Tax Court of Canada Rules Straddle Transactions Not a Sham

Paletta Estate v. H.M.Q. 2021 TCC 11



The appellant[1] entered into straddle transactions to shelter income.  The Minister of National Revenue (“Minister”) reassessed to disallow the losses created by the straddles on the basis that there was no source of income and that the trades were a sham.  The Tax Court of Canada (“TCC”) disagreed and (for the most part) found for the appellant.


The appellant was involved in various businesses, including meat packing and real estate development.  As part of his meat exporting business, the appellant would receive foreign currency.  He began speculating by selling certain amounts of this foreign currency.  In or around 1999, the appellant was introduced to a tax plan which would generate non-capital losses through forward foreign exchange trading.  These transactions are referred to as straddle transactions.

In simple terms, the appellant entered into a set of forward foreign exchange contracts.  He agreed to buy offsetting contracts to both buy and sell a foreign currency at a future date.  The plan would then generate non-capital losses. The appellant then decided the amount of the loss to be taken in that year, and the gain would be carried over the following year.  Justice Spiro found as a matter of fact that the sole purpose of the trading each year was the realization of the target loss, which was used to eliminate most (if not, all) of the appellant’s taxable income in that year.

Financial Background

The foreign exchange contracts at issue are not traded on an exchange but are entered into directly between two parties.  This is commonly referred to as the over-the-counter market.  This is important because value dates ( i.e. value of gains and losses) can be chosen by the parties. All of the foreign exchange trading at issue in this appeal occurred on the over-the-counter market between the appellant and three brokerage firms based in London, England.

Justice Spiro succinctly describes the forward as an agreement between two counterparties to trade a fixed amount of currency at a set rate on a pre‑determined value date.  An option subsumes two types of financial instruments, namely, a put and a call.  A call gives the holder the right to purchase the underlying asset or instrument at a specific price (the “strike price”) on or before the option’s expiration date. A put option gives the buyer the right to sell an underlying asset or instrument at a strike price on or before the option’s expiration date.

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. Similarly, a short call option and a long put option with the same value date and strike price constitute a synthetic short (sell) forward.”[2]

The Trades and Losses

The tax plan was relatively simple.  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.  Shortly after the start of the next taxation year the corresponding gain legs would be closed out and realized.  Finally, 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 the appellant anticipated receiving in that year.

Synthetic forwards were used to construct the straddles.  The straddles would result in losses. The actual losses (and gain in 2007) at issue were as follows:

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)


The appellant would advise the promoter the amount of loss to be taken in a particular year and would pay the brokerage firm a fee (set as a percentage of the target loss). Those fees would be divided amongst the promoters and the brokerage firms.

The appellant benefitted tremendously by entering into the straddles. Despite having received over $38,000,000 of income from 2000 to 2007, the appellant managed to keep his aggregate taxable income over the same period to just over $1,000,000 by means of forward foreign exchange trading.[3]


The Minister reassessed in 2014 (well outside the normal reassessment period) to disallow the losses on the basis that the forward foreign exchange trading was a sham, and that there was no source of income against which the claimed losses could be deducted.  Gross negligence penalties were also assessed.

Decision & Analysis

Experts were called to testify on the complicated financial underpinnings of the straddle transactions.  The appellant called experts in financial instruments and foreign exchange markets.  The Crown called experts in both risk measurement and financial derivatives and in foreign exchange trading.  In summary, the Crown’s experts opined that no one seeking to make money would engage in these trades, and that there was no business purpose for the straddles.

The Crown’s primary argument was that the appellant’s trading was not a source of income.  In other words, the Crown asserted that a tax loss scheme could not be considered a business.  Since the appellant’s motive was to create tax losses, he could not be said to have incurred actual losses from carrying on a business. The Crown also alleged that all of the trading documentation was fabricated, and that therefore the trading was a sham.  The Crown argued that because the target loss was ordained and that there was an inherent lack of risk in the trades, there could be no actual business.

The appellant argued that there was no sham and the straddles were legally effective.  The appellant relied on the reasoning in Friedberg[4] where the Supreme Court found that closing out loss legs in year one and then carrying forward the gains was legitimate.  Since the appellant did the same thing, in the appellant’s view the same result should follow.

Furthermore. The appellant argued that the Crown’s source argument was inconsistent with the Supreme Court’s decision in Stewart[5]. As forward foreign exchange trading is a commercial activity with no personal element, there was necessarily a source of income for purposes of the Income Tax Act.

Was there a business purpose?

It was agreed that the forward foreign exchange trades were entered into for deferral purposes.  But the Court indicated that an absence of business purpose did not mean that there was no source of income.  The Court relied on the Supreme Court’s statement in Stewart that where the nature of an activity is clearly commercial, there is no need to analyze the taxpayer’s business decisions. Such endeavours necessarily involve the pursuit of profit. As such, a source of income by definition exists, and there is no need to take the inquiry any further.[6]

Furthermore, the Walls[7] decision stands for the proposition that the Stewart test applies even if the activity in question is entirely tax-motivated.  With this legal backdrop, the Crown’s source argument failed.

Forward foreign exchange trading is, by its very nature, a commercial activity. In addition, there would always be a positive or negative difference between the value of the loss leg and the value of the gain leg at any particular time. As far as Mr. Pat Paletta was concerned, there was no personal or hobby element involved. The first test in Stewart was satisfied on that basis.  The Court’s decision in Stewart instructs us clearly that the source analysis in such circumstances must end there.[8]

The Court further found that there was a degree of risk, which was contrary to the Crown’s position that the trades bore no risk.

Were the trades a sham?

Justice Spiro detailed the current state of the law on sham.  All of the cases reviewed by Justice Spiro indicate the serious nature of a sham allegation, and that any evidence of deceit by a party must be clear and convincing.  The Crown alleged that since the appellant was not actually trading forward foreign exchange contracts, the entire scheme was a sham.

The Court was unpersuaded.  The Crown adduced no evidence of the fabrication of any trades at issue or the trading documentation.  The brokerage firms participating in the trades were bona fide firms.  There was simply nothing intentionally false or misleading about the trading documents.

Did Frieberg apply?

The Court was clear that the Friedberg decision applied. Friedberg “…stands for the proposition that straddle traders may report the results of their trades for tax purposes on a basis that does not reflect the true economic results of such trades. Unhappy as the Minister may be with that decision, there is no basis on which she can avoid its effect on the taxation years at issue.”[9]

The Court allowed the appeals (apart from filing errors resulting in the under=reporting of income in the 2002 taxation year).


Key Takeaways

It is important to note that in 2017 Parliament enacted a set of rules dealing specifically with straddles in subsections 18(17) to 18(23) of the Income Tax ActPaletta is therefore of limited relevance to trades occurring after March 22, 2017.

The Paletta decision is replete with critical principles of law, including but not limited to:

  • There is no business purpose test in Canadian tax law.[10]
  • Lack of business purpose is not a sham.[11]
  • The Crown argued that a judicial anti-avoidance doctrine of “window dressing” exists in Canada, which is different than the doctrine of sham. The Crown, however, did not cite any binding authority that establishes “window dressing” as a stand-alone judicial anti-avoidance doctrine.[12]

by Amit Ummat

[1] Appellant in this article refers to Mr. Pasquale Paletta. The actual appellant is his estate.

[2] Paletta Estate v. H.M.Q. 2021 TCC 11 (“Paletta”), at para. 24.

[3] Paletta, at para. 100.

[4] Friedberg v Canada [1993] 4 SCR 285 (“Friedberg”).

[5] Stewart v Canada 2002 SCC 46, [2002] SCR 645 (“Stewart”).

[6] Stewart, at para. 53.

[7] Walls v Canada [2002] 2 SCR 684.

[8] Paletta, at para 204.

[9] Paletta, at para. 191.

[10] Paletta, at para. 228.

[11] Ibid.

[12] Paletta, at para. 245.