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Lesson from the FCA’s Decision in Paletta: Seek a Legal Opinion to Obtain Sound Advice – Don’t Rely on Informal Communications

As was stated by Alexander Pope in his poem An Essay on Criticism composed in 1709, “A little learning is a dangerous thing”.

In the Federal Court of Appeal’s reasons for judgment in its recent decision in Canada v. Paletta,[1] the taxpayer intended to embark on forward foreign currency trading on a large scale in a manner that – he thought – could defer his taxable income for many years. After having been cautioned by his traditional accounting advisor to obtain legal advice before embarking on this plan, the taxpayer held informal discussions with various reputable tax lawyers. However, the taxpayer did not seek any formal written legal opinion from any of them, and when discussing his proposed plan with those tax lawyers he had not provided them with the necessary background information to properly assess the taxpayer’s actual circumstances. Consequently, the favorable verbal feedback obtained by the taxpayer from his informal discussions with those tax lawyers to whom he failed to disclose essential details of his proposed plan (i.e. a “little learning”) turned into “a dangerous thing”!

The process of obtaining comprehensive legal or accounting advice on the tax consequences of a proposed transaction involves a taxpayer disclosing all relevant details of that proposed transaction to his lawyer or accounting tax advisor. Typically, the tax advisor will then research the law applicable to the proposed transaction, consider how the law (often including the general anti-avoidance rule in section 245 of the Income Tax Act (the “Act”)) should apply to the proposed transaction, weigh the likelihood of the proposed transaction producing the tax consequences desired by the taxpayer and deliver a written opinion to the taxpayer. That process often requires the tax advisor, who knows what “red flags” to look out for, to question his or her taxpayer client about important details underlying the proposed transaction. In this way, the process of seeking a written tax opinion should identify all requirements that will need to be met in order for the proposed transaction to achieve the taxpayer’s objectives, including the optimum manner of implementing that transaction. That process also should identify any incorrect assumptions that the taxpayer has made (often pertaining to such matters as the accounting treatment that should result from completing the proposed transaction, the prescribed tax forms that should be filed with the Canada Revenue Agency (the “CRA”), books and records that should be maintained and the specific contracts or other documentation that should be prepared and executed by the parties to the proposed transaction).

Making an incorrect assumption about a legal principle on which a proposed transaction is grounded can be fatal to its success.  In the Paletta case, a fatal incorrect assumption was made (namely, that certain decisions of the Supreme Court of Canada supported the position that the taxpayer’s trading in foreign currency futures constituted a “source” of income – namely, a “business” – despite the absence of the taxpayer having an intention to earn a profit from those trading activities) that proved extraordinarily costly for that taxpayer. The Federal Court of Appeal expressed the view that this incorrect assumption likely would have been identified if the taxpayer had sought a legal opinion before proceeding with his proposed transaction.

 

Background

The background of that case is that over several years, the taxpayer entered into annual pairs of foreign currency purchase and sale contracts the sole purpose of which was to realize a loss at the end of a particular current taxation year and a roughly equal amount of gain at the beginning of the next succeeding taxation year. Specifically, each loss was designed to offset the total of any foreign currency gain realized at the end of the preceding year together with the amount of other sources of income earned by the taxpayer during the current year that was about to end. An offsetting approximately equivalent amount of gain would be realized by the taxpayer at the commencement of the next succeeding year.  A crucial finding of fact in this case is that the taxpayer had no intention to derive any net profit from these foreign currency purchase and sale transactions.

The taxpayer deducted all the losses he sustained from his foreign currency trading activities – claiming that they constituted business losses. The CRA reassessed the taxpayer for all years denying him a deduction for the losses and imposing gross negligence penalties under subsection 163(2).

 

Decision of the Tax Court of Canada

The Tax Court of Canada upheld the taxpayer’s argument, stating that it was required to follow the Supreme Court of Canada’s decisions in Stewart v. Canada[2], Walls v. Canada[3] and Friedberg[4].

The Tax Court Justice had interpreted Stewart and Walls as holding that if a taxpayer is engaged in commercial activities with no personal element, then the taxpayer had earned income from a “source” that was a “business”, regardless of whether or not he had an intention to earn any net profit therefrom.

 

Decision of the Federal Court of Appeal

The Federal Court of Appeal, however, overturned the Tax Court’s decision, with Justice Noël making the following forceful comments (underlining added by me):

38 This reading is incompatible with what the Supreme Court actually said in Stewart.  Not only did Stewart not oblige the Tax Court to hold that there was a source of income in these circumstances, but it required the Tax Court to come to the opposite conclusion. In Stewart, the Supreme Court made it clear that the test being devised was consistent with the traditional common law definition of “business”. The word “business” is given an inclusive and expansive meaning under the Act (subsection 248(1)), but is left otherwise undefined.  As in such circumstances, the private law—the common law on the facts of Stewart — fills the gap, the Supreme Court explained that the Stewart test gave effect to the common law definition of “business” (Stewart, para. 51):

Equating “source of income” with an activity undertaken “in pursuit of profit” accords with the traditional common law definition of “business”, i.e., “anything which occupies the time and attention and labour of a man for the purpose of profit”: Smith, supra, at p. 258; Terminal Dock, supra….

39 Yet, the Tax Court read Stewart as requiring it to equate “source of income” with an activity that is not undertaken in “pursuit of profit” and to provide for a result that conflicts, rather than accords, with the common law definition of “business”. This turns Stewart on its head. Contrary to what the Tax Court believed, it could not hold that Mr. Paletta was engaged in a commercial activity in the face of evidence establishing that he had no intention to profit. The objective of the Stewart test, which was to reaffirm “pursuit of profit” as the decisive consideration in ascertaining the existence of a business, precludes the possibility that this test could be construed so as to require the recognition of a business in the face of evidence that establishes that profits are not being pursued.

…..

44 The purpose of the exercise in Walls was to highlight the failings of the REOP test and show the contrasting result obtained under the Stewart test. Applying the Stewart test, the Supreme Court held that the operation was a commercial activity, a conclusion that could only be reached if the evidence was consistent with the partners’ claim that they intended to profit from this activity.

In discussing the Friedberg case, the Federal Court of Appeal in the Paletta case stated as follows:

55 The Tax Court pointed to Friedberg as the other Supreme Court decision that obliged it to hold that Mr. Paletta had a source of income despite the fact that he had no intention to profit (Reasons, paras. 10 and 271). Mr. Friedberg was engaged in the gold futures trading business. The only issue before the Supreme Court was whether Mr. Friedberg had to report his gains from that source using the mark-to-market method rather than the realization method.

The Federal Court of Appeal in the Paletta case went on to point out that the gold futures trading plan that was utilized by Mr. Friedberg enabled him, by adopting the realization method of computing his gains and losses, to decrease his tax burden by realizing the loss in the first year and the matching gain in the subsequent year, the same way as Mr. Paletta did. Both the Federal Court of Appeal and the Supreme Court of Canada in the Friedberg case concluded that Mr. Friedberg had reported his losses and gains when they actually occurred and that it was open to him to report his income using whichever of the mark-to-market or realization method he chose.

Moreover, the Federal Court of Appeal in the Paletta case disagreed with the interpretation of the Tax Court Justice in that case that the approach utilized by Mr. Paletta was essentially the same tax plan as had been used by Mr. Friedberg – asserting that whereas Mr Friedberg had intended to profit from his trading activities (stating that Mr. Friedberg traded in gold futures “primarily to earn profits from his speculation”), Mr. Paletta had no such intention to earn a profit.

 

Imposition of Gross Negligence Penalties

The “little learning is a dangerous thing” aspect of the Paletta case arises in the context of the CRA’s havingimposed gross negligence penalties on Mr. Paletta under subsection 163(2) of the Act. It is this part of the reasons for judgment of Justice Noël in which the importance of a taxpayer not relying on informal verbal communications from tax counsel arising from “off the cuff” consultations is emphasized.

The foreign exchange trading plan had been brought to Mr. Paletta by Messrs. Wiseman and Moore, respectively relationship partner and tax partner with Mr. Paletta’s long-time firm of accounting advisors. Mr. Wiseman believed that Mr. Paletta’s situation might be different from that in Friedberg because Mr. Friedberg was involved in commodities as a dealer.  He therefore recommended that Mr. Paletta obtain legal advice before embarking on the plan.

Below are relevant excerpts from the reasons for judgment of Justice Noël in Paletta (underlining added by me):

66 In contrast, subsection 163(2) requires that the false statement be made knowingly or in circumstances amounting to gross negligence.

…..

76 In late September 2001, Mr. Wiseman renewed his warning about the plan during a meeting with Mr. Paletta and his son.  He was aware that Mr. Paletta had already spoken to a tax lawyer about the validity of his plan, subsequent to his initial advice, but “strongly recommend[ed]” that another legal opinion be obtained. Mr. Wiseman gave this advice in the presence of Mr. Moore and papered it in a letter that had annexed to it the CRA’s formal warning on the use of tax shelters (Letter dated October 5, 2011 from Stephen R. Wiseman: Appeal Book, Vol. 11, pp. 3717-3723).  This formal warning specified that the CRA will no longer issue rulings on the fundamental question whether a business exists when dealing with tax shelter arrangements, the very issue with which Mr. Paletta was confronted.

77 Despite these warnings, Mr. Paletta and his son did not see fit to obtain a formal legal opinion.  Angelo Paletta explained that the monetary exposure resulting from the plan was minimal. Rather, they relied on the verbal advice obtained during what can fairly be described as three “off the cuff” consultations with different tax lawyers while visiting law firms on other matters.

78 The first encounter took place mid-2000 before trading started and the last in the summer or fall of 2001, after Stephen Wiseman’s renewed advice to obtain another legal opinion. The Estate[5] offers these encounters as a demonstration that Mr. Paletta acted as a reasonably prudent person would.

79 The first tax lawyer consulted was John Tobin of Borden & Elliot LLP, in Toronto.  Based on the Tax Court’s account of the meeting, Mr. Tobin, after mentioning the Friedberg case, confirmed that the plan was legitimate. According to the Tax Court, this was the first time that Mr. Paletta and his son heard of the Friedberg case (Reasons, para. 62).

80 The Tax Court’s assessment of what took place during the meeting is not consistent with the evidence on this narrow point.  As noted earlier, Friedberg

had been brought to the attention of the Palettas when the plan was first presented to them (Transcript of the Cross-examination of Stephen Wiseman: Appeal Book, Vol. 23, p. 8203). In addition, Angelo Paletta was cross-examined about the precise circumstances in which the Friedberg case came up during his conversation with John Tobin.  This is how the exchange went (Appeal Book, Vol. 22, p. 8012):

Q: Well, I put it to you, Sir, that you put into Mr. Tobin’s head in your discussions with him that it was comparable to the Friedberg case, the trades that you were going to do, correct?

A: Yes.

81 Immediately after this exchange, Angelo Paletta was asked about the question that he put to Jack Bernstein of Aird & Berlis LLP during their verbal consultation in the summer or fall of 2001 (ibid., p. 8013):

Q: And you asked Mr. Bernstein a similar question, correct?

A: Yes.

82 The other encounter took place towards the end of 2000. Mr. Paletta and his son met with Jim Love of Love & Whalen while visiting him on other tax matters. Like Messrs. Tobin and Bernstein, Mr. Love confirmed that the plan was fine after mentioning Friedberg as the leading case (Reasons, para. 63).

83 The evidence suggests that in all three cases, Mr. Paletta and his son presented the plan as not being materially different from the one that was in issue in Friedberg. Not surprisingly, all three lawyers expressed the view that the plan was legally sound on the basis that Friedberg remained good law. However, as explained earlier, the facts in Friedberg were fundamentally different as Mr. Friedberg was conducting his trading activities for profit whereas Mr. Paletta’s sole purpose was tax avoidance.  Had this fundamental difference been brought to the attention of the tax lawyers, a discussion about the source issue and the relevant case law would necessarily have ensued and a red flag would have been waved. When regard is had to the common law definition of “business” and the binding and plain common sense rule set out in Moloney (see para. 61 above),[6] no minimally competent tax lawyer could have sanctioned Mr. Paletta’s plan to portray his trades as a business, if informed that he was making these trades not for profit but for the sole purpose of generating tax losses in order to avoid paying taxes.

84 Had a formal opinion been obtained, all material facts would have been disclosed with the result that the source issue would not have gone unnoticed. Angelo Paletta’s claim that the financial exposure involved in the trading did not justify obtaining a formal opinion is not rationally acceptable. The financial exposure resulting from the interest rate differential was indeed minimal, but the tax exposure resulting from the ongoing use that was to be made of the plan was in the millions of dollars at his personal level, and much more if the exposure for the two corporations that participated in the same plan is taken into account. This tax exposure had to be at the forefront of Mr. Paletta’s mind since reducing his tax burden was the only reason why he traded during the seven-year period. The other explanation for not seeking a formal legal opinion—i.e., that Mr. Paletta trusted lawyers at their word or on a handshake—is no more rational given the high risk that was flagged by his accountants as to the validity of the plan and again, the multi-million dollar tax exposure.

85 The question that must be asked in the circumstances is why would a knowledgeable business person in the position of Mr. Paletta not cover the risk to which he was exposed by obtaining a formal opinion? The only answer that comes to mind is that Mr. Paletta was indifferent or wilfully blind to whether his plan complied with the law or not and was content to assume the risk.

86 The Estate also relies on various legal opinions obtained from his brokers during the course of trading.  These opinions were not addressed to Mr. Paletta, and according to his son, neither he nor Mr. Paletta read them. That said, they both understood that the opinions supported their view that the plan was legally sound.

87 The first opinion is from Fraser Milner Casgrain LLP and is addressed to a promoter of the forward FX trading strategy.  The opinion was issued in December of 2002 and confirms the legal validity of the strategy. However, the opinion is given on the premise that the persons who will take up the strategy will do so “for the primary or secondary purpose of gaining and producing income” (see paras. 3.5, 4.5.9 and 4.5.10: Appeal Book, Vol. 11, pp. 3727 and 3741). As such, this opinion could have brought no comfort to Mr. Paletta.  On the contrary, it points to the fundamental flaw underlying his plan.

The point being made by Justice Noël is summarized as follows toward the end of his reasons:

92 Mr. Paletta and his son were warned that the tax shelter plan they were contemplating could be problematic.  Both knew from the beginning that the sole purpose behind the plan was tax avoidance. Rather than addressing the risk head on by obtaining a formal legal opinion, Mr. Paletta chose to ignore it. This behaviour shows at the very least that Mr. Paletta was indifferent or wilfully blind to the legal validity of his plan and that he was only concerned about fulfilling his desire to pay no tax.

93 The Crown has succeeded in demonstrating that Mr. Paletta was grossly negligent in portraying his trading losses as business losses even though they were not. I therefore find that the penalty set out in subsection 163(2) of the Act was properly assessed.

 

Conclusion

The reasons for judgment of the Federal Court of Appeal in the Paletta case highlight the danger in a taxpayer who is about to embark on a significant transaction assuming that he or she comprehends the legal requirements underlying the extreme complexity of the many interwoven provisions of the Income Tax Act. A seemingly straightforward concept such as “business” can have subtle, intricate and crucial underlying ramifications for purposes of the Act.

Experienced taxpayers are well aware of the importance of obtaining written advice from an experienced tax accountant or lawyer before undertaking a significant transaction. Cases like Paletta demonstrate the devastating consequences that can befall a person who embark on a substantial transaction without having obtained comprehensive tax advice.

[1]  2022 FCA 86.

[2]  2002 SCC 46.

[3]  2002 SCC 47.

[4]  [1993] 4 S.C.R. 285.

[5]  Mr. Paletta died a few months before his appeal to the Tax Court of Canada was heard, and his appeal was continued by his estate.

[6]  Maloney v. R., 92 D.T.C. 6570 (FCA), held that an activity that is motivated solely by the avoidance of a person’s tax cannot be regarded as a “source” of income for purposes of the Act.