All About Estates

Business purpose, source of income, and sham gets a thorough review

In a recent court case (Paletta Estate v. The Queen) the estate successfully appealed that it was entitled to $55 million in losses in the 2000 to 2006 taxation years generated through forward foreign exchange trading.

The estate purchased straddled forward foreign exchange contracts – one long and one short. The taxpayer closed the loss leg of the straddle before the end of the year (realizing a loss in the year) and closed the gain leg of the straddle early in the following year (recognizing the gain in the subsequent year). The taxpayer followed the same process year over year, using the loss leg of the straddle to shelter virtually all income earned in the year, including the gains from the straddle closed at the beginning of the year. The taxpayer followed this process for seven years, resulting in $55 million of losses.

The Minister disallowed the losses and advanced several arguments to support the disallowance of the losses, including that (i) the straddle transactions were not a source of income because there was no business purposes and (ii) the arrangement was a sham. The TCC found that the taxpayer purchased the straddles to incur tax losses in an amount that would be sufficient to offset the income earned in the year, but the absence of a business purposes did not lead to a finding that the straddles were not a source of income. Following the SCC’s decision in Stewart v. Canada, because forward foreign exchange trading is a commercial activity, it is a source of income notwithstanding the tax motivation. Moreover, the TCC dismissed the Minister’s sham argument on the basis that there was nothing false or misleading about the trades and that none of the parties sought to deceive anyone.

As a separate issue, the TCC held that the taxpayer underreported approximately $8M of income in the 2002 taxation year when the taxpayer failed to include the gain leg of the straddle transaction, and upheld the Minister’s assessment of gross-negligence penalties in respect of this income.

About Derek de Gannes
Derek A. de Gannes: Senior Director, Private Client Services of RSM Canada. RSM Canada is committed to the highest level of integrity, quality and professionalism and provides clients with solutions in the area of Audit, Tax and Transaction Services. Email: derek.degannes@rsmcanada.com

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