Paletta — Forward FX straddle plan “not a sham” says TCC
Paletta — Forward FX straddle plan “not a sham” says TC
The TCC allowed a taxpayer’s pre-2017 non-capital losses from forward FX straddle trading
In Paletta Estate v. The Queen (2021 TCC 11), the Tax Court of Canada (TCC) found that the taxpayer's forward foreign exchange straddle activities were not a sham, and constituted a source of income from a commercial activity. As a result, the TCC reversed the CRA's reassessments, and allowed the taxpayer's non-capital losses from these transactions over an eight-year period from 2000 to 2007. Justice Spiro of the TCC noted the significance of the Supreme Court of Canada's (SCC) decision in Friedberg v. The Queen ( 4 S.C.R. 285), in which the SCC allowed the taxpayer's losses in what was essentially the same tax plan to realize losses in one taxation year and defer the related gain until the subsequent taxation year.
Although the TCC acknowledged that legislative amendments in 2017 may override the Friedberg decision, the TCC noted that these amendments did not apply retroactively or retrospectively and do not allow the CRA to reassess pre-2017 taxation years ignoring Friedberg.
KPMG Law acted as counsel for the taxpayer in this case.
Generally, a straddle is a transaction in which a taxpayer concurrently enters into two (or more) positions (e.g., forward foreign exchange contracts) that are expected to generate equal and offsetting gains and losses. In a basic straddle transaction, the taxpayer disposes of the position with the accrued loss to realize that loss shortly before its taxation year-end. Then, shortly after the beginning of the following year, the taxpayer disposes of the other position to realize the accrued gain. Prior to legislative amendments introduced in 2017, the taxpayer could generally use the loss to offset its other income, while deferring the recognition of the offsetting gain until the following taxation year.
Finance announced specific anti-avoidance rules that targeted straddle transactions using derivatives traded on income account in the 2017 federal budget (subsections 18(17) to (23) of the Act). Specifically, these rules defer the realization of any loss on the disposition of a position to the extent of any unrealized gain on an offsetting position, subject to certain exceptions. These anti-avoidance rules apply to losses realized on a position entered into on or after March 22, 2017.
The facts have been simplified for purposes of this article.
In early 2000, the taxpayer, Mr. P, entered into a tax plan designed to generate non-capital losses through forward foreign exchange trading (the trading plan). Each year, Mr. P generated a target loss amount, and claimed this amount as a non-capital loss on his tax return. As a result, he claimed net losses of approximately $49 million to significantly reduce his taxable income for the 2000 to 2007 tax years.
Mr. P followed this trading plan, under which he entered into a set of forward foreign exchange contracts, one long (under which he agreed to buy a particular currency at a future date) and the other short (under which he agreed to sell the same currency on a future date). Under this plan, Mr. P realized a series of gains (the gain legs) and losses (the loss legs) that almost offset each other. Mr. P would recognize the losses in one tax year, and defer the offsetting gains to the following tax year. Essentially, there were three elements to the trading plan:
- Before year-end, Mr. P closed out the loss legs to realize the target loss for the year
- Shortly after the start of the next tax year, Mr. P closed out and realized the corresponding gain legs (and included those gains as income for that tax year)
- The target loss for the next tax year needed to be large enough to shelter:
- Mr. P's anticipated taxable income for that year
- The gain legs realized earlier in the year (from the previous year's trading cycle).
In 2014, the CRA reassessed Mr. P's 2000 to 2007 tax years and disallowed all of the losses claimed on the basis that Mr. P's trading transactions were a sham. The CRA claimed it was justified in reassessing beyond Mr. P's normal reassessment period for each tax year, because there were misrepresentations on his tax returns attributable to neglect, carelessness or willful default in claiming the losses.
The CRA also assessed Mr. P for penalties for the 2000 to 2006 tax years under the gross negligence provisions.
At issue was whether the CRA was justified in reassessing the statute-barred tax years in question, and denying the losses claimed, on the basis that Mr. P's trading plan was a sham and that Mr. P did not have a "source of income" from which to deduct the losses. Separately, at issue was whether Mr. P was subject to gross negligence penalties for any of the 2000 to 2006 tax years.
The CRA's primary argument was that Mr. P's trading plan was not a business because his motive was to generate tax losses. Therefore, the CRA's view was that Mr. P's incurred losses were not a result of carrying on a business and Mr. P did not have a source of income against which to deduct the losses. The CRA also argued that Mr. P assumed no risk in his trading plan, and that there needs to be an element of risk associated with carrying on a business. The CRA also noted that, even during periods where Mr. P had a negative balance in his trading account, his brokerage firm did not make a margin call.
The CRA also argued that Mr. P's contracts and positions were shams. Alternatively, the CRA argued that, if the trading plan was not considered a "sham", it should be considered "window dressing" as the plan was designed to generate losses while conveying the impression that Mr. P was carrying on a for-profit business.
In addressing whether it could assess Mr. P's statute-barred years, the CRA argued that Mr. P knew that the trading losses were a sham. Therefore, the CRA said it was justified in reassessing these years and gross negligence penalties should apply. The CRA further argued that even though accounting professionals prepared Mr. P's returns, he should have made inquiries to third parties.
In addressing the commerciality of his trading plan, Mr. P argued that there was no personal element to the plan, and always a slight difference between the loss leg's value and the gain leg's value. Therefore, there was always a possibility of profit and risk of loss from the straddle trade. Mr. P pointed to Stewart v. Canada (2002 SCC 46) to support his view, which provided that when an activity is clearly commercial and no personal element is involved, there is a source of income.
Mr. P also argued that his trading plan was not a sham and that the transactions were legally effective. Mr. P argued that his trading plan followed the same planning used in Friedberg v Canada (1993 4 SCR 285). In Friedberg, the Supreme Court of Canada (SCC) ruled that closing out a straddle transaction's loss leg in one year is not diminished by the value of any related gain leg not closed out in the same year. Mr. P also argued that the tax years in question (2000-2007) were before the anti-avoidance rules on straddle transactions were enacted.
Mr. P further argued that the CRA could not open the statute-barred years because he was not negligent or careless and relied on his accountants to prepare his tax returns and properly report the transactions.
The TCC held that Mr. P's trading plan did not constitute a sham or window dressing, and the trading plan constituted commercial activity, dismissing the CRA's arguments. The TCC also found that, with the exception of the 2002 taxation year where Mr. P failed to include the gain leg of his transaction in income, Mr. P had not made misrepresentations in his tax returns attributable to neglect, carelessness or willful default, and the CRA could not open those statute-barred years or assess gross negligence penalties.
The TCC relied on jurisprudence in its decision, and found that Mr. P's trading transactions were a source of income under the principles in Stewart. Specifically, the TCC noted that forward foreign exchange trading is, by its very nature a commercial activity, and that there would always be a positive or negative difference between the value of the loss leg and value of the gain leg at any particular time. Further, the TCC found that there was no personal or hobby element involved in Mr. P's trading transactions. The TCC also noted Walls v. Canada (2002 SCC 47), in which the SCC concluded that the principles in Stewart apply, even if the activity is entirely tax motivated and not in the form of carrying on a business. The TCC also concluded that the anti-avoidance rules introduced in 2017 to target straddle transactions cannot retroactively override the SCC decision in Friedberg. Therefore, the TCC said that the CRA could not reassess pre-2017 taxation years as though Friedberg "had never been decided".
In rejecting the CRA's arguments, the TCC stated that the CRA's position that Mr. P's transactions were a sham or window dressing reflects a "fundamental misunderstanding of forward foreign exchange trading and the role of margin in such trading". The TCC also noted that where the amount of risk is negligible, the amount of margin should be negligible as well, and dismissed the CRA's argument that the low margins support a sham trading scheme.
Finally, the TCC found that there were no misrepresentations attributable to neglect, carelessness or willful default on Mr. P's returns for all years in question (except for the missing gain leg in 2002).
Note: Any discussion or description of the facts of the case or the positions argued by the parties is based solely on publicly available information. For greater certainty, no confidential client or taxpayer information is disclosed.
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