Jeremy Scott Tax Law

Jeremy Scott Tax Law | The Queen Vs. Paletta — Understanding The Source Of Income Test

A historic case for the Canada Revenue Agency (CRA) concluded earlier this year: the Queen vs. Paletta. This case reassessed the decision of the Tax Court of Canada regarding the taxation of Mr. Pasquale Paletta (named in the case as the Taxpayer). The Paletta estate and Canada’s source of income test are excellent examples of just how complex tax rules can be, particularly if you are considering engaging in unusual activities. For support managing your own taxes, and to ensure your legal and financial rights are protected, contact Jeremy Scott Law at (902) 403-7201.

Understanding the Background of The Queen vs. Paletta Case

The Queen vs. Paletta was an appeal of Reassessments of  Mr. Paletta’s taxation years from 2000 to 2007. Since the Taxpayer died a few months before his case was heard, his estate continued the appeal.

The practice under scrutiny was that of entering into pairs of contracts for foreign currency. This practice allowed Mr. Paletta to simultaneously buy and sell the same amounts of currency. He purchased the pairs of contracts with slightly different dates in the near future. As one contract gained, the other resulted in a loss. The taxpayer would then close the contract that was in the loss position at the end of the year, but he would only close the one that had gained at the start of the next year. This ultimately enabled him to generate $38 million in income and claim $37 million in losses for tax purposes between the aforementioned years.

Determinations in The Queen vs. Paletta Case

The CRA issued a reassessment in 2014. The government agency determined that these trading losses from the 2000 to 2006 taxation years as well as the loss carry-over for the tax year of 2007 of losses for prior years should be denied. The Tax Court of Canada found that Mr. Paletta was not straddling transactions from profits, but it did find that the Taxpayer intended to use trades to realize immediate losses and defer gains indefinitely for tax purposes. For these reasons, the Tax Court of Canada ruled that Mr. Paletta’s trades formed a business, which resulted in an income.

However, this was not the end of the case. On May 17, 2022, the CRA appealed to the Federal Court of Appeal (FCA). Ultimately, the FCA sided with the CRA, unanimously overturning the decision of the Tax Court of Canada.

The Dangers of Engaging in Such Strategies

An accounting advisor recommended that Mr. Paletta seek legal counsel before engaging in his foreign currency contracts strategy. However, the taxpayer failed to ever receive a formal legal opinion. In addition, he never provided his tax lawyers with adequate information for them to evaluate the plan — the only feedback he received was from informal conversations.

Had Mr. Paletta gained informed legal advice on the possible consequences for his tax practices, he could have designed a strategy that took into consideration the general anti-avoidance rule in section 245 of the Income Tax Act. His lawyer would have been able to provide him with a written opinion about the chances that the strategy he wished to undertake would lead to his desired outcome. You can receive a written opinion on any transactions you are considering from a tax advisor at Jeremy Scott Law.

The Legal Tax Issues in Question

There were two issues that caused the CRA to bring the Paletta case to the FCA.

The first issue was to consider whether the Tax Court of Canada was correct in its ruling when it declared that Mr. Paletta formed a business through trades and therefore created a source of income.

The second issue was contingent upon whether the ruling was indeed correct. If it was incorrect, the question arose as to whether the Income Tax Act granted the CRA the right to reassess earlier tax years and apply gross negligent penalties. The years being analyzed fell outside the normal reassessment period, which (for individuals) is three years from the date of the original assessment, as stated in subsection 152(3.1) of the Income Tax Act.

The Paletta Estate and Canada’s Source of Income Test

To arrive at a decision in the Paletta case, the FCA used Canada’s source of income test. This is a pursuit of profit source test based on Stewart vs. Canada — for this reason, it is often simply called the Stewart test. In Stewart vs. Canada, the Supreme Court of Canada (SCC) ruled that when a taxpayer engages in an activity exclusively for tax avoidance reasons, the activity cannot be said to be forming a business to provide a source of income. This applies even in situations when the activity is not a hobby, lacks a personal element, and appears solely commercial. The FCA ruled that, based on this definition, Paletta’s straddle trades could not be classified as a source of income.

The Paletta estate, however, argued that when an activity is intended to reduce taxes, it becomes a business under the Income Tax Act. The estate based this claim on the SCC’s decision in Walls vs. Canada. However, the FCA determined that the activities in the Walls case were not purely for tax reasons, meaning a business did exist. Since the activities in the Paletta case were purely for tax avoidance, there was no business.

The FCA also ruled that the CRA would be allowed to return to the years outside the normal reassessment period to evaluate potential gross negligent penalties. This was allowed because Mr. Paletta was found to be engaged in conduct that fell considerably below what one would expect from a reasonable person.

Visit with an Experienced Canadian Tax Attorney Today

Mr. Paletta was deemed to have made a misrepresentation through his tax avoidance activities — and he should have known better. In particular, the FCA discovered that the taxpayer and his son continued to go ahead with their strategy even after being warned that it could lead to legal problems. As an experienced business professional, choosing to ignore this risk meant that Mr. Paletta was grossly negligent. If you have any questions about your own taxes after learning about the Paletta estate and Canada’s source of income test, contact Jeremy Scott Tax Law at (902) 403-7201.