These were beautifully written reasons leading to a despicable decision. Unfortunately, it seems legally right.
The gist of the scheme was to trade in currency futures contracts in a way that involves minimal risk, because the currencies would be sold and bought so as to “hedge” any risk. The schemes are called “straddles” because you cancel (“close”) the contract with the loss in your current tax year but you don’t cancel the contract with the gain until the following year. So you get the loss to reduce your current year taxes but you don’t report the gain until the next year when you run the scheme again to eliminate the earlier gain and any further income you’ve earned during the new year. The schemes allow wealthy taxpayers to defer payment of tax for many years.
Straddle schemes were approved by the Supreme Court of Canada in Friedberg, [1993] 4 S.C.R. 285. So it was hard for the Crown in this case to hold the position that claiming losses in one year but the corresponding gain in the next year is not proper for tax purposes.
Interestingly, on Friedberg, David Spiro was one of the three counsel representing the Crown at the Supreme Court. So he would certainly have no reason to be a friend of the decision. But as he notes, Finance and the various governments of the day over 25 years failed to do anything to shut the schemes down. They did eventually change the law, in 2017, but these transactions in Paletta covered years 2000 through 2007 to which the 2017 changes did not apply. Arguably, that Government delay is where the fault really lies for the decision in Paletta.
Although there were more elements to the Crown’s case, the one that seems to have the most body to it for appeal to the Federal Court of Appeal is the argument that there was no source of income. If there was no source of business income, there could be no claim to deductible losses.
The source of business income argument has to confront the Supreme Court of Canada decision in Stewart v. Canada, 2002 SCC 46. Justice Spiro gives the essence of Stewart at para 201:
“The most important teaching of Stewart for present purposes is this: provided that one’s activity is clearly commercial, and that no personal element is involved, there is a source of income.”
He also refers to the companion decision “Walls v Canada, 2002 SCC 47, [2002] 2 SCR 684, where the Court made clear that the Stewart test applies even if the activity in question was entirely tax motivated.” [202]
Justice Spiro’s analysis of Stewart and Walls seems right. It is hard to understand what honour the Supreme Court thought it had achieved by upholding schemes the purpose of which was purely to produce tax losses and consequently had no profit motive or business purpose apart from lowering tax payable. In the Walls case, a limited partnership scam seems clearly to have been conceived in a way that could produce no possible profit for the investors — apart from allowing them to reduce their income taxes. Yet the SCC endorsed it.
In explaining its reasons in Stewart, the SCC says: “Where the nature of an activity is clearly commercial, there is no need to analyze the taxpayer’s business decisions. Such endeavours necessarily involve the pursuit of profit.”
By contrast, the thinking is that where there is a personal element, the taxpayer is getting something from the activity aside from economic advantage, some pleasure that has no readily quantifiable economic value. The person might engage in the activity even though it loses money because it gives him something else.
But why shouldn’t we say the same thing where the only economic value a person can achieve from his undertaking is a reduction in his tax payable? Why is that not as much a “personal element” as a hobby? In neither case is the nature of the activity “clearly commercial” if the test is pursuit of profit.
Throughout his factual discussion, Justice Spiro concluded that “[t]he only purpose of his trading was tax avoidance.” [142] “There can be no doubt but that the straddle trading had no business purpose. Its only purpose was to allow Mr. Pat Paletta to claim non-capital losses that he could use to offset his taxable income each year.” [227]
How can an activity the only purpose of which is to eliminate tax payable constitute a source of income? Income for tax purposes is determined, obviously, before one calculates tax payable. Tax payable can’t be included in your business income; otherwise there would be an impossibly circular calculation each year for people.
Nonetheless, Justice Spiro was not the person to remedy this problem. In a fine conclusion he betrays his own feeling on the result that allowed Mr. Paletta to earn $38 million over eight years, while paying tax on only $1 million of income (para 100):
“‘We have to apply constitutionally valid statutes as they are written, and we have to follow binding precedents that pertain to the dispute before us, even if we do not like the result the authorities prescribe.'” [271]
Justice Spiro’s decision was reversed by the Federal Court of Appeal in Canada v. Paletta, 2022 FCA 86 (reasons given by the Chief Justice, Noel). The FCA said that Spiro J. misread Stewart, that the decision requires a pursuit of profit, which Justice Spiro had concluded Mr. Paletta did not have. (See e.g., FCA paras. 38-39.) The FCA also found that Spiro J. misread Walls. In Walls, the FCA showed there was a tax motivation but there was also a profit motive. [47, 50]