy the Crown’s burden of proof after the Appellant had adduced sufficient evidence that convinced me, on a balance of probabilities, that the trades actually occurred.

There is no evidence that [the dealer] fabricated any of the trades. The parties to the trades did not represent their legal rights and obligations to the Minister any differently than the way they themselves understood them. Neither of the counterparties sought to deceive anyone.

While the evidence demonstrated that the straddle trading had no business purpose, following a review of the jurisprudence, Justice Spiro held that there is no business purpose test in Canadian tax law and that a lack of a business purpose is not a sham. Further, Justice Spiro rejected the Crown’s argument that the judicial anti-avoidance doctrine of ‘window dressing’ exists in Canadian tax law.

Ineffective transactions

The Minister argued that the dealer acted on behalf of Mr. Paletta and the counterparties at the same time, leading to the dealer trading with himself. The Minister argued that such self-dealing rendered the trades legally ineffective. Justice Spiro dismissed this argument, holding that the evidence proved that the dealer only ever acted as agent for Mr. Paletta and that the trades were legally effective in accordance with their terms.

Statute barred years and gross negligence penalties

Finally, Justice Spiro held that the Crown failed to prove the elements required the Minister to assess the taxpayer beyond the normal reassessment period and, as such, the tax years at issue were statute barred. Specifically, the Crown failed to prove Mr. Paletta made misrepresentations attributable to neglect, carelessness, or wilful default. Additionally, there was no evidence that Mr. Paletta knowingly, or under circumstances attributable to gross negligence, made false representations or omissions in filing his returns as required in order for the Minister to apply gross negligence penalties.

One exception was that the Crown successfully proved that Mr. Paletta substantially underestimated his income for the 2002 year by such a degree that it was attributable to his own carelessness or neglect. Justice Spiro held that his failure to report more than $8 million in gains realized in 2002 amounted to conduct tantamount to intentional acting and fell short of the expected conduct of a reasonable person. Given this finding, Justice Spiro held that the Minister appropriately assessed the 2002 year outside of the normal reassessment period and he therefore, applied gross negligence penalties.


In the end, this case turned on the Appellant’s ability to adduce evidence that effectively and wholly demolished the Minister’s assumptions. With these assumptions demolished and following the Supreme Court of Canada in Friedberg and Stewart, Justice Spiro was obliged to find for the Appellant.

Justice Spiro allowed the appeals for each of the taxation years at issue but sent the 2002 year back to the Minister to be reassessed on the basis that $8 million in gain ought to be included in Mr. Paletta’s income for that year. Overall, this is a strong decision in favour of Mr. Paletta and shows the undeniable implications where the Crown is unable to provide evidence establishing that the Minister’s assumptions were correct. Justice Spiro’s decision also furthers the growing body of case law establishing that the Crown cannot merely rely on the Minister’s assumptions when the taxpayer is able to adduce a coherent body of evidence demolishing the same.

Justice Spiro also awarded costs to the Appellant for each of the 2000, 2001, and 2003 to 2006 tax years and to the Crown for the 2002 tax year. Justice Spiro gave the parties 30 days to come to an agreement regarding costs. Should the parties fail to come to such an agreement, the parties have a further 30 days to serve and file written submissions on costs. While the quantum of costs is yet to be seen, the Appellant clearly expended great effort marshalling evidence, hiring experts, and presenting its case. In the end, the Canada Revenue Agency’s continued dispute with Mr. Paletta despite clear evidence and jurisprudence against its position is likely to come at a great cost to taxpayers.

The Crown appealed the decision in Paletta Estate on March 19, 2021 on the basis that the Tax Court erred in concluding that foreign exchange trading constituted a source of income and that the taxpayer had not made misrepresentations attributable to neglect, carelessness or wilful default nor had he made a false statement knowingly or under circumstances amounting to gross negligence. It will be interesting to see how the Crown marshals her case on appeal given that the Court’s factual findings will be entitled to deference on appeal.

We will continue to follow this case closely. If you have any questions, or would like to discuss how Justice Spiro’s decision in Paletta Estate might apply to your specific circumstances, please reach out to BLG’s Tax Group or any of the contacts listed below.

1 Justice Spiro was Crown counsel on the Friedberg Supreme Court of Canada appeal.

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