THE ESTATE OF PASQUALE PALETTA, Appellant, v. HER MAJESTY THE QUEEN,, 2021 TCC 11

Docket: 2015-2662(IT)G BETWEEN: THE ESTATE OF PASQUALE PALETTA, Appellant, and HER MAJESTY THE QUEEN, Respondent . Appeal heard on August 20 and 21, November 12, 13, 14, 18, 19, 20, 21, 25, 26, 27 and 28, December 2 and 3, 2019 at Toronto, Ontario and March 11, 12, and 13, 2020 at Ottawa, Ontario and written representations received on July 30 and 31, 2020 Before: The Honourable Justice David E. Spiro Appearances : Counsel for the Appellant: Justin Kutyan and Kelly Ng Counsel for the Respondent: Suzanie Chua, Rana El-Khoury and Dina Elleithy JUDGMENT 1.

The appeals for the 2000, 2001, 2003, 2004, 2005, 2006, and 2007 taxation years are allowed, with costs to the Appellant, and the reassessments for those taxation years are vacated. 2. The appeal for the 2002 taxation year is allowed, with costs to the Respondent, and the reassessment for that taxation year is sent back to the Minister of National Revenue for reconsideration and reassessment on the basis that: (

a) the gain of $8,030,844.73 from closing out the gain legs in that year shall be taken into account in computing income in accordance with these reasons; and (

b) penalty under subsection 163(2) of the Income Tax Act (the “Act”) shall be reassessed on the basis that the understatement of income that is reasonably attributable to the false statement or omission is $8,030,844.73. 3. The parties shall have 30 days from today’s date to reach an agreement on costs, failing which the parties shall have a further 30 days to serve and file written submissions on costs. The parties shall have a further 10 days to serve and file their written responses, if any. No such submission shall exceed 10 pages in length. Signed at Ottawa, Canada, this 18th day of February 2021. “David E.

Spiro” Spiro J. Table of Contents I. Overview 1 II. The Losses at Issue 3 III. Witnesses 3 IV. Findings of Fact 4 A. Background 4

(1) The Relevant Foreign Exchange Markets 4 (

a) Over-the-Counter Market 4 (

b) Exchange-Traded Contracts 5

(2) Forwards, Options and Synthetic Forwards 5 (

a) Forwards 5 (

b) Options 6

(

c) Synthetic Forwards 6

(3) Trading on Margin 6

(4) How Forward Foreign Exchange Contracts Come to an End 9 B. The Chronology 11

(1) Mr. Pat Paletta’s Background 11

(2) Mr. Pat Paletta’s Trading Experience 11

(3) Introduction to the Promoter and the Tax Straddle 12

(4) Role of Tax Lawyers 12 (

a) Oral Consultations 12 (

b) Third-Party Opinions 13

(5) Annual Target Losses 13

(6) Fees Paid to the Promoter and the Brokerage Firms 14

(7) Mr. Angelo Paletta as Mr. Pat Paletta’s Agent 15

(8) Mr. Hodgins as Mr. Pat Paletta’s Agent 15

(9) Architecture of the Trades 16 (

a) Forward Straddle – Representative Example 16 (

i) Opening Positions 16 (ii) Modifying Positions 17 (iii) Closing Positions 19 (

b) Synthetic Forward Straddle 19 (

c) The Loss Legs and Gain Legs for Each Taxation Year 20

(10) Mr. Pat Paletta’s Knowledge of the Trading 21

(11) Review by the Canada Revenue Agency 22

(12) Change of Brokerage Firms 22

(13) The Reassessments 23 C. The $8 Million Understatement of Income for 2002 24 D. The Expert Witnesses 25

(1) The Appellant’s Experts 26 (

a) Mr. Simon Bird 26 (

b) Mr. Colin Knight 26

(2) The Crown’s Experts 26 (

a) Dr. Andrey Pavlov 26 (

b) Mr. Richard Poirier 27

(3) Observations on the Expert Reports 28 V. Positions of the Parties 29 A. The Crown’s Argument 29

(1) As Pleaded in the Amended Reply 29

(2) As Argued at Trial 30 (

a) No Source of Income 30 (

i) Tax Loss Scheme is Not a Business 30 (ii) Sham Forward Foreign Exchange Contracts and Options 30 (iii) Window Dressing 31 (iv) Facts Incompatible with the Existence of a Business 31

(3) Statute-Barred Taxation Years 32

(4) Gross Negligence Penalties 32 B. The Appellant’s Argument 33

(1) Friedberg and the Straddle Trade 33

(2) Stewart and Clear Commerciality 33

(3) Statute-Barred Taxation Years 34

(4) Gross Negligence Penalties 35 VI. Analysis 35 A. Realization of Losses for Tax Purposes 35

(1) Friedberg in the Federal Court – Trial Division (1989) 36

(2) Friedberg in the Federal Court of Appeal (1991) 37

(3) Friedberg in the Supreme Court of Canada (1993) 37

(4) Parliament’s Response to Friedberg (2017) 40 B. The Source Argument and the Stewart Decision 43 C. The Source Argument and Risk 47 D. Sham 48

(1) Lack of Business Purpose 52

(2) Customer Agreements 52

(3) Margin Amounts 53

(4) Irrevocable Letters of Credit 53

(5) Transaction Confirmations/Summaries 54

(6) Closing Out 55 E. Window Dressing 55 F. Ineffective Transactions 56 G. Statute-Barred Taxation Years 57 H. Gross Negligence Penalties 61 VII. Conclusion 66 VIII. Relief Granted 66 Citation: 2021 TCC 11 Date: 2021 0325 Docket: 2015-2662(IT)G BETWEEN: THE ESTATE OF PASQUALE PALETTA, Appellant, and HER MAJESTY THE QUEEN, Respondent. FURTHER AMENDED REASONS FOR JUDGMENT Spiro J.

I. Overview [ 1 ] With a view to deferring all or most of the tax that would otherwise have been payable by him under the Income Tax Act (the “Act”), Mr.

Pasquale ( " “Pat” " ) Paletta entered into a plan designed to generate non-capital losses through forward foreign exchange trading. [1] [ 2 ] The plan involved entering into a set of forward foreign exchange contracts, one long (agreeing to buy a particular currency on a future date) and the other short (agreeing to sell the same currency on a future date). [2] The contracts would almost exactly offset one another. [ 3 ] The contracts did not exactly offset one another because each contract had a slightly different value date (the date on which delivery of the currency was to be made), which created a small positive or negative difference at any particular time between the value of the long leg and the value of the short leg of the straddle. [ 4 ] Toward the end of each year, Mr.

Pat Paletta, in consultation with his accountants, would decide on the amount of loss that he wished to realize for income tax purposes for that year (the “target loss”). [ 5 ] Before December 31 Mr. Pat Paletta would close out the loss leg of the straddle, thereby realizing the target loss for that year. He would defer recognition of the corresponding gain leg by keeping it in place until after the beginning of the following year. [ 6 ] Early the following year, the gain leg would be closed out before its value date. The gain realized would be included in computing income for that year.

The following year the same trading pattern would be repeated but on a larger scale. Why a larger scale? Because the amount of each year’s target loss necessarily took into account the taxable income that Mr. Pat Paletta expected to receive in that year and the amount of the gain realized from closing out the gain leg carried over from the previous year. [ 7 ] In reassessing, the Minister of National Revenue (the “Minister”) assumed that the forward foreign exchange trading was a sham. On that basis, the Minister disallowed all of the losses claimed by Mr.

Pat Paletta for his 2000 to 2006 taxation years. [3] At trial, the Crown argued sham to support an overarching argument that there was no source of income against which the claimed losses could be deducted. [ 8 ] The Minister reassessed after the normal reassessment period in respect of each year. The onus was, therefore, on the Crown to prove that Mr. Pat Paletta made a misrepresentation each year in filing his return that was attributable to neglect, carelessness, or wilful default. [ 9 ] The Minister also assessed gross negligence penalties against Mr. Pat Paletta for the 2000 to 2006 taxation years.

The Crown has the onus to prove the facts necessary to sustain those penalties as well. [ 10 ] On the basis of my finding that the forward foreign exchange trading was not a sham and my obligation, as a trial judge, to follow the decisions of the Supreme Court of Canada in Friedberg [4] and Stewart , [5] the Appellant [6] must prevail in these appeals with one limited exception. [ 11 ] The exception is this: the Minister was justified in opening Mr. Pat Paletta’s 2002 taxation year as he was careless or neglectful in understating his income for that year by $8,030,844.73.

In addition, he was grossly negligent in understating his income for that year by that amount. Accordingly, the penalty under subsection 163(2) for that year should be reassessed in accordance with these reasons. [ 12 ] Two corporations owned or controlled by Mr. Pat Paletta, Tender Choice Foods Inc. and Paletta International Corporation, participated in the same plan with the same counterparties.

The Minister alleges that those corporations deducted over $150 million in losses during the period at issue. [7] Those corporations have instituted appeals as well but they have been held in abeyance pending the determination of this appeal. II. The Losses at Issue [ 13 ] Mr.

Pat Paletta claimed some $55 million in losses for his 2000 to 2006 taxation years and reported just over $6 million in profit for his 2007 taxation year, for a total of almost $49 million in net losses from forward foreign exchange trading during the period at issue: Taxation Year Claimed Losses/Gains 2000 ($6,184,460.89) 2001 ($2,150,917.06) 2002 ($10,007,726.00) 2003 ($6,198,247.76) 2004 ($4,294,300.06) 2005 [8] ($5,134,923.14) 2006 ($21,236,115.40) 2007 $6,444,216.20 Total: ($48,762,747.11) III.

Witnesses [ 14 ] In addition to four expert witnesses, whose evidence will be described below, the following lay witnesses testified at trial. I found each of them credible: Angelo Paletta Mr. Pat Paletta’s eldest son Ralph Baber Former CEO of Union PLC [9] Graham Wellesley Former CEO of IFX Ltd. and former CEO of ODL Securities Ltd. Tim Hodgins Mr. Pat Paletta’s forward foreign exchange broker Stephen Wiseman An accountant at Taylor Leibow LLP Robert Ban An accountant at Taylor Leibow LLP Stephen Kleinschmidt Former Canada Revenue Agency (“CRA”) officer

IV. Findings of Fact A. Background

(1) The Relevant Foreign Exchange Markets (

a) Over-the-Counter Market [ 15 ] Most forward foreign exchange contracts are not traded on any exchange but are entered into directly between two counterparties. This is known as the “Over-the-Counter” or “OTC” market. In this market, value dates (the date on which the terms of the contract must be fulfilled) are infinitely variable —any dates may be chosen by the counterparties—and the OTC market is always open for trading.

A forward foreign exchange contract reflects a direct contractual relationship between two counterparties. [ 16 ] The OTC market is dominated by large global banks constituting what is known as the “interbank market”. The interbank market accounts for the largest volume of forward foreign exchange trading in the world. Certain brokerage firms act as intermediaries between the large global banks and smaller entities that are not large enough to deal directly with those banks on the interbank market.

Those brokerage firms act as agents for their clients or as counterparties depending upon the needs of the particular client. The counterparties to the trades at issue were such brokerage houses. [ 17 ] All of the forward foreign exchange trading at issue occurred on the OTC market between Mr. Pat Paletta and three brokerage firms based in London, England: Union Cal Limited (or “UCAL”), IFX Ltd. (or “IFX”), and ODL Securities Ltd. (or “ODL”). [ 18 ] All of the evidence adduced is consistent with the Minister’s assumptions that: UCAL, IFX and ODL were the counter-party to the trades . . . . [10] . . .

In every forex option or forward contract transaction . . . entered into by the Appellant, UCAL/IFX/ODL was the counterparty. [11] . . .. . . UCAL/IFX/ODL was . . . the counterparty to any and all contracts that the Appellant entered into with UCAL/IFX/ODL. . . . [12] (

b) Exchange-Traded Contracts [ 19 ] Standard form futures contracts have been developed for trading on exchanges such as the London International Financial Futures and Options Exchange, the Chicago Mercantile Exchange, and the Philadelphia Stock Exchange. [13] Although they are relatively easy to trade, they offer less flexibility than one would find on the OTC market. Exchange-traded futures contracts generally offer a limited number of value dates (generally falling at the end of the month) and have identical terms and conditions. [14] Mr. Pat Paletta did not trade futures contracts on an exchange.

Instead, he traded forward foreign exchange contracts directly with the brokerage firms as his counterparties.

(2) Forwards, Options and Synthetic Forwards (

a) Forwards [ 20 ] A forward foreign exchange contract is an agreement between two counterparties to trade a fixed amount of currency at a set rate on a pre-determined value date. [15] Forward foreign exchange contracts are traded in the OTC market. They are not traded on any exchange.

The counterparties agree among themselves on the currencies, the value date, the quantity, and the exchange rate. [16] The future purchaser of a particular currency is holding a “long” position in that currency and the future seller of the particular currency is holding a “short” position in that currency. [17] In a contract such as USD/CAD, if the value of the USD rises beyond the price specified in the contract, the buyer of the USD (the holder of the “long” contract) will make a profit and the seller of the USD (the holder of the “short” contract) will suffer a corresponding loss. [18] (

b) Options [ 21 ] Options are financial instruments with strictly defined terms and conditions. One may buy (long) or sell (short) an option contract. There are two types of option contracts—calls and puts. [ 22 ] A call option gives the holder (the buyer) the right, but not the obligation, to purchase the underlying asset or instrument at a specific price (the “strike price”) on or before the option’s expiration date.

The writer or seller of the option has the obligation to sell the underlying asset to the holder if the holder chooses to exercise the option. [19] [ 23 ] A put option gives the buyer the right, but not the obligation, to sell an underlying asset or instrument at a strike price on or before the option’s expiration date. The seller of the option has the obligation to buy the asset or instrument if the holder chooses to exercise the option. [20] (

c) Synthetic Forwards [ 24 ] A synthetic forward is created by using two options to synthesize the effect of a forward. A long call option and a short put option with the same value date and strike price constitute a synthetic long (buy) forward. [21] Similarly, a short call option and a long put option with the same value date and strike price constitute a synthetic short (sell) forward. [22]

(3) Trading on Margin [ 25 ] Margin protects a brokerage firm from the risk of default by its client. It is a form of collateral which offers protection to the brokerage firm against loss. [23] It appears in different forms but typically consists of cash or near cash instruments.

Ultimately, it is anything that a brokerage reasonably believes will offer it protection against clients who are unable to cover their losses. [24] [ 26 ] According to the uncontroverted evidence of the CEO of two of the brokerage firms, there is no hard and fast rule with respect to the amount of margin required in the OTC market. [25] Margin amounts on the OTC market are discretionary and negotiable. [ 27 ] Each brokerage firm assesses the value of a particular client’s positions, as well as the firm’s entire position, at the end of each day. This is called

“marking to market”. Marking to market is an essential part of assessing risk for any brokerage firm. [ 28 ] When a particular brokerage firm reviewed the financial risk to which it was exposed in respect of Mr. Pat Paletta’s account at the end of each day, it did so on the basis of the net value of all positions in his account. To the extent that a positive net balance existed in the account, no additional margin was required and Mr. Pat Paletta was entitled to withdraw the surplus. To the extent that a negative net balance existed in the account, the brokerage firm was entitled to call for additional margin.

Whether it did so or not was a discretionary decision. [ 29 ] The margin required for Mr. Pat Paletta to trade forward foreign exchange contracts started as 5% of the target loss amount in 2000 and 2001 but was negotiated as low as 1% for 2002 and 2005 to 2007. [ 30 ] In 2003 and 2004 the margin required was 0.33% and 0.8% of the target loss, respectively. In those two years the target loss was initially lower.

No additional margin was required when the target loss was later increased. [ 31 ] The amount of margin required related directly to the target loss for each taxation year: Taxation Year Target Loss Margin Required Margin as a % of Target Loss 2000 $6,000,000 $300,000 5% 2001 $8,000,000 $400,000 5% 2002 $10,000,000 $100,000 1% 2003 $15,000,000 $50,000 0.33% 2004 $20,000,000 $160,000 0.8% 2005 $25,000,000 $250,000 1% 2006 $45,000,000 $450,000 1% 2007 $40,000,000 $400,000 1% [ 32 ] Mr. Pat Paletta primarily used irrevocable letters of credit as margin. The fees that Mr.

Pat Paletta paid to the Royal Bank of Canada to secure those irrevocable letters of credit ranged from CAN$263 to CAN$3,576. [26] As mentioned above, the margin provided protection to the brokerage firms against the risk of default by Mr. Pat Paletta on his net obligation to them at any particular time. [27] [ 33 ] During the following periods, a negative net balance existed in Mr. Pat Paletta’s trading account, yet no margin call was made by the brokerage firm and, in the last instance, new trades were entered into: (

a) November 30, 2001 to March 29, 2002 [28] (

b) April 2, 2003 to June 19, 2003 [29] (

c) August 19, 2005 to September 13, 2005 [30] [ 34 ] The Minister assumed that the forward foreign exchange trades undertaken by Mr. Pat Paletta “would have resulted in margin calls in a real forex market” [31] yet there were no such margin calls. [32] [ 35 ] The inference that I draw from the discretionary decision made by the brokerage firms not to make margin calls when they were otherwise entitled to do so is that they made a business decision. They were reasonably comfortable with the degree of risk they carried in respect of Mr.

Pat Paletta’s account notwithstanding any margin shortfall at any particular time. That inference is based primarily on the evidence of the Crown’s expert on financial risk, Dr. Pavlov, who opined that the amount of risk to which the brokerage firms were exposed was negligible.

It, therefore, follows that the margin required by the brokerage firms would have been negligible as well. [ 36 ] The Minister also assumed that the: [p]rincipal values of the forex option and forward contracts were denominated in the hundreds of millions of dollars, whereas the cost . . . [of] these options and forward contracts was only in the tens of thousands of dollars. [33] [ 37 ] This assumption is technically correct, but its implication is not. The implication is that there was something untoward about trading in the OTC market on margin.

Based on the evidence of the CEOs of the brokerage firms and the experts, I find that there was nothing untoward, let alone unusual, about trading on margin in the OTC market. [ 38 ] Similarly, in attempting to justify the assessment of gross negligence penalties, the Minister alleged that: the purported amount of foreign currency purchased was obviously excessive given the immaterial amount purportedly invested. [34] [ 39 ] Once again, if the amount of risk was negligible, the amount of margin should be negligible as well.

According to the Crown’s own theory of the case, the modest amount of margin that was actually required by the brokerage firms in this case would not have been unreasonable in the circumstances. [ 40 ] I find that initial margin was computed as a percentage of the target loss for the year and that margin was maintained at a level that each brokerage firm was comfortable with in light of the negligible exposure to risk created by the net results of Mr.

Pat Paletta’s trading. [ 41 ] I also find, based on the evidence of the CEOs of all three brokerage firms, that the transitory margin deficiencies described above were not a cause for concern in light of their overall assessment of risk given their ongoing business relationship with Mr. Pat Paletta and his companies. [35] [ 42 ] In light of the fact that margin is discretionary and negotiable in the context of the OTC market, and that the risk was negligible, the occasional margin deficiency was not a cause for concern to any of the brokerage firms.

(4) How Forward Foreign Exchange Contracts Come to an End [ 43 ] Forward foreign exchange contracts come to an end by (

a) delivering to the counterparty the currency contracted for on the value date, or (

b) entering into an equal and offsetting position with the counterparty before the value date (known as “ " closing out " ” the contract). [36] [ 44 ] Delivery occurs when the counterparties exchange the contracted amounts of each currency on the value date specified in the contract. For example, assume a forward contract selling EUR for USD on January 30, 2002. On the value date, January 30, 2002, the selling (or short) counterparty would deliver the EUR and the buying (or long) counterparty would deliver the USD.

[ 45 ] The other method used to bring a forward foreign exchange contract to an end is by entering into the equal and opposite position with one’s counterparty. For example, assume a forward contract to sell EUR for USD on January 30, 2002. At any time before January 30, 2002, the counterparty selling the EUR may enter into an equal and opposite contract with its counterparty to buy the same amount of EUR for USD on the same value date. The original contract has now been “ " closed out " ” or terminated.

At that time, a gain or loss is crystallized as the contract has been effectively extinguished. [ 46 ] Both methods of bringing forward foreign exchange contracts to an end are equally effective and both are used in the market. [ 47 ] The Minister assumed, quite correctly, that: [a]ll positions taken by the Appellant could only be closed out by entering into offsetting positions with UCAL/IFX/ODL. [37] [ 48 ] The Minister also correctly assumed that the forward foreign exchange contracts “were never held to performance on [their] specified value dates.” [38] That assumption is consistent with the evidence. [ 49 ] However, when that assumption is read in the context of all the other assumptions made by the Minister, its implication is that there was something wrong, or at least rather suspicious, about not holding forward foreign exchange contracts to their value dates.

I am satisfied, based on the evidence of the CEOs of the brokerage firms and the expert evidence, that such contracts may be, and often are, closed out before their value dates. [39] [ 50 ] The Minister further assumed (in an assumption that, at best, is an assumption of mixed fact and law) that all of the forward foreign exchange contracts: . . . were not (could not have been) actually settled in a legal sense (legitimately extinguished) until their respective value dates. [40] [ 51 ] On the evidence, that assumption is wrong.

The assumption discloses a fundamental lack of understanding of how the forward foreign exchange market works and of the fact that such contracts may be closed out before their value dates. [41] B. The Chronology

(1) Mr. Pat Paletta’s Background [ 52 ] Mr. Pat Paletta immigrated to Canada from a small village in Italy in the 1950s. Starting with almost nothing, he built businesses ranging from meat packing to real estate development. His eldest son, Mr. Angelo Paletta, assumed increasingly important roles in his father’s businesses starting at an early age. [ 53 ] Mr. Pat Paletta left school early. He did not have the benefit of a post-secondary education. He was, however, very good with numbers.

As a self-made man, he was hands-on with respect to each business and was deeply interested in all aspects of his businesses, including the financial side. [ 54 ] He entrusted all of his accounting and tax matters to his accountants at Taylor Leibow LLP, with whom he met on a weekly basis, mostly on Saturday mornings. During those meetings, Mr. Pat Paletta would discuss not only accounting and tax issues, but business initiatives and strategic planning as well. [ 55 ] Mr. Pat Paletta incorporated various corporations to carry on many of his businesses.

However, he operated cattle feedlots as a sole proprietor. [42] He decided to use that sole proprietorship to carry on the trading at issue.

(2) Mr. Pat Paletta’s Trading Experience [ 56 ] In the early 1980s, Mr. Pat Paletta purchased cattle from Australia, New Zealand, and Nicaragua, for which he paid in either USD or the local currency. In addition, he purchased capital equipment from Europe and paid for that equipment in foreign currency. [43] He would generally ask his office manager to call the Royal Bank of Canada to have rates quoted to him, and would then buy or sell currency based on his business needs. [44] [ 57 ] By the early 1990s, Mr. Pat Paletta exported meat to 20 countries and received foreign currency on those sales.

Those receipts could be as high as tens of millions of dollars in a year. [45] [ 58 ] Mr. Angelo Paletta testified that Mr. Pat Paletta would occasionally speculate by selling some of his accumulated foreign currency or buying additional currency based on what he had heard in the marketplace. [46] Before the events at issue, that was the extent of his involvement in foreign exchange.

(3) Introduction to the Promoter and the Tax Straddle [ 59 ] Late in 1999, or early in 2000, Mr. Pat Paletta’s accountants recommended a tax plan to him. [47] They suggested that he meet with Mr. David Lewis, who had a tax plan they said was worth considering. Mr. Lewis was a principal at a firm called Affinity Financial. Mr. Angelo Paletta understood that Affinity Financial was a corporation that provided tax avoidance plans to clients.

Although there was no evidence of the plan having been reduced to writing, it was understood that the plan was designed to generate non-capital losses through forward foreign exchange trading. [ 60 ] Mr. Pat Paletta and Mr. Angelo Paletta met Mr. Hodgins and the CEO of Union PLC before commencing the trading in 2000. Initially, Mr. Angelo Paletta provided instructions to Mr. Lewis, who would relay those instructions to Mr. Hodgins. In late 2004 or early 2005, Mr. Angelo Paletta stopped dealing with Mr. Lewis and started dealing directly with Mr. Hodgins. [48]

(4) Role of Tax Lawyers (

a) Oral Consultations [ 61 ] While Mr. Pat Paletta was considering Mr. Lewis’s tax avoidance plan, he and his eldest son visited several law firms on a number of unrelated matters. [ 62 ] In mid-2000, before trading commenced, Mr. Pat Paletta and his eldest son were at the law offices of Borden & Elliot LLP in Toronto, where they met with a non-tax lawyer on another matter. They asked whether they could see a tax lawyer. They were introduced to Mr. John Tobin. They had a discussion with Mr. Tobin about the tax plan and asked Mr. Tobin if it was acceptable, if it was legal, and whether it met CRA requirements. Mr.

Tobin mentioned the Friedberg case to them. That was the first time they heard of it. Mr. Tobin advised them that the plan was legitimate and met CRA standards. No written opinion was requested.

[ 63 ] Toward the end of 2000, before trading commenced, Mr. Pat Paletta and his eldest son were at the law offices of Love & Whalen, where they met with Mr. Jim Love on other tax matters. They had a discussion with Mr. Love about the tax plan and asked for his advice on the status of it, whether it was legal, and whether it met the requirements of the CRA. Mr. Love confirmed that it did and mentioned Friedberg as the leading case. They did not ask Mr. Love for a written opinion. [ 64 ] In the summer or fall of 2001, after trading had commenced, another tax lawyer was consulted. That was Mr.

Jack Bernstein at Aird & Berlis LLP, whom Mr. Pat Paletta and his eldest son met on the same basis as they had met Mr. Tobin the year before. In light of a general warning issued by the CRA earlier that summer regarding tax shelter transactions (and passed along to them by their accountants), they wanted to confirm that the tax plan remained sound. They received that confirmation from Mr. Bernstein. Once again, no written opinion was requested. (

b) Third-Party Opinions [ 65 ] While the trading proceeded, Mr. Angelo Paletta was presented with several written opinions relating to the tax plan. They were all addressed to third parties. Mr. Pat Paletta never requested or obtained a written opinion addressed to him in respect of the tax plan. The written opinions were passed along to the Palettas at first by Mr. Lewis and later on by Mr. Hodgins. [ 66 ] Mr. Angelo Paletta testified that while he and his father relied on those opinions, they did not read any of them. They were simply filed away. [49]

(5) Annual Target Losses [ 67 ] Through his eldest son, Mr. Pat Paletta provided to Mr. Lewis (and, in later years, to Mr. Hodgins directly) the target loss amount each year. The target loss amount was the amount of loss that Mr. Pat Paletta, in consultation with his accountants, wanted his trading to generate, enabling him to claim the target loss amount as a non-capital loss on his tax return for that year, thereby eliminating either all or most of his taxable income for the year. [ 68 ] Other than the first year, the target loss amount was arrived at by taking into account the aggregate of the (

a) taxable income that Mr. Pat Paletta expected to receive that year and (

b) the gains realized from closing out the gain leg carried over from the previous year. [ 69 ] The target loss for each taxation year was as follows: Taxation Year Target Loss Amount 2000 $6,000,000 2001 $8,000,000 2002 $10,000,000 2003 $15,000,000 2004 $20,000,000 2005 $25,000,000 2006 $45,000,000 2007 $40,000,000 [ 70 ] I find that the sole purpose of the trading each year was the realization of the target loss for that year. The annual fee paid by Mr. Pat Paletta (later negotiated downward on his behalf by Mr. Angelo Paletta) was a percentage of the target loss for the year.

The initial margin required by the brokerage firm was a percentage of that year’s target loss. Everything, without exception, revolved around the target loss each year and its realization.

(6) Fees Paid to the Promoter and the Brokerage Firms [ 71 ] The fees paid to each brokerage firm for the trading each year were initially set as a percentage of the target loss requested for that year. However, in later years Mr.

Angelo Paletta ignored the amounts called for by that formula, as well as specific fee requests from the brokerages, and would generally pay progressively smaller amounts: Taxation Year Target Loss Amount Fees Formula 2000 $6,000,000 $210,000 3.5% of the target loss [50] 2001 $8,000,000 $120,000 1.5% of the target loss [51] 2002 $10,000,000 $100,000 1% of the target loss [52] 2003 $15,000,000 $94,000 1% of the first $5,000,000 target loss, then 0.4% for an additional $11,000,000 target loss (despite the target later being reduced to $15,000,000, the fees were not reduced or refunded) [53] 2004 $20,000,000 $106,000 No formula was used.

Mr. Angelo Paletta made a payment of $56,000 and later made another payment of $50,000. [54] 2005 $25,000,000 $50,000 No formula was used. Mr. Angelo Paletta made an initial payment of $20,000; another payment of $15,000 was paid later that year, and $15,000 was paid early in 2006. [55] 2006 $45,000,000 $70,000 No formula was used. Initially Mr. Angelo Paletta paid $12,500 (he testified that this was one-half of the amount ODL Securities Ltd. had requested). Later an additional $25,000 was wired, and then another $32,500. [56] 2007 $40,000,000 $20,000 No formula was used.

Only the one payment was in evidence. [57] [ 72 ] In the first years of trading, the fees were divided among Mr. Lewis, the particular brokerage firm, and Mr. Hodgins and his father. Later on, after Mr. Angelo Paletta stopped dealing with Mr. Lewis, the fees were divided among the particular brokerage firm and Mr. Hodgins and his father.

(7) Mr. Angelo Paletta as Mr. Pat Paletta’s Agent

[ 73 ] Mr. Pat Paletta assigned his eldest son, Mr. Angelo Paletta, the day-to-day responsibility for monitoring the trading undertaken on his behalf by Mr. Hodgins. All email messages in respect of the trading originated from or were sent to Mr. Angelo Paletta as his father did not have his own email account. At all times, Mr. Angelo Paletta acted as his father’s agent with respect to the trading.

(8) Mr. Hodgins as Mr. Pat Paletta’s Agent [ 74 ] The Minister assumed that Mr. Hodgins acted as agent for Mr. Pat Paletta in executing the forward foreign exchange trades undertaken in order to achieve the target loss each year. [58] That assumption is consistent with the evidence.

Among the relevant assumptions are: The Appellant did not give any instructions [i.e. the currency pairs to be traded, the amounts to be traded, whether to enter into “buy” or “sell” positions, the expiry of value dates and the trade prices (bid/ask)] for any of the forex contracts purportedly entered into with UCAL/IFX/ODL and so reflected in their accounts. . . . [59] Tim Hodgins, at his discretion, entered into and caused to be executed the purported contracts (trades) as needed to create each straddle loss and then subsequently unwind that straddle loss. [60] [ 75 ] On the evidence, the Minister was correct in assuming that Mr.

Pat Paletta had given discretionary authority to Mr. Hodgins to undertake whatever trading on his behalf was necessary in order to realize the target loss each year.

(9) Architecture of the Trades [ 76 ] From 2000 to 2003, Mr. Hodgins used synthetic forwards to construct the straddle trades for each trading cycle. Mr. Hodgins would ask the forward foreign exchange desk and the foreign exchange options desk at the brokerage firm for prices on the trades. [61] Although more trades were required when options were used, it was initially less costly for Mr. Hodgins to use options in order to achieve Mr.

Pat Paletta’s objective. [62] The synthetic forwards are further explained in paragraphs 93 and 94 below. [ 77 ] For the later trading cycles (2004 to 2007), only forwards were used to construct the straddle. As forwards are easier to explain than synthetic forwards, only forwards are used in the example below. (

a) Forward Straddle – Representative Example [ 78 ] The architecture of the straddle trades used by Mr. Pat Paletta involved a three-step process: opening positions, modifying positions, and closing positions. The process is best illustrated by way of an example using USD/CAD trades. (

i) Opening Positions [ 79 ] Mr. Pat Paletta entered into opening positions with a pair of forward contracts. In the first contract, Mr. Pat Paletta agreed to sell US$80,000,000 for CAD on a value date of April 10, 2006.

In the second contract, he agreed to buy the same amount of USD on a value date of May 8, 2006: Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/ Loss (CAD) Closes A 07-Nov-05 10-Apr-06 Sell (80,000,000) 1.18330000 94,664,000 n/a B 07-Nov-05 08-May-06 Buy 80,000,000 1.18243000 (94,594,400) n/a (ii) Modifying Positions [ 80 ] As one contract increased in value over time, the other would decrease in value by approximately (though not exactly) the same amount.

In this example, the market value of the USD relative to the CAD increased over time, which caused the short (sell) trades to lose value, meaning that Trade A was in a loss position. [63] [ 81 ] Shortly before the end of 2005, Mr. Pat Paletta entered into additional pairs of contracts to modify his original position. In this case, Mr. Pat Paletta entered into trades C and D. Trade C takes exactly the opposite position to Trade A, thereby closing out Trade A and realizing a loss of $711,600.

Trade D replaced Trade A , reducing the day count between the two legs from 28 days to 10 days, thereby reducing the risk: Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/ Loss (CAD) Closes C 15-Nov-05 10-Apr-06 Buy 80,000,000 1.19219500 (95,375,600) (711,600) A D 15-Nov-05 28-Apr-06 Sell (80,000,000) 1.19155500 95,324,400 n/a [ 82 ] At this point the only two open positions were trades B and D: Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/ Loss (CAD) Closes B 07-Nov-05 08-May-06 Buy 80,000,000 1.18243000 (94,594,400) n/a D 15-Nov-05 28-Apr-06 Sell (80,000,000) 1.19155500 95,324,400 n/a [ 83 ] Closer to the end of the year, Mr.

Pat Paletta entered into additional positions, further modifying his open positions. In this example, Trade F exactly offset Trade B, thereby closing it out and realizing a loss of $1,352,160. Trade E replaced Trade B, reducing the day count between the two legs from 10 days to 6, further reducing the risk:

Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/ Loss (CAD) Closes E 24-Nov-05 02-May-06 Buy 80,000,000 1.16577500 (93,262,000) n/a F 24-Nov-05 08-May-06 Sell (80,000,000) 1.16552800 93,242,240 (1,352,160) B [ 84 ] At this point the only two open positions were trades D and E: Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/Loss (CAD) Closes D 15-Nov-05 28-Apr-06 Sell (80,000,000) 1.19155500 95,324,400 n/a E 24-Nov-05 02-May-06 Buy 80,000,000 1.16577500 (93,262,000) n/a [ 85 ] Just before the end of the year, Mr.

Pat Paletta entered into two additional modifying positions. In this example, he entered into trades G and H. Trade G was the exact opposite of Trade E, thereby closing out Trade E and realizing an additional loss of $758,000.

Trade H replaced Trade E and slightly increased the day count between the two legs from 6 days to 7: Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/Loss (CAD) Closes G 15-Dec-05 02-May-06 Sell (80,000,000) 1.15630000 92,504,000 (758,000) E H 15-Dec-05 09-May-06 Buy 80,000,000 1.15621800 (92,497,440) n/a [ 86 ] At this point the only open positions were trades D and H, which carried over into the following year: Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/Loss (CAD) Closes D 15-Nov-05 28-Apr-06 Sell (80,000,000) 1.19155500 95,324,400 n/a H 15-Dec-05 09-May-06 Buy 80,000,000 1.15621800 (92,497,440) n/a [ 87 ] At the end of 2005, Mr.

Pat Paletta realized losses in the amount of $2,821,760, consisting of the loss of $711,600, the loss of $1,352,160 and the loss of $758,000. [64] [ 88 ] The process of entering into an opening position, adding contract pairs and closing the loss legs would be repeated as many times as necessary to achieve the target loss for the year.

In 2005, the target loss was $25,000,000, so there would have been a number of opening positions established and then modified in a similar manner until the target loss was reached by year-end. (iii) Closing Positions [ 89 ] Finally, early in 2006, the remaining positions (Trade D and Trade

H) would be closed out by entering into equal and opposite trades: Trade Trade Date Value Date Buy / Sell Amount (USD) Rate Price (CAD) Profit/Loss (CAD) Closes I 26-Jan-06 28-Apr-06 Buy 80,000,000 1.14663200 (91,730,560) 3,593,840 D J 26-Jan-06 09-May-06 Sell (80,000,000) 1.14633725 91,706,980 (790,460) H [ 90 ] Although Trade J was the gain leg of the trade, a small loss was realized. The gain from closing out Trade I, however, entirely offset that loss. It was not unusual for some loss to be embedded within the gain leg of the trades, and vice versa.

The total gain realized on the closing out of the gain leg in early 2006 was $2,803,380 ($3,593,840 - $790,460). [ 91 ] Mr. Pat Paletta would have claimed a trading loss of $2,821,760 for tax purposes, while suffering an economic loss of only $18,380. [65] [ 92 ] These steps would be repeated each year in a trading cycle which straddled the year-end. Each trading cycle enabled Mr. Pat Paletta to realize large losses and defer large gains for income tax purposes, all with little or no economic loss. (

b) Synthetic Forward Straddle [ 93 ] Synthetic forward straddles are more complex than forwards as they use options to achieve the same result.

If one buys a call option (a long call) and sells a put option (a short put) at the same strike price, the result will be the same profit or loss as buying a forward. [66] If one sells a call option (a short call) and buys a put option (long put) at the same strike price, the result will be the same profit and loss as selling a forward. [67] Two option contracts are required to create the same result as a forward contract. [ 94 ] The basic three-step trading process used in the forward straddle remains the same, but instead of using forwards, twice as many option contracts are utilized to achieve the same result.

The amount paid up front in order to enter into the option contracts (the “o " ption premium " ”) determines the amount of profit and loss at the end of the year. All other steps remain the same. (

c) The Loss Legs and Gain Legs for Each Taxation Year [ 95 ] By utilizing the trading pattern described in the above example, the trading produced the following gains and losses. The amounts below were agreed to by the parties as the amounts at issue at trial (all currency in CAD unless otherwise noted): Trading Cycle Losses Gains (Realized the Following Taxation Year) Net Difference (Economic Profit/Loss) 2000 (US$3,924,370.00) US$3,924,501.00 US$131.00 2001 (US$5,207,318.00) US$5,186,544.00 (US$20,774.00) 2002 (US$6,496,870.00) US$6,499,883.00 US$3,013.00

2003 (US$12,361,830.00) US$12,374,000.00 US$12,170.00 2004 ($20,467,060.00) $20,313,547.00 ($153,513.00) 2005 ($25,231,920.00) $25,212,680.00 ($19,240.00) 2006 ($46,485,910.00) $46,422,000.00 ($63,910.00) 2007 ($39,998,730.00) N/A N/A [ 96 ] For ease of reference, using the appropriate exchange rates, the losses and gains converted to CAD are: Trading Cycle Exchange Rate Losses Gains (Realized the Following Taxation Year) Net Difference (Economic Profit/Loss) 2000 1.5224 [68] ($5,974,460.89) $5,974,660.32 $199.43 2001 1.5484 [69] ($8,063,011.19) $8,030,844.73 ($32,166.46) 2002 1.5250 [70] ($9,907,726.75) $9,912,321.58 $4,594.82 2003 1.2952 [71] ($16,011,042.22) $16,026,804.80 $15,762.58 2004 1.0000 ($20,467,060.00) $20,313,547.00 ($153,513.00) 2005 1.0000 ($25,231,920.00) $25,212,680.00 ($19,240.00) 2006 1.0000 ($46,485,910.00) $46,422,000.00 ($63,910.00) 2007 1.0000 ($39,998,730.00) N/A N/A [ 97 ] Mr.

Pat Paletta claimed the following losses and gains on his returns: Taxation Year Claimed Losses/Gains 2000 ($6,184,460.89) 2001 ($2,150,917.06) 2002 ($10,007,726.00) 2003 ($6,198,247.76) 2004 ($4,294,300.06) 2005 ($5,134,923.14) 2006 ($21,236,115.40) 2007 $6,444,216.20 Total: ($48,762,747.11) [ 98 ] There is no evidence as to why Mr. Pat Paletta chose to show a profit from forward foreign exchange trading for his 2007 taxation year.

The choice of a lower target loss amount for 2007 resulted in the realization of a gain that year. [72] He had losses from previous trading that he was able to use to shelter most of his other income for that year. The important point here is that he was able to report taxable income of only $446,646 for his 2007 taxation year, even after realizing a trading gain of $6,444,216. [73] [ 99 ] Over the eight taxation years at issue, Mr.

Pat Paletta reported taxable income of nil for five of them (2000, 2002, 2003, 2004, and 2006), just over $142,000 for one of them (2001), just over $415,000 for another (2005) and, as already noted, just over $446,000 for the final taxation year at issue (2007). [74] [ 100 ] Despite having received over $38,000,000 of income from 2000 to 2007, [75] Mr.

Pat Paletta managed to keep his aggregate taxable income over the same period to just over $1,000,000 by means of forward foreign exchange trading. [76] This clearly illustrates the benefit of the tax losses generated by the trading. [77] From the start of trading to the end of 2007, he paid approximately 1/38th of the tax that an individual in his position would have paid without the benefit of the trading at issue.

(10) Mr. Pat Paletta’s Knowledge of the Trading [ 101 ] The tax plan at issue is quite simple. Both Mr. Pat Paletta and his eldest son knew from the outset the three basic elements of the plan: 1. Before the end of the year, the loss legs of the straddle would be closed out so as to realize the target loss for the year; 2. Shortly after the start of the next taxation year the corresponding gain legs would be closed out and realized—they both understood that those gains must be included in computing income for the next taxation year; and 3. The target loss for the next taxation year would be sufficient to shelter (

a) the gains realized earlier in the taxation year and (

b) the taxable income that Mr. Pat Paletta anticipated receiving in that year. [78] [ 102 ] T hose three features of the plan would have been obvious to everyone, even at the most basic level of analysis.

(11) Review by the Canada Revenue Agency [ 103 ] In 2004 and 2005, Mr. Kleinschmidt, an official of the CRA, was assigned to determine whether there was any basis on which to audit Mr. Pat Paletta’s 2002 or 2003 taxation years. [79] It is likely that the quantum of the losses claimed by Mr. Pat Paletta attracted the CRA’s attention. [ 104 ] Mr. Kleinschmidt reviewed the documents that were passed along to him by the accountants and concluded that there was no need for the CRA to proceed with an audit.

His conclusion was based primarily on internal CRA advice that the decision of the Supreme Court of Canada in Friedberg was determinative. [ 105 ] The accountants, as well as Mr. Pat Paletta and his eldest son, took the CRA’s decision not to audit as an indication that the CRA, like the accountants and tax lawyers, had no reservations about the tax plan that was being used to eliminate all or most of Mr. Pat Paletta’s taxable income each year.

(12) Change of Brokerage Firms

[ 106 ] Mr. Pat Paletta used three different brokerage firms as counterparties for his trades over the first seven years of trading. Why did he not remain with just one firm? Because he followed Mr. Hodgins when Mr. Hodgins and his father moved from one brokerage firm to another. From 2000 to 2007, Mr. Hodgins was at three different brokerage firms, all based in London. [ 107 ] When Mr. Hodgins and his father moved from one brokerage firm to the next, Mr. Pat Paletta moved his trading account as well. After Union Cal Limited, Mr. Hodgins moved to IFX Ltd. That move occurred in November of 2001.

After IFX Ltd., Mr. Hodgins moved to ODL Securities Ltd. That move occurred in April of 2004. [ 108 ] Each move required Mr. Hodgins and Mr. Angelo Paletta to arrange for Mr. Pat Paletta to sign new account opening documentation, which he did in each case. Immediately after each move, the balance in Mr. Pat Paletta’s trading account was transferred to his account at the new brokerage firm.

(13) The Reassessments [ 109 ] The dates of assessment and reassessment for each of the taxation years at issue are set out below: Taxation Year Date of Assessment Date of Reassessment 2000 N/A January 20, 2014 2001 August 6, 2002 January 20, 2014 2002 September 5, 2003 January 20, 2014 2003 July 15, 2004 January 20, 2014 2004 August 8, 2005 January 20, 2014 2005 May 30, 2006 January 20, 2014 2006 May 31, 2007 January 20, 2014 2007 June 23, 2008 January 20, 2014 [ 110 ] The Minister reassessed to disallow Mr. Pat Paletta’s deduction of all losses claimed.

The losses claimed and disallowed are set out in paragraphs 13 and 97, above. [ 111 ] The Minister reassessed all taxation years at issue on January 20, 2014. As the Minister reassessed outside the normal reassessment period for each taxation year, the Crown had the onus to prove that Mr. Pat Paletta, for each year, made a misrepresentation attributable to neglect, carelessness, or wilful default in claiming the losses at issue. [ 112 ] The Minister also assessed penalties under subsection 163(2) of the Act for the 2000 to 2006 taxation years.

The Crown had the onus of proof in respect of penalties assessed under that subsection. Those penalties are generally known as “gross negligence” penalties. C. The $8 Million Understatement of Income for 2002 [ 113 ] At trial, the Crown highlighted a number of errors in the transaction documents. For example, a few trades were noted as “closed” when they were actually “open”. The transaction confirmations could have been more clearly presented, particularly to show the architecture of the straddle trades. Mr. Hodgins was forthright in describing their shortcomings in that regard.

He worked with the templates available to him at each brokerage firm, but they had not been designed with straddle trades in mind. [ 114 ] There were also certain computational errors made by Mr. Hodgins that appeared on the transaction documents and which he corrected during the course of his testimony. Those errors could not have easily been detected or corrected by Mr. Pat Paletta. In the big picture, they are of little moment. [ 115 ] But there is one egregious error that could have been, and should have been, easily detected and corrected by Mr. Pat Paletta. [ 116 ] Surprisingly, Mr.

Pat Paletta failed to include any of the gains realized on the closing out of the gain legs in early 2002 in computing his income for that year. Those gains were clearly part of the 2001 trading cycle which Mr. Pat Paletta knew had to be taken into account in computing his income for 2002. [ 117 ] Buried among 259 assumptions pleaded in the Amended Reply is the following assumption of fact: The Appellant reported a $6.5 million USD (10.0 million CAD) loss for tax purposes in 2002.

His reported loss should have been 1.3 million USD, comprised of the $6.5 million USD loss for 2002 net of the $5.2 million USD gain carried forward from 2001. However, the $5.2 million USD gain leg was not recognized for tax reporting purposes in 2002 even though otherwise realized for trading statement purposes. [80] [ 118 ] The Minister was on to something here. In his 2002 return Mr. Pat Paletta claimed a loss from foreign currency trading of $10,007,726. [81] Mr.

Robert Ban, one of his accountants, testified that the amount of the 2002 trading loss was taken from Exhibit A57. [82] Exhibit A57 is an email which includes a spreadsheet and a cash movement

summary . [83] The spreadsheet is a

summary of trades that occurred between December 23, 2002 and December 30, 2002; it includes both winning and losing trades. The spreadsheet states that there are losses in the amount of $40,017,027 and gains in the amount of $30,109,301. $100,000 in fees were claimed as an expense that year, so all of this was reported on Mr. Pat Paletta’s 2002 return as a net loss of $10,007,726. [ 119 ] When one compares the

summary in Exhibit A57 with the 2002 trading statements, it becomes clear that Exhibit A57 does not include the gains from closing out the gain legs from the 2001 trading cycle which were realized in early 2002. The account statements and related documentation show trading in early 2002 in which gains of $8,030,844.73 were realized. [84] Those trades were the result of closing out the gain legs from the 2001 trading cycle but were not included by Mr. Pat Paletta in computing income for his 2002 taxation year.

Exhibit A57 reflects only the results of the trades closed out between December 23, 2002, and December 30, 2002 which were the loss legs from the 2002 trading cycle. [ 120 ] Exhibit A57 was sent by Mr. Lewis to Mr. Angelo Paletta and was immediately forwarded by Mr. Angelo Paletta to Mr. Wiseman, one of the accountants. [85] Mr. Angelo Paletta did not review the document. He simply passed it along to Mr. Wiseman. [86] [ 121 ] Mr.

Pat Paletta claimed a loss of $10,007,726.00 [87] for the 2002 taxation year when he had only incurred a loss of $1,976,882.02. [88] $5,459,460.64 of this overstated loss was claimed in 2002. [89] The unused portion of the overstated loss, $4,548,265.36, was carried over to the 2005 taxation year under

section 111 of the Act. [90] [ 122 ] I will return to this understatement of income when deciding whether the Minister was justified in opening the 2002 taxation year and in assessing a gross negligence penalty in respect of that year.

D. The Expert Witnesses [ 123 ] As this appeal involved highly technical financial matters, I received evidence from four expert witnesses (two of whom were called by the Appellant and two by the Crown) to provide the ready-made inferences necessary for me to understand forward foreign exchange trading and the financial risks involved.

(1) The Appellant’s Experts (

a) Mr. Simon Bird [ 124 ] I qualified Mr. Bird as an expert in financial instruments, including foreign exchange instruments. Mr. Bird has extensive investment banking experience. He traded foreign exchange instruments including forwards and swaps. His report and his testimony provided vital information on the foreign exchange market, foreign exchange products, how trading over the counter works, and the risks of foreign exchange trading. I found his evidence useful and have given it considerable weight. (

b) Mr. Colin Knight [ 125 ] I qualified Mr. Knight as an expert in foreign exchange markets and trading. Mr. Knight has extensive experience with foreign exchange products and has worked in the industry for over 20 years. He provided information about the foreign exchange market, as well as foreign exchange products. I will discuss his evidence further below.

(2) The Crown’s Experts (

a) Dr. Andrey Pavlov [ 126 ] Before considering the value of Dr. Pavlov’s evidence, it is important to review the Minister’s assumptions with respect to risk. [ 127 ] The Minister assumed that Mr. Pat Paletta entered into the straddle trades on the understanding that they “would bear no risk.” [91] The Minister assumed that, in fact, Mr. Pat Paletta “bore no commercial risk” with respect to the trades [92] and assumed that Mr.

Pat Paletta “was never at risk”. [93] [ 128 ] On a similar note, in attempting to justify opening all of the taxation years at issue, the Crown pleaded as a material fact that the trades were “risk free” [94] and that all the transactions were “without risk”. [95] [ 129 ] It was against that backdrop that I qualified Dr. Pavlov as an expert in the measurement of risk of financial derivatives. Dr. Pavlov has extensive experience in measuring financial risk. His research focuses on the measurement of risk in various market settings. In Dr. Pavlov’s opinion, Mr.

Pat Paletta’s straddle trading involved “negligible risk”. That means some risk or very small risk. It does not mean no risk. [ 130 ] In argument, the Crown contended that the straddle trades involved no risk, which is consistent with the Minister’s assumptions and allegations but which is inconsistent with Dr. Pavlov’s evidence. I find that Mr. Pat Paletta’s trading carried with it some risk. Whether the amount of risk is described as very small or “negligible” matters not. The point is that the trading was not without risk. [ 131 ] How did the risk arise?

It arose because the value dates of the contracts forming each leg of the straddle were slightly different. The closer the respective value dates to one another, the lower the risk. The further apart the respective value dates, the greater the risk. [ 132 ] The trades forming each leg would always have slightly different value dates, meaning that the value of one would always exceed the value of the other.

This slight difference was taken into account by the brokerage firm at the end of each day when the net positions were “marked to market” so that the brokerage firm could assess its own exposure to risk and, if necessary, call for additional margin. (

b) Mr. Richard Poirier [ 133 ] I qualified Mr. Poirier as an expert in foreign exchange trading from the perspective of a Canadian commercial bank. Mr. Poirier spent most of his career with the National Bank of Canada and has a significant amount of foreign exchange trading experience in that context. [ 134 ] He opined that no one seeking to make money would engage in the trades undertaken by Mr. Pat Paletta. All of the evidence supports his conclusion on that point. [ 135 ] However, he went further. Mr.

Poirier concluded that because there was no business purpose for the straddle trading, the trading must not have occurred. On the evidence, that conclusion is unsustainable. [ 136 ] As the reports of Mr. Poirier and Mr. Knight share a fundamental flaw, I will discuss them together.

(3) Observations on the Expert Reports [ 137 ] The essence of Mr. Poirier’s opinion was as follows: 1. The trades never happened . 2. If those trades happened, what Mr. Paletta did was not Fx trading. [96] [ 138 ] Mr. Poirier was correct to conclude that there were “ " no commercial or economical [ sic ] reasons to do those trades " ”. [97] [ 139 ] Unfortunately, Mr. Poirier had not been asked to assume that the trading at issue was undertaken for tax purposes only.

He was, therefore, unable to understand why anyone would ever engage in that type of trading: When you trade Fx you do it either for hedging or to speculate, to make profit. In my career I have never seen anyone trading to lose money, which it seems Mr. Paletta is claiming he did. [98] [ 140 ] In rebuttal to Mr. Poirier’s report, Mr. Knight stated that, in his opinion, Mr. Pat Paletta’s “ " trading appears to have been carried out with the intention of making a profit overall " ”. [99] Unfortunately, that conclusion too is inconsistent with the evidence.

[ 141 ] Doubling down on his “for profit” hypothesis, Mr. Knight arrived at the following conclusion: Mr. Paletta used a sophisticated interest rate strategy that might be classified as speculative arbitrage. He used FX swaps to take focussed exposure to the interest rate differential between currencies over a narrow date range. [100] [ 142 ] Mr. Knight concluded that Mr. Pat Paletta might have been using other strategies to make money, including the “arbitrage butterfly” [101] and “cutting losses and letting profits run”. [102] On the evidence, Mr. Pat Paletta used none of those strategies.

The only purpose of his trading was tax avoidance. [ 143 ] It is for that reason Mr. Knight’s reports are entitled to little weight. His speculation about various trading strategies that Mr. Pat Paletta might have been using were ill-founded in light of the evidence. The only trading strategy used by Mr. Pat Paletta was one designed to ensure immediate loss realization and indefinite gain deferral for tax purposes. [ 144 ] Unfortunately, Mr. Knight was not asked to consider the hypothetical of a trader who engaged in the trades at issue for tax purposes only. [ 145 ] By way of contrast, Dr.

Pavlov’s report was most useful and is entitled to considerable weight. It helped to demolish the Minister’s assumptions that: 1. there was no risk to the straddle trading; [103] and 2. the margin required by each of the brokerage firms was insufficient to support that trading. [104] [ 146 ] I have accepted Dr. Pavlov’s opinion that the risk involved in the straddle trading was negligible. In light of that opinion, which was consistent with the evidence of the CEOs of the brokerage firms and Mr.

Hodgins, I have found that there was some risk to the straddle trading and, therefore, the relatively modest amount of margin required by each of the brokerage firms was not unreasonable in the circumstances. In such circumstances, the fact that there were never any margin calls is unsurprising. V. Positions of the Parties A. The Crown’s Argument

(1) As Pleaded in the Amended Reply [ 147 ] The arguments outlined by the Crown in the Amended Reply were: (

a) all of the purported foreign currency option contracts and positions and all contracts and agreements entered into with Union CAL, IFX and ODL were shams ; (

b) if the trades occurred and were not shams, which is denied, the trades were not legally effective in that there were no legally effective contracts for the purchase or sale of any commodity; (

c) the Appellant did not incur the Claimed Losses; (

d) in the further alternative, the trades were not commercial transactions as the Appellant had no real liability at the end of the 2000 to 2007 taxation years and bore no risk ; (

e) in the further alternative, there was no business or potentially income producing property as, according to the understanding between the Appellant and the Hodgins, the group of trades engaged in by the Appellant could not produce any income to the Appellant. Therefore there could be no source of income with respect to the trades and the trades did not produce a loss under

section 3 or 4 of the Act; and (

f) in the further alternative, if there was a business activity, there were no realized losses as at the end of each of the Taxation Years as realization of losses and gains would have occurred simultaneously on the expiry or value dates. [105] [Emphasis added]

(2) As Argued at Trial [ 148 ] By the time final argument was presented, the Crown’s arguments had shifted from those outlined in the Amended Reply. In final argument, the Crown made a single overarching point—Mr. Pat Paletta’s trading was not a source of income . All of the other arguments in the Amended Reply, including the sham argument, were relegated to a secondary role in support of the Crown’s source argument. (

a) No Source of Income (

i) Tax Loss Scheme is Not a Business [ 149 ] The Crown argued that there was no source of income because a tax loss scheme is not a business. Mr. Pat Paletta’s predominant motive was the pursuit of tax losses, and as a result, he did not incur any losses from carrying on a business. (ii) Sham Forward Foreign Exchange Contracts and Options [ 150 ] The Crown argued that there was no source of income because all of the trade documentation was fabricated by Mr. Hodgins. The Minister made assumptions of fact that the trading was a sham.

The Appellant had the onus of proving that these assumptions were incorrect. [106] The parties to the trades made significant misrepresentations in purporting to trade forward foreign exchange contracts. Mr. Hodgins preordained all of the trades and had no choice but to achieve the target losses. [107] Mr. Hodgins represented Mr. Pat Paletta as well as the brokerage firms on all trades. There was no purpose to the trading other than the realization of tax losses. As a result, the relationship between Mr. Pat Paletta and the brokerages was a sham.

Finally, the trading statements themselves were a sham. [108] (iii) Window Dressing

[ 151 ] The Crown argued that there was no source of income because Mr. Pat Paletta did not intend to carry on a trading business between 2000 and 2007. He only intended to obtain a tax benefit: . . .

The trades were window dressing , an activity undertaken to generate losses, while conveying the impression that the appellant was carrying on a business with a view to profit. . . . [109] [Emphasis added] [ 152 ] The Crown argued that “window dressing” is a separate doctrine from “sham”, and that even if I did not find sham, that I should find “window dressing”. (iv) Facts Incompatible with the Existence of a Business [ 153 ] The final argument made by the Crown in support of the source argument is that the facts are incompatible with the existence of a business. Specifically, it was argued that: (

a) the target loss amount each year was a preordained amount; (

b) there was a lack of risk in these trades and this differs from the amount of risk normally associated with forward foreign exchange trading; and (

c) the trades were legally ineffective. [110] [ 154 ] The Crown argued that an activity that is predetermined to result in a specific amount of loss is not a business. [111] The trading was preordained to result in a loss equal to the amount of the target loss. Since the amount of the loss was known at the commencement of that year’s trading, the trading at issue could not have been a business. [112] Risk is required in order for an activity to be recognized as a business. [113] Mr.

Pat Paletta’s trading did not involve sufficient risk to constitute a business. [ 155 ] The “ " legally ineffective " ” argument is premised on the assumption that Mr. Hodgins acted for both parties in making the trades. [114] There was no contract because there was no offer and acceptance. Mr. Pat Paletta could not have offered, or accepted, any of the trades because he did not know or understand the terms of any of the trades he purported to enter into. [115] Mr. Hodgins was, therefore, trading with himself which amounts to no trading at all.

(3) Statute-Barred Taxation Years [ 156 ] The Crown argued that the misrepresentations conceded by the Appellant were attributable to wilful default because Mr. Pat Paletta knew that the trading losses were a sham and that the losses reported for tax purposes were not supported by the trading statements. [116] Mr. Pat Paletta knew that the realization method was an artificial way of accounting for the trades and did not reflect the economic reality of the situation. [117] The trades were preordained [118] and Mr.

Pat Paletta cannot use the fact that accounting professionals prepared his returns as a defence. [119] He should have made inquiries of third parties [120] and was wilfully blind. As a result, there was negligent misrepresentation and all statute-barred years should be reopened. [ 157 ] With respect to the 2002 taxation year, Mr. Pat Paletta neglected to take into account the gain legs from the 2001 trading that he says he closed out and realized in early 2002. [121] He made no inquiries and was wilfully blind in respect of this error. [122] As a result, the 2002 taxation year should be reopened.

The Crown also argued that the 2002 error affected the correctness of all subsequent returns. [123]

(4) Gross Negligence Penalties [ 158 ] The Crown argued that the evidence demonstrates, on a balance of probabilities, that the misrepresentations conceded by the Appellant for the 2000 to 2006 taxation years were attributable to gross negligence. Mr.

Pat Paletta was aware of many suspicious circumstances surrounding the trading activity and the people involved in it, yet he continued to trade. [124] He was wilfully blind and his indifference was tantamount to intentional conduct or an indifference as to whether the law was complied with. [125] He cannot rely on the defence that his accountants were negligent because of his business acumen, past trading experience, and the fact that he did not take precautionary steps when his accountants expressed concerns in 2001.

In addition, he was wilfully blind. [126] As a result, the Crown argued that the gross negligence penalties should be upheld. B. The Appellant’s Argument [ 159 ] The Appellant argued that the forward foreign exchange trading was not a sham and that the transactions were legally effective.

(1) Friedberg and the Straddle Trade [ 160 ] The Appellant argued that the teachings of the Supreme Court of Canada in Friedberg are (

a) by closing out the loss leg of a straddle, a trader will thereby realize a loss for the year, and (

b) such loss is not diminished by the value of any related gain leg not closed out in the year. [ 161 ] Mr. Friedberg closed out the loss legs of his straddle trades before year-end but kept the gain legs in place into the following year, thereby deferring the corresponding gains. [127] Mr. Pat Paletta did the same. Therefore, the same result should follow .

(2) Stewart and Clear Commerciality [ 162 ] With respect to the Crown’s source argument, the Appellant contended that the law, as stated by the Supreme Court of Canada in Stewart , forms an insurmountable obstacle to the Crown’s argument that there was no “ " source of income " ” from the trading. [ 163 ] There was always a slight difference between the value of the loss leg and the value of the gain leg. Therefore, there was always a possibility of profit and risk of loss from the straddle trade. As forward foreign exchange trading is inherently a commercial activity, and as there is no personal element involved, there was necessarily a source of income for purposes of

section 9 of the Act.

(3) Statute-Barred Taxation Years [ 164 ] The Appellant concedes that certain computational errors were made in each of the 2001 to 2007 taxation years but says that those misrepresentations were not attributable to neglect, carelessness, or wilful default. [128] [ 165 ] The Appellant argues that Mr. Pat Paletta obtained professional advice regarding the trades, obtaining his own oral opinions as well as written

opinions passed along to him by Mr. Lewis and later by Mr. Hodgins. [129] Mr. Pat Paletta relied on tax professionals to prepare his returns. [130] The foreign exchange trading deferral was similar to another deferral strategy that Mr. Pat Paletta had used in the past. [131] The CRA reviewed the trading in the early taxation years, concluding that the strategy was acceptable and that there was nothing to audit. [132] Finally, Mr.

Pat Paletta exercised the requisite degree of care in reviewing his returns with his accountants before signing them. [133] As a result, the statute-barred years cannot be opened in respect of the losses claimed from forward foreign exchange trading. [ 166 ] With respect to the 2002 taxation year, the Appellant acknowledged that a mistake was made but says it was made by the accountants. Mr.

Pat Paletta had only the most high-level and general understanding of the trading pattern and relied on his accountants to properly report the transactions. [134] The accountants were not only provided with the 2002 working papers (Exhibit A57) but with the trade statements as well. [135] Exhibit A56 was the 2002 to 2003 trade blotter, which was also sent to Mr. Angelo Paletta. [136] Exhibit A57 was a response to further inquiries by Mr. Wiseman about Exhibit A56. [137] Mr. Angelo Paletta testified that it would have been forwarded directly to Mr.

Wiseman. [138] It is worth noting that the trade blotter also begins in December of 2002 and does not include the 2001 gain trades that were closed in January of 2002. [139] The Crown has not shown that either Mr. Pat Paletta or Mr. Angelo Paletta failed to make inquiries of the accountants. [140] [ 167 ] The Appellant argues that Mr.

Pat Paletta was not negligent or careless because he relied on his accountants and, despite reviewing the 2002 return with them, was unable to identify the error because it was beyond his ability to do so. [ 168 ] It is, therefore, the Appellant’s position that none of the statute-barred years can be opened.

(4) Gross Negligence Penalties [ 169 ] The Appellant submits that gross negligence penalties should not be upheld as Mr. Pat Paletta did not have knowledge of, and was not grossly negligent in making, the false statements in his returns. [141] [ 170 ] Mr. Pat Paletta considered the reporting of the trades thoughtfully, obtained professional advice on the proper reporting of the trades, and relied on his longstanding and trusted accountants to prepare his returns.

He reviewed the returns with them and received comfort from the CRA itself as the CRA had reviewed the trades in an earlier year. [142] The Crown did not introduce any evidence to show that Mr. Pat Paletta was grossly negligent in reporting the trades. [143] VI. Analysis A. Realization of Losses for Tax Purposes [ 171 ] In commencing the analysis, it is critical to understand the significance of the decision of the Supreme Court of Canada in Friedberg as Mr. Pat Paletta used essentially the same tax plan. Both taxpayers constructed straddle trades for tax purposes.

Both taxpayers closed out their loss legs before year-end. Both taxpayers contended that they had incurred losses for tax purposes in the year in which the loss legs were closed out. Both taxpayers carried over the related gain legs into the following year. A list of relevant similarities and differences between the two cases is attached as Appendix " A " . [ 172 ] One of the differences between the two cases is that Mr. Friedberg traded futures on an exchange (or on what the Minister calls the “open market”) while Mr. Pat Paletta traded forward foreign exchange contracts with a counterparty on the OTC market.

Any trades not executed on an “open market” somehow appear to the Minister to be inherently suspect. On the evidence, there is no basis for the Minister’s suspicion. After hearing the evidence of the CEO of each of the three brokerage firms and the evidence of Mr. Hodgins and the experts, there is nothing unusual, let alone suspicious, about trading forward foreign exchange contracts with a counterparty on the OTC market. In fact, that is precisely how it is done.

(1) Friedberg in the Federal Court – Trial Division (1989) [ 173 ] In Friedberg v The Queen , 1989 CarswellNat 206 , the issue was whether the Minister properly reassessed Mr. Friedberg’s tax losses from his straddle trades in commodity futures. The Minister’s case proceeded on two different grounds. The first was that the “mark to market” method of accounting ought to have been used by Mr. Friedberg in reporting his gains or losses for tax purposes rather than the “lower of cost or market” method. [ 174 ] The second ground was that Mr.

Friedberg’s tax losses artificially reduced his income and, therefore, contravened subsection 245(1) of the Act (which was later replaced by the general anti-avoidance rule): 245(1) Artificial transactions – In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income. [ 175 ] At trial, each party adduced expert accounting evidence.

The expert evidence strongly suggested that the “mark to market” method of accounting measured the economic results of Mr. Friedberg’s trading more accurately than the “ " lower of cost or market " ” method.

Both methods, however, were acceptable under generally accepted accounting principles (“ " GAAP " ”). [ 176 ] The relevant question that arose for consideration by Associate Chief Justice Jerome of the Federal Court – Trial Division (the “F.C.T.D.”) was: . . . may the taxpayer compute his loss on the closing out of the short position without regard for the gain accruing on the as yet unrealized long position? [144] [ 177 ] Associate Chief Justice Jerome answered that question in the affirmative. He concluded that no provision of the Act required Mr. Friedberg to use the “ " mark to market " ” method. Mr.

Friedberg was, therefore, free to use any other method consistent with GAAP. [ 178 ] With respect to the Crown’s subsection 245(1) argument, Associate Chief Justice Jerome: . . . addressed this point by noting that the real distinction between the marking to market and the lower of cost or market methods of accounting for futures transactions was one of timing. Under both methods, the gain realized on the winning leg is recognized for tax purposes. The only difference is the time at which the recognition occurs.

He also noted that the amount of the loss realized on the losing leg was determined by market forces and was not in any sense fictitious. This being so, there was no artificial reduction of income, and subsection 245(1) did not apply to limit the loss. [145] [ 179 ] The Crown appealed to the Federal Court of Appeal.

(2) Friedberg in the Federal Court of Appeal

(1991) [180] In Friedberg v Canada (1991), (FCA), 135 NR 61, the Federal Court of Appeal affirmed the decision of the F.C.T.D. In hiscase comment on the decision, Thomas McDonnell neatly summarizes the reasoning of Associate Chief Justice Jerome which was upheld by the FederalCourt of Appeal: The trial judge said that the Act does not expressly provide how gains and losses on spread transactions are to be accounted for indetermining liability for tax.

He said that in the absence of an express statutory provision to the contrary, a taxpayer’s income for taxpurposes is to be determined in accordance with generally accepted accounting practices. The trial judge went on to say that where there aretwo acceptable methods of accounting for income under GAAP, the taxpayer is free to choose whichever method he finds most advantageousin computing his tax liability.

Again, it is important to note that the taxpayer’s right to do so was, in the trial judge’s view, dependent on thefact that the Act is silent on how the taxpayer is to account for gains and losses on commodity spread transactions. The Court of Appeal has now upheld this aspect of the trial judge’s decision. . . . [146] [181] The Crown sought, and received, leave to appeal to the Supreme Court of Canada.

(3) Friedberg in the Supreme Court of Canada (1993) [182] After hearing from senior counsel for the Crown, the Court rendered its decision from the bench. [147] The reasons were delivered by JusticeIacobucci on behalf of the Court: Iacobucci J. -- We are all of the view that this appeal should be dismissed. The respondent taxpayer traded extensively in commodity futures during the taxation years 1978 to 1981 and claimed as income taxdeductions business losses arising out of trading in gold futures on his own account.

On the facts, the respondent reported his losses when they were actually incurred, and his gains when they were actually realized. In ourview, the appellant has not demonstrated that there is any error in adopting this approach. While the “marked to market” accounting methodproposed by the appellant may better describe the taxpayer’s income position for some purposes, we are not satisfied that it can describeincome for income tax purposes, nor are we satisfied that a margin account balance is the appropriate measure of realized income for taxpurposes.

Similarly, while we recognize that the “lower of cost or market” method advocated by the respondent suggests that unincurredlosses can be deducted in the calculation of income, no unincurred losses were deducted by the respondent on the facts of this case.Accordingly, we need not determine the income tax validity of this implication of the “lower of cost or market” metho

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