FX Straddle Trading Activity Not a Business – FCA Applies The “Pursuit Of Profit” Source Test in Paletta

1. OVERVIEW

On May 17, 2022, the Federal Court of Appeal (the “FCA”) delivered its decision in Paletta,[1] which applied the “pursuit of profit” source test in Stewart[2] (the “Stewart test”) by ruling that an activity devoted solely to tax avoidance cannot give rise to a source of income in the form of a business under the Income Tax Act[3] (Canada) (the “Act”). This is true even if the activity lacks a personal or hobby element and appears to be purely commercial in nature.

The first issue in Paletta was whether the Tax Court of Canada (the “TCC”) properly held that the forward foreign exchange (“FX”) straddle trading activities (the “straddle trades”) of the taxpayer, Mr. Paletta, constituted a business under the Act.[4] If not, the second issue was whether the Canada Revenue Agency (the “CRA”) could reassess Mr. Paletta for years beyond the normal reassessment period under subparagraph 152(4)(a)(i) and impose “gross negligence” penalties under subsection 163(2).[5] The FCA ruled that the straddle trades were not a source of income and that the CRA could open up years beyond the normal reassessment period and assess gross negligence penalties.[6]

2. FACTS

During his 2000 through 2007 taxation years, Mr. Paletta generated a total of $38 million in income.[7] The straddle trades generated losses of $37 million, which Mr. Paletta sought to deduct as business losses.[8]

The straddle trades involved Mr. Paletta “entering into pairs of contracts with certain brokerage firms to simultaneously purchase and sell the same amount of foreign currency at different but closely proximate dates in the future.”[9] As FX rates fluctuated, one contract would accrue unrealized gains while the other would accrue unrealized losses of virtually the same magnitude as the gains.[10] In order to offset his income from other sources, Mr. Paletta would realize the losses just before the end of the taxation year, while the gains would be realized in the following taxation year.[11] The volume of the straddle trade was increased each year so that the newly realized losses would offset not only the realized gains but also Mr. Paletta’s income from other sources, hence enabling him to defer tax liability “indefinitely.”[12]