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Correcting Tax Mistakes after Fairmont and Jean Coutu

I was very glad to be a panelist for the Canadian Tax Foundation’s conference on the Supreme Court of Canada’s decisions in Fairmont and Jean Coutu.

During the discussion the panelists were asked about the ways taxpayers may correct tax mistakes after these two decisions of the Supreme Court.

In my remarks, I suggested taxpayers would be wise to review the revised requirements for rectification, and to consider the other remedies that may be available. I cited a list of potential remedies and, as a starting point, a selection of cases on these remedies:

The Supreme Court’s decision in Fairmont did not diminish or alter the other remedies that may be available to a taxpayer following an unintended tax result. I suggest that these other remedies may become more significant as taxpayers and their professional advisers determine how a particular tax mistake may be corrected following Fairmont and Jean Coutu.

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Correcting Tax Mistakes after Fairmont and Jean Coutu

Baytex: ABQB Grants Rectification

In Baytex Energy Ltd. et  al. v. The Queen (2015 ABQB 278), the Alberta Court of Queen’s Bench considered whether rectification and/or rescission were available to address mistakes that could result in the taxpayer being taxed on additional resource income of $135 million for 2003-2006 and $528 million for 2007-2010.

The Court determined that the requirements for rectification had been satisfied and thus granted the rectification of certain documents to accord with the parties’ original intention.

Facts

Baytex Energy Trust (the “Trust”) was a publicly-traded mutual fund trust (the Trust later converted to Baytex Energy Corp. (“BEC”), a publicly-traded dividend-paying corporation). The Trust wholly-owned Baytex Energy Ltd. (“BEL”), which owned and operated oil and gas properties prior to transferring the properties to Baytex Energy Partnership on January 1, 2010.

The Baytex companies were subject to the pre-2007 oil and gas royalty regime in the Income Tax Act, which required certain additional resource income for an oil and gas producer (referred to in the judgment as “Phantom Income”) and denied certain deductions for provincial Crown royalties and taxes. A 25% resource allowance was available to the producer. The Phantom Income could be transferred by the producer to another party, and a non-deductible and off-setting reimbursement would be made back to the producer. In this case, BEL and the Trust agreed that BEL would transfer 99% of its income and cash flow to the Trust.

In the Budget of February 18, 2003, the federal government announced the phase-out of the oil and gas royalty regime and the elimination of the regime as of January 1, 2007.

Parties’ Agreements

BEL and the Trust executed a Net Profits Interest Agreement (the “Original Agreement”) in September 2003 for the transfer of income and the off-setting reimbursement. However, the written terms of the Original Agreement failed to address the transfer of Phantom Income. A subsequent agreement (the “Collateral Agreement”) – not all of the terms of which were reduced to writing – addressed the transfer of Phantom Income.

The parties intended that the transfer and reimbursement would cease effective January 1, 2007 because of the elimination of the oil and gas royalty regime in the Income Tax Act.

However, from January 1, 2007 to December 31, 2010, the parties continued the practice of transferring and reimbursing the Phantom Income. When this error was initially discovered in 2008, the Baytex companies’ tax professionals advised that the Original Agreement should be amended to provide for the reimbursement beyond 2006 to be consistent with the practice of the parties. The Baytex companies were told this amendment would have no adverse tax consequences. Based on this advice, the parties entered into an Amended Agreement.

The CRA reviewed the Baytex companies’ arrangements and concluded that an additional $135 million was taxable income to BEL for 2003-2006, and that the Trust earned an additional $528 million of taxable income for 2007-2010.

Rectification/Rescission

The Baytex companies sought rectification of the agreements. The CRA did not oppose the rectification of the agreements for the pre-2007 period, but did oppose the rectification for the post-2006 period on the basis that the Baytex companies had intentionally amended the Original Agreement, based on professional advice, to reflect the practice of transfer and reimbursement, and thus the parties mistaken assumption about the tax consequences would not meet the test for rectification. The taxpayers argued that the evidence (which consisted of two affidavits of BEC’s Chief Financial Officer) established that the parties always intended to transfer and reimburse the Phantom Income and that no transfers would occur after January 1, 2007.

The Court considered the authorities on rectification and concluded that the test for granting rectification had been met. The uncontroverted evidence was that the parties’ common intention was to transfer BEL’s income to the Trust, and that this practice would cease as of January 1, 2007. The Original Agreement and the Amended Agreement were inconsistent with this common intention. The precise form of the corrected agreement was not in dispute. And there were no other considerations that would limit/prevent the availability of rectification. Accordingly, the Court granted the rectification.

While this determination was sufficient to dispose of the application, the Court did go on to consider whether, if the Court was wrong on rectification, rescission was available to the parties. The Court held that the Amended Agreement triggered an unintended tax consequence that constituted a fundamental mistake that went to the root of the contract. The Court concluded that rescission was available to rescind the Amended Agreement, which would restore the parties to their Original Agreement, which the Crown had agreed should be rectified.

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Baytex: ABQB Grants Rectification

Brent Kern Family Trust: FCA Dismisses Appeal

In Brent Kern Family Trust v. The Queen (2014 FCA 230), the Federal Court of Appeal dismissed the taxpayer’s appeal with reasons delivered from the bench. The taxpayer had argued that the decision of Canada v. Sommerer (2012 FCA 207) should not apply in this case and, in the alternative, that Sommerer was wrongly decided and ought not to be followed.

Brent Kern Family Trust was a case in which the taxpayer undertook a series of transactions whereby a taxpayer (Mr. K) completed an estate freeze for two corporations (the underlying facts are described in detail in the Tax Court decision (2013 TCC 327)).

Following the estate freeze, two family trusts were set up each with Mr. K and his family as beneficiaries as well as each trust having a separate corporate beneficiary. Next, each of the trusts subscribed for common shares in the corporate beneficiary of the other trust.

Once the structure was in place, a dividend was flowed through the structure and, as a final step, one of the trusts paid funds to Mr. K but relied on the application of subsection 75(2) of the Act to deem the dividend income received by the trust to be income in the hands of one of the corporate beneficiaries. Accordingly, if subsection 75(2) of the Act applied, the income would not be subject to tax as a result of section 112 of the Act and Mr. K could keep the gross amount of the funds.

In the decision rendered at trial, the Tax Court held that Sommerer case applied and subsection 75(2) of the Act did not apply on the basis that the trust purchased the property in question for valuable consideration and no “reversionary transfer” occurred.

In Brent Kern Family Trust, the Court of Appeal found that there was no reviewable error in the trial judge’s finding that Sommerer applied, that the Court of Appeal in Sommerer “spent considerable time analyzing the text, content and purpose of subsection 75(2)”, and no reviewable error had been brought to the Court’s attention in the present case.

The Court of Appeal dismissed the taxpayer’s appeal and upheld the Tax Court’s decision.

We note also that at least one taxpayer has brought an application in a provincial court to correct a transaction where the taxpayer never intended for Sommerer to apply. In Re Pallen Trust (2014 BCSC 405), the B.C. Supreme Court rescinded two dividends, the effect of which was to eliminate the tax liability in the trust. Re Pallen Trust is under appeal to the B.C. Court of Appeal.

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Brent Kern Family Trust: FCA Dismisses Appeal

B.C. Supreme Court Rescinds Land Transfers

In Re 0741508 BC Ltd and 0768723 BC Ltd  (2014 BCSC 1791), the British Columbia Supreme Court (“BCSC”) considered whether rescission should be granted in respect of two real estate transactions in which the applicant corporations had transferred several parcels of land to a partnership.

The transactions were undertaken as part of a proposed commercial development of the land. The parties intended – in accordance with industry practice – that there would be no net GST/HST payable on the land transfers (i.e., the GST/HST payable would be offset by an input tax credit).

However, the partnership was not registered for GST/HST purposes under the Excise Tax Act (“ETA”) and accordingly the input tax credit was not available. The CRA audited members of the corporate group and reassessed nearly $6 million in GST/HST and penalties.

The parties brought an application to the BCSC for rescission of the transfers (i.e., to effectively put the property back in the hands of the selling corporations).

The application was opposed only by the CRA, which argued that rescission should not be available as the mistake in question was not related to the purpose of the transaction but only its consequences. In Gibbon v Mitchell ([1990] 1 W.L.R. 1304 (Ch.), a U.K. court held that rescission would be granted for a mistake where “the mistake is as to the effect of the transaction itself and not merely as to its consequences or the advantages to be gained by entering into it”. Similar reasoning was followed by the Ontario court in 771225 Ontario Inc. v Bramco Holdings Co Ltd. ([1994] 17 O.R. (3d) 571 (Gen. Div.)), which held that an assessed land transfer tax “was a consequence of the transaction, rather than its purpose, and therefore the case did not fall within the strict confines of the rule for granting relief.”

In considering whether to exercise its discretion to order equitable rescission, the BCSC cited McMaster University v Wilchar Construction Ltd. ([1971] 3 O.R. 801 (H.C.)):

In equity, to admit of correction, mistake need not relate to the essential substance of the contract, and provided that there is mistake as to the promise or as to some material term of the contract, if the Court finds that there has been honest, even though inadvertent, mistake, it will afford relief in any case where it considers that it would be unfair, unjust or unconscionable not to correct it.

In the present case, the BCSC noted that, in Re: Pallen Trust (2014 BCSC 305) the court had rejected Gibbon and instead relied on the test adopted in the U.K. Supreme Court decision in Pitt v Commissioners for Her Majesty’s Revenue and Customs ([2013] UKSC 26) to determine whether to rescind a voluntary transaction.

Equitable rescission, under Pallen, would be available where there was a “causative mistake of sufficient gravity” as to the “legal character or nature of the transaction, or as to some matter of fact or law which is basic to the transaction” such that it would be unconscionable, unjust or unfair not to correct the mistake.

The BCSC noted that, in the transactions at hand, the intention of the parties had always been that the partnership would be registered under the ETA so that no net GST/HST would be payable. This was distinguishable from Bramco, where there had never been a specific intention to minimize the applicable tax.

The BCSC reiterated the principle set out in McMaster and Pallen that “if there has been an honest, even though inadvertent mistake, equity will afford relief in any case that the court considers that it would be unfair, unjust, or unconscionable not to correct it” and held that it would be unfair and unjust for either Canada and/or the Province to gain over $6 million plus accruing interest solely because of a mistake in not registering under the ETA.

The BCSC granted the rescission and held that there was “no adequate legal remedy available, the petitioners are not seeking to carry out retroactive tax planning, and there is no prejudice to third parties.”

The Court did not explicitly consider whether the mistake met the threshold of being of sufficient gravity as to the legal character, nature of the transaction, or as to some matter of fact or law which is basic to the transaction.  Presumably, the punitive and negative results of the transaction were sufficiently grave – that is, the mistake about the fact as to whether ETA registration had been completed was sufficiently grave – that the Court found rescission should be granted.

Pallen has been appealed to the B.C. Court of Appeal.  It will be interesting to see if the present case is appealed as well.  Either way, the equitable doctrine of rescission continues to develop in the context of unintended tax consequences.

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B.C. Supreme Court Rescinds Land Transfers