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Jean Coutu: SCC Revises Test for Rectification under the Civil Code

On December 9, 2016, the Supreme Court of Canada rendered its judgment in Jean Coutu Group (PJC) Inc. v Attorney General of Canada (2016 SCC 55) along with its companion case Canada (Attorney General) v Fairmont Hotels Inc. (2016 SCC 56).

Our post on the Court’s decision in Fairmont Hotels is available here.

In Jean Coutu, a 7-2 decision, the Supreme Court specified and enhanced the civil law test applicable to rectification of a written instrument where the taxpayer has suffered an unintended and adverse tax result. The Court had previously addressed this test in Quebec (Agence du revenu) v Services Environnementaux AES Inc. (2013 SCC 65).

The Supreme Court confirmed that a general intention of tax neutrality does not permit the modification instruments in accordance with the Civil Code of Quebec.

In Jean-Coutu, the taxpayer brought a motion for rectification in the Superior Court of Quebec in order to modify certain documents for transactions that were undertaken to neutralize the effect of the fluctuations in foreign exchange rates. The transactions had achieved this goal, but such transactions had the unexpected and adverse effect of creating foreign accrual property income for one of the companies in the corporate group.

The taxpayer argued that the constant and clear intention of the parties to address the exchange rate fluctuation without generating adverse tax consequences was not reflected in the transaction documents.

The Quebec Superior Court allowed the taxpayer’s motion on the basis that the evidence showed there was discrepancy between the clear intention of the parties and the tax consequence of the transaction as executed.

The Quebec Court of Appeal allowed the Crown’s appeal and stated that the taxpayer’s general intent that its transactions be completed in a tax-neutral manner was insufficient to support a motion for rectification.

On appeal, the Supreme Court defined the issue as follows:

[14] This appeal raises the following key issue: Where parties agree to undertake one or several transactions with a general intention that tax consequences thereof be neutral, but where unintended and unforeseen tax consequences result, does art. 1425 C.C.Q. allow the written documents recording and implementing their agreement to be amended with retroactive effect to make them consistent with that intention of tax neutrality?

In its analysis, the Court applied and confirmed the guidelines it developed in Services Environnementaux AES Inc.

Pursuant to an exhaustive review of the provisions of the Civil Code of Quebec applicable to contracts, the Supreme Court reaffirmed that under the Quebec civil law the agrement or contract lies in the common intention of the parties. A contract is created by “an agreement of wills by which one or several persons obligate themselves to one or several other persons to perform a prestation” (see Article 1378 of the C.C.Q.), which prestation must be “possible and determinate or determinable” (see Article 1378 of the C.C.Q.), and must have a cause (see Article 1410 of the C.C.Q.) and an object (see Article 1412 of the C.C.Q.).

For the majority, Justice Wagner stated that, in light of these provisions of the Civil Code of Quebec, a court may not use the remedy offered by article 1425 C.C.Q. to modify a transactional scheme because it generated unforeseen adverse tax consequences. The Court stated:

[23] A taxpayer’s general intention of tax neutrality cannot form the object of a contract within the meaning of art. 1412 C.C.Q., because it is insufficiently precise. It entails no sufficiently precise agreed-on juridical operation. Nor can such a general intention in itself relate to prestations that are determinate or determinable within the meaning of art. 1373 C.C.Q. It says nothing about what one party is bound to do or not to do for the benefit of the other. Therefore, a general intention of tax neutrality, in the absence of a precise juridical operation and a determinate or determinable prestation or prestations, cannot give rise to a common intention that would form part of the original agreement (negotium) and serve as a basis for modifying the written documents expressing that agreement (instrumentum). As a result, art. 1425 C.C.Q. cannot be relied on to give effect to a general intention of tax neutrality where the writings recording the contracting parties’ common intention produce unintended and unforeseen tax consequences.

And specifying the applicable test developed in Services Environnementaux AES Inc., the Court stated:

[24] In my opinion, when unintended tax consequences result from a contract whose desired consequences, whether in whole or in part, are tax avoidance, deferral or minimization, amendments to the expression of the agreement in accordance with art. 1425 C.C.Q. can be available only under two conditions. First, if the unintended tax consequences were originally and specifically sought to be avoided, through sufficiently precise obligations which objects, the prestation to execute, are determinate or determinable; and second, when the obligations, if properly expressed and the corresponding prestations, if properly executed, would have succeeded in doing so. This is because contractual interpretation focuses on what the contracting parties actually agreed to do, not on what their motivations were in entering into an agreement or the consequences they intended it to have.

Furthermore, the Court distinguished Jean Coutu from Services Environnementaux AES Inc.:

[31] In contrast, in the appeal here, the parties to the contract did not originally and specifically agree upon a juridical operation for the purpose of turning their general intention to neutralize tax consequences into a series of specific obligations and prestations. This general intention of the parties was not sufficiently precise to establish the details of a contemplated operation […] The determinate scenario agreed on by PJC Canada and PJC USA was drawn up properly, but because it was drawn up properly, it produced unintended and unforeseen tax consequences.

The Court dismissed the taxpayer’s appeal and affirmed the decision of the Quebec Court of Appeal.

In dissent, Justice Côté stated that the convergence of principles between the common law and the civil law as expressed by the majority in Jean Coutu was inconsistent with the contract law applicable in Quebec:

[91] […] I agree with my colleague that convergence between Quebec civil law and the common law of the other provinces is desirable from a tax policy perspective (para. 52). Indeed, in this Court, the parties agreed that the common law and the civil law are functionally similar with respect to the availability of rectification. But retreating from the interpretation of art. 1425 C.C.Q. adopted in AES in order to achieve harmony with this Court’s contraction of equitable discretion in Fairmont is inconsistent with the law of contract in Quebec.. […] Given that contracts can be expressed orally without recourse to written instruments, AES left open the possibility of rectifying errors in oral expression (paras. 28 and 32). This is consistent with the civil law principle, inherent in arts. 1378 and 1425 C.C.Q., that a contract is based on the common intention of the parties, not on the expression of that intention.

[92] The majority’s reasons in Fairmont are irreconcilable with these articles of the Code. Rectification in Canadian common law jurisdictions in now “limited to cases where the agreement between the parties was not correctly recorded in the instrument that became the final expression of their agreement” (Fairmont, at para. 3). There appears to be no scope for rectifying oral agreements. With respect, to the extent that my colleague in this case would import this limitation into the civil law, the “convergence” between the two legal systems is, in my opinion, far from “natural” (majority reasons, at para. 52).

The decision rendered by the Supreme Court in Jean Coutu is of significant importance as it restricts the circumstances in which taxpayers may rely on Article 1425 of the Civil Code to rectify transaction documents in tax cases.

Quebec tax professionals should carefully consider the additional guidelines provided in Jean Coutu in assessing whether or not a motion for rectification is available to correct mistakes resulting in unintended and unforeseen adverse tax consequences.

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Jean Coutu: SCC Revises Test for Rectification under the Civil Code

Wilson: SCC Overhauls Standard of Review?

Tax professionals who advise clients on judicial review of the CRA’s discretionary decisions should monitor developments in the standard of review in light of the Supreme Court of Canada’s decision in Wilson v Atomic Energy of Canada Ltd (2016 SCC 29).

In Wilson, the appellant was a non-unionized procurement specialist who worked for Atomic Energy of Canada Ltd. for four and a half years. He was dismissed in November 2009 and filed an unjust dismissal complaint under the Canada Labour Code. At issue was whether the significant severance package provided to Mr. Wilson rendered the dismissal just.

The labour adjudicator found that a severance payment did not exempt an employer from a determination with respect to whether a dismissal was just. Applying a standard of review of reasonableness, the application judge reversed the decision of the labour adjudicator, finding that the Code permitted the dismissal of non-unionized employees without cause. The Federal Court of Appeal agreed, but held that the appropriate standard of review was one of correctness.

The Supreme Court of Canada allowed the appeal and restored the decision of the labour adjudicator. The Court split 5-3 and issued several sets of reasons in its decision.

On the merits, Justice Abella wrote for the Court that the standard of review with respect to a labour arbitrator was one of reasonableness, to be assessed in the specific context under review. In this case, Justice Abella found the interpretation of the labour adjudicator was reasonable. However, Justice Abella remarked – albeit in obiter – that the line between reasonableness and correctness had begun to blur in the case law. A single standard of reasonableness, she stated, would operate to both protect deference and give effect to one correct answer where the rule of law required it. This would give effect to the different gradations of deference to be given to administrative decision makers in different contexts.

Chief Justice McLachlin and Justices Karakatsanis, Wagner and Gascon concurred with Justice Abella’s reasons and expressed appreciation for her attempt to galvanize constructive conversation about the standard of review. However, they declined to recast the standard of review. Justice Cromwell also concurred in the result, but rejected Justice Abella’s attempt to define a new framework, finding that the correctness/reasonableness distinction that emerged in Dunsmuir was still appropriate.

Justices Cote, Brown and Moldaver dissented. Agreeing with the Federal Court of Appeal, they stated that a standard of correctness applied and that the contradictions inherent in a growing body of labour decisions called for judicial clarity. Specifically, they held that “where there is lingering disagreement on a matter of statutory interpretation between administrative decision-makers, and where it is clear that the legislature could only have intended the statute to bear one meaning, correctness review is appropriate”.

What does Wilson mean for tax litigators? First, even though four members of the Court declined to overhaul the Dunsmuir framework, they lauded Justice Abella’s attempt to refine this area of law. The views expressed in the reasons indicate that the Court may be willing to revisit and clarify Dunsmuir (which also contained three sets of reasons).

Second, to the extent that members of the Court wish to supplant the Dunsmuir test with a single standard of reasonableness (containing gradients of deference), attempts to challenge the CRA’s discretionary decisions could be met with increased difficulty in the future.

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Wilson: SCC Overhauls Standard of Review?

SCC Clarifies Law on Admissibility of Expert Evidence

The Supreme Court has released its decision in White Burgess Langille Inman v. Abbott and Haliburton (2015 SCC 23) in which it considered whether the standards for admissibility of expert evidence should take into account the proposed expert’s (alleged) lack of independence or bias.

The Supreme Court’s decision brings some much-needed clarity to the issue of whether a trial judge can disqualify an expert based on impartiality and lack of independence at the qualification stage (i.e., Mohan).  Until now, there has been conflicting case law on this issue, with the majority of the cases supporting the conclusion that, at a certain point, expert evidence should be ruled inadmissible due to the expert’s lack of impartiality and/or independence.

The important questions that remained unanswered, and that trial courts struggled with, were (1) should the elements of an expert’s duty (i.e., independence and impartiality) go to admissibility of the evidence rather than simply to its weight? (2) If so, is there a threshold admissibility requirement in relation to independence and impartiality?

The Supreme Court unanimously answered both questions with “yes.”

(1)   The Expert’s Duty

The Supreme Court stated that expert witnesses have a duty to the court to give fair, objective and non-partisan opinion evidence.  They must be aware of this duty and be able and willing to carry it out.  Underlying the various formulations of the duty of an expert are three related concepts:

(i)        Impartiality: The expert’s opinion must be impartial in the sense that it reflects an objective assessment of the questions at hand.

(ii)        Independent: It must be independent it in the sense that it is the product of the expert’s independent judgment, uninfluenced by who has retained him or her or the outcome of the litigation.

(iii)        Absence of Bias: It must be unbiased in the sense that it does not unfairly favour one party’s position over another.  The “acid test” is whether the expert’s opinion would not change regardless of which party retained him or her.

However, the Supreme Court recognized that these concepts must be applied to the realities of adversary litigation.  Experts are generally retained, instructed and paid by one of the adversaries. According to the Court, “these facts alone do not undermine the expert’s independence, impartiality and freedom of bias.”

(2)   The Framework

The Court concluded that concerns related to the expert’s duty to the court and his or her willingness and capacity to comply with it are best addressed at the “qualification of expert” element of the Mohan framework (which is part 4 of that test).  A proposed expert witness who is unable and unwilling to fulfill his or her duty to the court is not properly qualified to perform the role of an expert.  If the expert witness does not meet this threshold admissibility requirement, his or her evidence should not be admitted.  Once this threshold is met, however, remaining concerns about an expert witness’s compliance with his or her duty should be considered as part of the overall cost-benefit analysis which the judge conducts to carry out his or her gatekeeping function.

The Supreme Court essentially adopted the 2-part test set out by the Ontario Court of Appeal in R. v. Abbey (2009 ONCA 624) and added its own gloss with respect part 4 of that test:

Step 1

The proponent of the expert evidence must establish the threshold requirements of admissibility.  These are the four Mohan factors (relevance, necessity, absence of an exclusionary rule, and properly qualified expert).

In addition, in the case of an opinion based on novel or contested science or science used for a novel purpose, the reliability of the underlying science for that purpose (see R. v. J.-L.J. (2000 SCC 51) per Binnie J.).

After reviewing Canadian, British, Australian, and U.S. authorities, the Supreme Court concluded that an expert’s lack of independence and impartiality goes to the admissibility of the evidence in addition to being considered in relation to the weight to be given to the evidence if admitted.  In reaching this conclusion, it relied upon Justice Binnie’s oft cited quote in R. v. J-L.J.: “The admissibility of the expert evidence should be scrutinized at the time it is proffered, and not allowed too easy an entry on the basis that all of the frailties could go at the end of the day to weight rather than admissibility”.

The Court concluded that concerns related to the expert’s duty to the court and his or her willingness and capacity to comply with it are best addressed initially in the “properly qualified expert” element of the Mohan framework.  In another recent decision, the Supreme Court held that for expert testimony to be inadmissible, more than a simple appearance of bias is necessary.  The question is not whether a reasonable person would consider that the expert is not independent.  Rather, what must be determined is whether the expert’s lack of independence renders him or her incapable of giving an impartial opinion in the specific circumstances of the case (Mouvement Laïque Québécois v. Saguenay (City) (2015 SCC 160) at para. 106).

Evidence that does not meet these threshold requirements should be excluded.

Step 2

Finding that expert evidence meets the basic threshold does not end the inquiry. At the second discretionary gatekeeping step, the judge balances the potential risks and benefits of admitting the evidence in order to decide whether the potential benefits justify the risks (put another way, whether otherwise admissible expert evidence should be excluded because its probative value was overborne by its prejudicial effect).  This is a residual discretion to exclude evidence based on a cost-benefit analysis. The Court adopted Doherty J.A.’s summary of this balancing exercise in Abbey – that the “trial judge must decide whether expert evidence that meets the preconditions to admissibility is sufficiently beneficial to the trial process to warrant its admission despite the potential harm to the trial process that may flow from the admission of the expert evidence.”

(3)   The Threshold

The Court also discussed the appropriate threshold for admissibility.  If a witness is unable or unwilling to fulfill his or her duty, they do not qualify to perform the role of an expert and should be excluded.  The expert witness must, therefore, be aware of this primary duty to the court and be able and willing to carry it out.  While the Court wouldn’t go so far as to hold that the expert’s independence and impartiality should be presumed absent challenge, the Court did state that absent such challenge, the expert’s attestation or testimony recognizing and accepting the duty will generally be sufficient to establish that this threshold is met.

Once the expert testifies on oath to this effect, the burden is on the party opposing the admission of the evidence to show that there is a realistic concern that the expert’s evidence should not be received because the expert is unable and/or unwilling to comply with that duty. If the opponent does so, the burden to establish on a balance of probabilities this aspect of the admissibility threshold remains on the party proposing to call the evidence.  If this is not done, the evidence, or those parts of it that are tainted by a lack of independence or by impartiality, should be excluded.

The Court held that this threshold requirement is not particularly onerous and it will likely be quite rare that a proposed expert’s evidence would be ruled in admissible for failing to meet it. The trial judge must determine, having regard to both the particular circumstances of the proposed expert and the substance of the proposed evidence, whether the expert is able and willing to carry out his or her primary duty to the court.  It is the nature and extent of the interest or connection with the litigation or a party thereto which matters, not the mere fact of the interest or connection.  The Court further stated that the existence of some interest or a relationship does not automatically render the evidence of the proposed expert inadmissible.  For example, a mere employment relationship with the party calling the evidence will be insufficient to do so.

The Court went on to provide some examples of types of interests/relationships that may warrant exclusion of the expert’s evidence:

  • A direct financial interest in the outcome of the litigation will be of some concern;
  • A very close familial relationship with one of the parties;
  • Situations in which the proposed expert will probably incur professional liability if his or her opinion is not accepted by the court; or
  • An expert who, in his or her proposed evidence or otherwise, assumes the role of an advocate for a party.

The decision as to whether an expert should be permitted to give evidence despite having an interest or connection with the litigation is a matter of fact and degree.  The concept of apparent bias is not relevant to the question of whether or not an expert witness will be unable or unwilling to fulfill its primary duty to the court.  When looking at an expert’s interest or relationship with a party, the question is whether the relationship or interest results in the expert being unable or unwilling to carry out his or her primary duty to the court to provide fair, non-partisan and objective assistance.

The Court emphasized that exclusion at the threshold stage of the analysis should occur only in very clear cases in which the proposed expert is unable or unwilling to provide the court with fair, objective and non-partisan evidence.  Anything less than clear unwillingness or inability to do so should not lead to exclusion, but be taken into account in the overall weighing of costs and benefits of receiving the evidence.

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SCC Clarifies Law on Admissibility of Expert Evidence

SCC Grants Leave to Appeal in Guindon v. The Queen

The Supreme Court of Canada has granted leave to appeal in Guindon v. The Queen (Docket # 35519).  In this case, the Supreme Court of Canada will consider whether penalties imposed under section 163.2 of the Income Tax Act (Canada) constitute an “offence” within the meaning of s. 11 of the Charter.

The Tax Court found that the penalty imposed under section 163.2 of the Act is a
criminal penalty, not a civil one, and therefore subject to the same constitutional protections as other penal statutes enacted by the federal government.

The Federal Court of Appeal reversed the Tax Court’s ruling, first on the basis that Ms. Guindon had not followed the proper process in challenging section 163.2 by failing to provide notice of a constitutional question, and so the Tax Court lacked the jurisdiction to make the order it did. However, the Federal Court of Appeal considered the merits of the issue in any event, and held that advisor penalty proceedings are not criminal in nature and do not impose “true penal consequences.”

Our previous comments on the decisions are here and here.

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SCC Grants Leave to Appeal in Guindon v. The Queen

The Latest Word from the Supreme Court of Canada on Conflicts of Interest: Canadian National Railway Co. v. McKercher LLP

The Supreme Court of Canada shed a bit more light on the “bright line rule” for determining when a conflict exists when a law firm represents clients whose interests are adverse in the recent decision of Canadian National Railway Co. v. McKercher LLP, 2013 SCC 39. The Court also provided further clarification regarding a law firm’s duty of loyalty to its clients and guidance for determining the appropriate remedy where this duty is breached.

In McKercher, Gordon Wallace hired McKercher LLP to act for him as the representative plaintiff in a proposed $1.75 billion class action against Canadian National Railway (CN) and others for allegedly overcharging western farmers to transport grain. At the time McKercher was retained by Mr. Wallace, the firm was acting for CN on several unrelated matters. McKercher did not tell CN in advance that it was entering into a retainer with Mr. Wallace, and after entering into this new retainer, the firm withdrew as counsel on some of CN’s matters. CN learned that McKercher was acting for Mr. Wallace in the proposed class action when it received a copy of the Statement of Claim, at which point CN terminated its relationship with McKercher and applied to disqualify the firm from representing Mr. Wallace. The Court of Queen’s Bench of Saskatchewan ruled in CN’s favour and disqualified McKercher from acting in the class action. However, the Court of Appeal overturned the disqualification and allowed McKercher to continue acting for Mr. Wallace, and CN appealed to the Supreme Court of Canada.

The Supreme Court allowed CN’s appeal, finding that McKercher breached its duty of loyalty owed to CN by breaching its duties (1) to avoid conflicts of interest, (2) of candour, and (3) of commitment to its client’s cause, which the Court described as the three salient aspects of the duty of loyalty.

In considering whether a conflict of interest existed, the Supreme Court applied the bright-line rule and found that McKercher clearly crossed the bright line by accepting the retainer with Mr. Wallace without CN’s consent. The Court upheld a strict interpretation of the rule, which stipulates that a law firm cannot concurrently represent clients whose interests are adverse without first obtaining their consent, even if the matters are unrelated.

Despite expressly rejecting arguments for a less strict interpretation of the rule, the Supreme Court pointed out that the scope of the rule is not unlimited. The Court clarified that the bright-line rule:

  1. only applies where the clients’ immediate interests are directly adverse in the legal matters the firm is representing them on;
  2. only applies to legal interests, not to commercial or strategic interests;
  3. cannot be used tactically; and
  4. does not apply where it would be unreasonable for a client to expect that the firm would not act against it in an unrelated matter (for example, with professional litigants, whose consent can be inferred when the conflicting matters are unrelated and there is no risk of improper use of confidential information).

When the bright-line rule does not apply, the Court endorsed a more contextual approach and stated that the test for determining whether a conflict of interest exists is whether there is a substantial risk that the lawyer’s representation of the client would be materially or adversely affected.

The Supreme Court observed that disqualification is normally the appropriate remedy for a breach of the bright-line rule in order to:

  1. avoid misuse of confidential information;
  2. avoid impaired representation; and
  3. maintain confidence in the administration of justice.

However, the Supreme Court noted that disqualification may not always be warranted where there is no risk of misuse of confidential information or prejudice to the complaining party. In cases where disqualification is sought only to maintain confidence in the justice system, courts must consider factors that may weigh against disqualification, including:

  • conduct that could disentitle the complaining party from seeking disqualification (such as delay in applying for disqualification);
  • significant prejudice to the non-complaining client in retaining its choice of, or any, counsel;
  • a law firm’s having accepted the conflicting matter in good faith and with the belief that the concurrent representation would not breach the bright-line rule.

The Court found that McKercher did not have confidential information that could prejudice CN in the class action. Therefore, the only relevant ground for disqualification in this case is to maintain public confidence in the administration of justice, which requires consideration of the above factors. As a result, the McKercher case has been returned to the Court of Queen’s Bench to determine the appropriate remedy for CN in light of the Supreme Court’s reasons.

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The Latest Word from the Supreme Court of Canada on Conflicts of Interest: Canadian National Railway Co. v. McKercher LLP

Daishowa-Marubeni: A Tree Fell in the Forest and the SCC Caught it!

In Daishowa-Marubeni International Ltd. v. The Queen, 2013 SCC 29, Justice Rothstein marries tax philosophy and tax practice by asking and answering the question:

If a tree falls in the forest and you are not around to replant it, how does it affect your taxes?

The Court analyzes the difference for tax purposes between liabilities and embedded obligations, considers the law of contingent liabilities, the role of tax symmetry in the Income Tax Act (Canada) (the “Act”), the role of the agreement between the parties and the role of accounting treatment in reaching the conclusion that embedded obligations are not liabilities that form part of proceeds of disposition.

For a full analysis of the decision, click here.

Daishowa-Marubeni: A Tree Fell in the Forest and the SCC Caught it!

Supreme Court of Canada Considers Two Quebec Rectification Cases

In what circumstances may the Superior Court of Quebec correct a written instrument that does not reflect the parties’ intent?  That is the question that was considered by the Supreme Court of Canada on November 8, 2012 on appeals from decisions of the Quebec Court of Appeal in Agence du Revenu du Québec (formerly the Deputy Minister of Revenue of Quebec) v. Services Environnementaux AES Inc., et al. and Agence du Revenu du Québec v. Jean Riopel, et al.

The panel consisted of McLachlin C.J. and LeBel, Fish, Abella, Rothstein, Cromwell and Karakatsanis JJ. The Court reserved judgment in both cases.

Services environnementaux AES Inc.

Centre technologique AES Inc. (“Centre”) was a wholly-owned subsidiary of Services environnementaux AES Inc. (“AES”). In the context of a corporate reorganization, AES decided to sell 25% of its shares in Centre to a new investor. AES and Centre instructed their advisors that there was to be an exchange of shares under section 86 of the Income Tax Act (“ITA”) and the corresponding provisions of the provincial legislation.

AES believed – mistakenly – that the adjusted cost base of its shares in Centre was $1,217,029. Based on that error, a promissory note of $ 1,217,028 was received by AES as part of the consideration for its shares.

Subsequently, AES received a Notice of Reassessment that added a taxable capital gain of $840,770 to its taxable income. The parties discovered that the adjusted cost base of the shares had been miscalculated and that it was, in fact, only $96,001.

AES filed an application in the Superior Court of Quebec for an order rectifying the written instruments for the transactions. The Superior Court granted the application, noting that its judgment was effective as of the date of the transactions and that it was enforceable against third parties (including tax authorities). The Court of Appeal dismissed the appeal of the Quebec Revenue Agency (QRA).

Riopel

The Riopel case is another case about a corporate reorganization gone wrong.

Mr. Riopel was the sole shareholder of a corporation and held a 60% stake in a second corporation. Ms. Archambeault, Mr. Riopel’s wife, held the remaining 40% of the shares in the second corporation. The parties intended to amalgamate the corporations, with Mr. Riopel as the sole remaining shareholder of the amalgamated corporation. Both shareholders met with a tax advisor and agreed on plan for the reorganization. The parties were clear that the reorganization was to be completed with no immediate tax impact.

However, the Articles of Amalgamation included an error (i.e., the Articles did not reflect the correct share ownership). The shareholders’ professional advisors realized the error, and they tried to correct the situation without notifying the taxpayers.

Subsequently, Ms. Archambeault received a Notice of Reassessment adding a deemed dividend of $335,000 to her taxable income. The shareholders and the corporation brought an application in the Superior Court of Quebec to rectify the written instruments to accord with their true intention (i.e., implementing a reorganization without immediate tax effect).

The Superior Court denied the rectification on the basis that the agreement between the parties was distinct from the mandate given to their advisors. The Court suggested that the error could have vitiated the agreement, but it was not the remedy sought by the parties. The Court added that the error affected both the form and substance of the transactions. Accordingly, rectification was not an appropriate remedy.

That decision was reversed by the Court of Appeal of Quebec. The Court of Appeal applied the reasoning in AES and ordered the rectification so as to give effect to the parties’ common intention.

Position of the Tax Authorities in the Supreme Court of Canada (Oral Argument)

In the Supreme Court, counsel for QRA argued that the rectifications obtained by the taxpayers were not an exercise of interpretation of contracts as permitted by the Civil Code of Quebec (“CCQ”). The contracts in question were clear and should not have been modified, even though the transactions had unintended tax consequences for the parties.

Indeed, tax considerations may be the motivation behind a transaction, but they do not reflect the intent of the parties and are therefore not part of the “scope of the contract”. Thus, according to counsel for QRA, the Court of Appeal erred in rectifying the written instruments in order to make them consistent with the parties’ tax motivations. The parties could have sought cancellation of the contracts, but they failed to do so.

Justice LeBel asked if there was a legal principle that would operate to prevent parties from varying or rescinding a contract. Counsel for QRA responded that there was none, but that such a variation or rescission cannot have retroactive effect with respect to third parties. The situation would be different if the contract was cancelled by the Court since the contract is then deemed to never have existed. In such a case, the QRA would respect the decision of the Court and would assess the taxpayer accordingly.

Justice LeBel also asked if the tax authorities are third parties for the purposes of civil law. QRA’s position is that they are third parties and they have an obligation to apply the law based on the contracts concluded by the taxpayers.

Justice Fish noted that there was no dispute that the parties intended to comply with the provisions of the ITA and that, in this case, they had failed to do so because of human error. Counsel for QRA replied that the only relevant intent was in respect of the actual terms of the contract and not the tax motivation. The CCQ does not operate to vary clear contractual provisions so as to conform to the parties’ tax motivation. A possible remedy would have been the cancellation of the contracts, but that was not what the parties sought.

Counsel for the Attorney General of Canada essentially took the same position. Counsel explained that a party (or parties) cannot rewrite the history of a transaction because of unexpected tax consequences. Counsel emphasized that a distinction must be drawn between the motivation of the parties and the object of the contract. He added that the courts have long recognized that a “mistake in assumption” does not warrant the rectification of a contract. This applies in both common law and civil law.

Position of AES in the Supreme Court of Canada (Oral Argument)

Counsel argued that AES did not ask the Superior Court to modify a contract, but rather to rectify a written instrument to accord with the parties’ common intention in order to reflect the true legal relationship. In this case, the parties intended to complete the transaction in accordance with section 86 of the ITA but the written instrument did not reflect this intention. Accordingly, it was legitimate and necessary for the Superior Court to order rectification.

Justice LeBel asked about the impact of the law of evidence in the context of an application for rectification (i.e., the parol evidence rule). Counsel responded that the restrictions on presenting evidence of a party’s intent did not apply in this case since it has been admitted that the parties’ intention was not correctly reflected in the written document.

Justice LeBel also asked if it was AES’s position that a tax authority is a third party to a contract. Counsel stated that a government has an obligation to enforce tax law based on bona fide legal relationships between the parties. A tax authority would not be a third party because it would have no rights to claim with respect to the rectification of a written instrument. However, on a practical level, it may be appropriate to give the tax authorities an opportunity to be heard.

In closing, counsel stated that an application for rectification in Quebec is based solely on the principles of civil law and that it is not an attempt to “import” a common law concept.

Position of Riopel in the Supreme Court of Canada (Oral Argument)

Counsel stated that this was not a tax case but rather a civil law case. The question that must be asked was the following: Where can the contract be found? It is a mistake to confuse the contract with the written document evidencing it.

The Court of Appeal relied on Article 1425 of the CCQ to grant the application for rectification. Indeed, the application met the three criteria developed by the Court of Appeal in AES (i.e., necessity, legitimacy and no harm to third parties). Moreover, even if the tax authorities should be regarded as third parties, they would not be prejudiced because the rectification had no impact on the tax base.

Justice LeBel noted that numerous errors had been committed. Counsel responded that the errors all had a common origin, namely the Articles of Amalgamation. The number of written instruments to be rectified was not relevant, as long as the purpose was to give effect to the parties’ true intention.

Justice LeBel also wondered if this was an exercise of contractual interpretation. Counsel responded that granting rectification is an operation of correction following the interpretation of the parties’ true intention. Just because the provisions of a contract are clear does not mean that they reflect the parties’ intentions.

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As noted above, judgment was reserved in both appeals. We will report on the decisions as soon as they are released.

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Supreme Court of Canada Considers Two Quebec Rectification Cases

Section 31 of the Income Tax Act – Moldowan Overruled!

It’s been just over four months since the Supreme Court of Canada (the “SCC”) heard oral argument in The Queen v. John H. Craig (see our prior blog post for coverage of the hearing and background on section 31), the only section 31 restricted farm loss case to reach the SCC since the oft-criticized Moldowan v. R., 1977 DTC 5213.

Result: Moldowan has been overruled. It took an uncharacteristically short period of time for the SCC to render its judgment – the unanimous decision emphatically stated that “Moldowan cannot stand.”

Justice Rothstein delivered the reasons, which prescribe a new analysis to be undertaken when a taxpayer needs to determine if his or her income from farming activities (such as a horse racing or breeding business), when combined with some other source of income (such as employment or business income) constitutes a “chief source of income.” If this test is satisfied, then the taxpayer may deduct the full amount of any losses from the farming operation against the other source of income, without restriction. If the test is not satisfied, then section 31 restricts the amount of the deductible loss in any given taxation year to $8,750.

The New Test: The new test outlined by the SCC is still a fact-based analysis to be applied to the particular circumstances of the taxpayer, and has two steps:

Step 1: At the outset, a determination needs to be made that the farming business is in fact a business (a source of income from which losses may be deducted), as opposed to a personal endeavour. This test is enunciated in Stewart v. Canada (2002 SCC 46) as the “commercial manner” test, stating that the farming operation is a business if there is no personal or hobby element; or if there is a personal or hobby element, then the venture must be undertaken in a sufficiently commercial manner “in accordance with objective standards of businesslike behaviour” in order to be considered a business.

Step 2: Once it is determined that the farming operation is a business, the taxpayer is entitled to full deduction of farming losses against another source of income if it is determined that farming and the other source of income is his or her chief source of income, based on the following factors, taken together: the amount of capital invested in farming and the other source of income; the income from each of the two sources of income; the time spent on the two sources of income; and the taxpayer’s ordinary mode of living, farming history and future intentions and expectations. To be successful, it must be shown that the taxpayer has invested significant funds and has spent considerable time attending to the farming business and that the taxpayer places significant emphasis on both the farming and non-farming sources of income. Further, it is not necessary that income from the farming business exceed income from the other source of income – this fact is irrelevant to the analysis.

The new test could be described as the “significant endeavors” test – which is much more palatable than the defunct ‘reasonable expectation of profit’ test or ‘three classes of farmer’ test that has now been buried along with Moldowan. RIP.

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Section 31 of the Income Tax Act – Moldowan Overruled!

Reuters: Corporations Face Long Odds in Tax Cases Heard by the United States Supreme Court – Situation Brighter in Canada

Reuters recently reported a study showing that corporations face very long odds in tax appeals heard by the United States Supreme Court. There were 919 income tax cases in the Supreme Court of the United States from 1909 to 2011. 364 of those cases involved corporations. In “abuse” cases, the government won 61% of the time. In other cases, the government won 68% of the time. The real story is likely much grimmer since the statistics show that the US Supreme Court only grants review in about 2% of leave applications.

The Canadian Supreme Court heard 356 income tax cases between 1920 and 2003. Of these, the statistics show that the government won 223, or roughly 2/3. The record of Supreme Court tax cases between 2004 and 2012 is essentially similar. While an exact breakdown of corporate cases is not available, anecdotal evidence suggests that the success rate of corporations is roughly 1/3 (a more detailed analysis will be available in the future).

While the Canadian experience appears superficially to mirror the American statistics, a very different story is disclosed by Canadian leave to appeal statistics.

Year      Denied Granted
2001

579

79

2002

433

53

2003

523

75

2004

466

83

2005

492

65

2006

406

55

2007

550

69

2008

448

51

2009

444

59

2010

388

54

2011

398

62

Total

5127

705

     
Grand Total

5832

 
     
Average

0.120885

 

As the chart demonstrates, roughly 12% of leave applications are granted in Canada. Thus, corporations and other taxpayers may have as high as 6 times more likelihood of success in a tax appeal before the Supreme Court of Canada than in cases before the Supreme Court of the United States.

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Reuters: Corporations Face Long Odds in Tax Cases Heard by the United States Supreme Court – Situation Brighter in Canada

The cards are on the table – Supreme Court of Canada hears argument on whether to confirm or overrule Moldowan

Were your ears ringing this morning? They might have been if you are a racehorse owner or breeder in Canada, or if you are any other type of farmer who earns income from farming and some other source of income and are thus subject to section 31 of the Income Tax Act (the “Act”).

Section 31 of the Act is the restricted farm loss rule that operates to restrict the deductibility of your full farming losses against other sources of income if farming or a combination of farming and some other source of income is not your “chief source of income.”

For the past 35 years, section 31 has been applied to taxpayers on the basis of the Supreme Court of Canada’s decision in Moldowan v. R., 1977 DTC 5213 (S.C.C.), which has resulted in section 31 being one of the most litigated provisions of the Act and replete with confusion, ambiguity and inconsistent results. Finally, the Supreme Court of Canada granted leave in The Queen v. John R. Craig, which was heard this morning by a seven judge panel (Chief Justice McLachlin and Justice Fish were absent). For our earlier blog post on the case (including the factum filed by each party), click here.

The argument took two hours to complete. In the first hour the Court heard argument from counsel representing the Canada Revenue Agency (“Crown Counsel”), which was divided equally into two distinct sets of submissions organized by issue, and argued in succession by two Department of Justice lawyers.

The first issue addressed by Crown Counsel was its assertion that the legal doctrine of stare decisis was misapplied by the Federal Court of Appeal when it decided Craig, which, in the Crown’s submission, suggested that if Moldowan was applied in the manner desired by the Crown, then the case should have ended there with a Crown victory. Madam Justice Abella and Mr. Justice Rothstein took charge of this issue and put Crown Counsel to task with several related questions.

Justice Abella was very active in her questioning and emphasized that the evolution of the principles of statutory interpretation over the course of time makes it appropriate for outdated concepts to be reviewed. Further, the Supreme Court of Canada is THE venue for addressing any inconsistencies and is charged with the task of adjusting the principles for future application if the updated approach yields a different outcome.

It was also emphasized by both Justice Abella and Justice Rothstein that it is appropriate for lower courts to indicate that there is a problem with a prior precedent or an approach to interpretation, since that is the only way the record can be built and the matter brought before the Supreme Court of Canada for final resolution. That’s why they are there.

It was also noteworthy that Crown Counsel stated that the main issue to be decided was stare decisis, whereas Justice Rothstein was clear in his comments that the Supreme Court of Canada is free to overrule itself, and emphasized to Crown Counsel that the real question is whether Moldowan is right or wrong in the face of so much judicial and academic criticism. Those are the submissions he wanted to hear.

The second half of Crown Counsel’s submissions focused on the assertion that the Moldowan analysis of section 31 is correct and should not be disturbed.

Other tidbits from the panel during Crown Counsel’s submissions was Mr. Justice Moldaver’s comment that the ‘government is quite happy with Moldowan’ and Justice Abella’s comment that ‘farming is inherently unreliable as a source of income’ emphasizing the complexity of dealing with farming in the context of tax law. Justices LeBel, Karakatsanis and Cromwell also engaged Crown Counsel with questions during argument.

Mr. Craig’s counsel (“Taxpayer Counsel”) spent his hour focusing on Moldowan and why it needs to be overruled, given current principles of statutory interpretation, its unfairness to taxpayers and emphasizing the better approach taken by the Federal Court of Appeal in Gunn v. R., 2006 DTC 6544 (F.C.A.), which was followed by the Federal Court of Appeal in Craig. Further, it was submitted by Taxpayer Counsel that Mr. Craig would be successful with respect to the section 31 issue even upon strict application of the Moldowan principles.

The Justices were quite engaged in this discussion, which elicited questions or comments from Justices Abella, Moldaver, Cromwell, Karakatsanis, Deschamps and LeBel, all primarily directed at the wording of section 31 and how sense can be made of its wording to create fairness and certainty.

Taxpayer Counsel spent very little time on the stare decisis issue on the basis that, in its submission, the real issue is the correct interpretation of section 31.

After exactly two hours of argument, the far reaching financial implications on racehorse owners, breeders and other part-time farmers is now in the hands of the highest Court in the land to determine the future application of section 31, once and for all. The judgment is expected to be rendered within the next six to twelve months. Stay tuned.

For further background on this issue and a more comprehensive analysis of the history of section 31 prior to the appeal of Craig to the Supreme Court of Canada, click here.

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The cards are on the table – Supreme Court of Canada hears argument on whether to confirm or overrule Moldowan