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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 intended 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

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

Fairmont: SCC Revises Common Law Test for Tax Rectifications

In a 7-2 decision in AG (Canada) v. Fairmont Hotels Inc. (2016 SCC 56), the Supreme Court of Canada has modified the common law test for rectification where the taxpayer has suffered an unintended and adverse tax result. The Court also clarified the standard of proof in respect of evidence of the parties’ intent on a rectification application.

A general intent to avoid or minimize tax is no longer sufficient to support an application for rectification.

In the companion case of Jean Coutu Group (PJC) Inc. v. AG (Canada), the Supreme Court reached a similar conclusion regarding tax intent and the modification of documents under the Quebec Civil Code (we shall follow-up with another post on this decision).

In Fairmont, the taxpayer brought an application to rectify certain share redemptions and to substitute a loan arrangement. The taxpayer argued that its intent at all times was to unwind some earlier loan arrangements on a tax-neutral basis.

The Ontario Superior Court of Justice (2014 ONSC 7302) cited Juliar et. al. v A.G. (Canada) (50 O.R. 3d 728) (Ont. C.A.) (Dentons was counsel to the successful taxpayers in Juliar) and other tax rectification cases. The Superior Court of Justice allowed the taxpayer’s application and unwound the impugned steps in the transaction and substituted the proper steps that accorded with the parties’ intention to avoid tax.

The Ontario Court of Appeal dismissed the Crown’s appeal (2015 ONCA 441).

See our previous posts on Fairmont here and here.

In the Supreme Court, the Crown argued that the result in Juliar conflicts with the Supreme Court’s decision in Performance Industries. The Crown urged the Court to import the requirements from Performance Industries to tax rectification cases.

In response, the taxpayer noted that Juliar (and most other tax rectification applications) are cases of mutual mistake, whereas Performance Industries was a case of unilateral mistake. Previous lower court decisions had rejected this attempt to import the Performance Industries requirements to tax rectifications. Further, the taxpayer noted the irony that the Crown was suggesting the result in Performance Industries should limit the availability of rectification when the Court’s decision in that case had in fact broadened the application of rectification as a remedy.

For the majority, Justice Brown stated that, under the new stricter test for tax rectification, a court may not modify an instrument merely because a party has discovered that its operation generates an adverse and unplanned tax liability. The Court stated:

[16] As I have recounted, both courts below considered the Court of Appeal’s decision in Juliar, coupled with the chambers judge’s findings, to be dispositive. In my respectful view, however, Juliar is irreconcilable with this Court’s jurisprudence and with the narrowly confined circumstances to which this Court has restricted the availability of rectification. …

[23] … Juliar does not account for this Court’s direction, in Shell Canada Ltd. v. Canada[1999] 3 S.C.R. 622, at para. 45, that a taxpayer should expect to be taxed “based on what it actually did, not based on what it could have done”. While this statement in Shell Canada was applied to support the proposition that a taxpayer should not be denied a sought-after fiscal objective merely because others had not availed themselves of the same advantage, it cuts the other way, too:  taxpayers should not be judicially accorded a benefit based solely on what they would have done had they known better. …

[30] This Court’s statement in Performance Industries (at para. 31) that “[r]ectification is predicated on the existence of a prior oral contract whose terms are definite and ascertainable” is to the same effect. The point, again, is that rectification corrects the recording in an instrument of an agreement (here, to redeem shares). Rectification does not operate simply because an agreement failed to achieve an intended effect (here, tax neutrality) — irrespective of whether the intention to achieve that effect was “common” and “continuing”. …

On the standard of proof, the Court stated:

[36] In my view, the applicable standard of proof to be applied to evidence adduced in support of a grant of rectification is that which McDougall identifies as the standard generally applicable to all civil cases: the balance of probabilities. But this merely addresses the standard, and not the quality of evidence by which that standard is to be discharged. As the Court also said in McDougall (at para. 46), “evidence must always be sufficiently clear, convincing and cogent”. A party seeking rectification faces a difficult task in meeting this standard, because the evidence must satisfy a court that the true substance of its unilateral intention or agreement with another party was not accurately recorded in the instrument to which it nonetheless subscribed. A court will typically require evidence exhibiting a high degree of clarity, persuasiveness and cogency before substituting the terms of a written instrument with those said to form the party’s true, if only orally expressed, intended course of action.

In conclusion, the Court stated:

[38] To summarize, rectification is an equitable remedy designed to correct errors in the recording of terms in written legal instruments. Where the error is said to result from a mistake common to both or all parties to the agreement, rectification is available upon the court being satisfied that, on a balance of probabilities, there was a prior agreement whose terms are definite and ascertainable; that the agreement was still in effect at the time the instrument was executed; that the instrument fails to accurately record the agreement; and that the instrument, if rectified, would carry out the parties’ prior agreement.

The Court allowed the Crown’s appeal, with the result that the taxpayer’s application for rectification of the impugned transactions failed.

In dissent, Justice Abella stated that, in her view, there was no reason to impose a stricter standard in tax cases, and on the facts of the Fairmont case rectification should have been granted:

[71] It is true that a taxpayer should expect to be taxed based on what is actually done, not based on what could have been done (Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, at para. 45), but this principle does not deprive equity of a role where what a party or parties genuinely intended to do was transcribed or implemented incorrectly.

[72] On the other hand, parties should not be given carte blanche to exploit rectification for purposes of engaging in retroactive tax planning.  Courts will not permit parties to undo decisions simply because they have come to regret them later.  Allowing parties to rewrite documents and restructure their affairs based solely on a generalized and all-encompassing preference for paying lower taxes is not consistent with the equitable principles that inform rectification. …

[83] The requirements for rectification in the tax context articulated in AES are, in my respectful view, functionally equivalent to the test under the common law.  Civil law and common law rectification in the tax context are clearly based on analogous principles, namely, that the true intention of the parties has primacy over errors in the transcription or implementation of that agreement, subject to a need for precision and the rights of third parties who detrimentally rely on the agreement.

[84] That means that there is no principled basis in either the common or civil law for a stricter standard in the tax context simply because it is the government which is positioned to benefit from a mistake.  The tax department is not entitled to play “Gotcha” any more than any other third party who did not rely to its detriment on the mistake.

The implications of the Supreme Court’s decisions in Fairmont and Jean Coutu are far-reaching, as they significantly change the threshold requirements for granting rectification in tax cases.

The result in these cases also raises the issue of whether other equitable remedies (i.e., rescission, declaratory orders, etc.) may be available, and whether taxpayers may seek alternative remedies if the requirements for rectification may not be satisfied.

The broader impact of the Court’s decision in Fairmont is also unclear. Fairmont was a case in which the taxpayer sought to correct various documents relating to steps in a commercial transaction. How will the Fairmont principles in respect of intent in the commercial context impact rectification applications in respect of wills and trusts?

Tax professionals should consider this new test for tax rectifications to determine the appropriate manner for correcting mistakes that result in unintended and adverse tax consequences.

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Fairmont: SCC Revises Common Law Test for Tax Rectifications

SCC Rectification Decisions to be Released on Friday December 9

The Supreme Court of Canada’s decisions in two rectification cases, AG (Canada) v. Fairmont Hotels Inc. (Docket #36606) and Jean Coutu Group (PJC) Inc. v. AG (Canada) (Docket #36505), will be released on Friday December 9, 2016 at 9:45 a.m.

See our previous posts on Fairmont here and here.

The Supreme Court’s decisions in Fairmont and Jean Coutu will be the first decisions from the Court on rectification since AES and Jean Riopel.

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SCC Rectification Decisions to be Released on Friday December 9

Zhang: BC SC Refuses to Rectify Share Transfer

In Zhang v. Canada (A.G.) (2015 BSCS 1256), the British Columbia Supreme Court refused to grant rectification of a transaction in respect of which the taxpayers had no common intention to avoid capital gains tax on a share transfer.

The taxpayer was resident in British Columbia. He carried on a business of manufacturing and distributing laser equipment. In 2002, the taxpayer incorporated LABest Optronics Co. Ltd. (“LABest”) in China to carry on the business.

In 2003, the taxpayer met with his accountant to discuss his 2002 Canadian tax return. In the course of this discussion, the taxpayer asked about the distribution of income from LABest, and the accountant suggested that income earned in the company could be taxed in China and distributed to a Canadian corporate shareholder as exempt surplus dividends without further Canadian tax being imposed, and then later paid to the taxpayer.

Subsequently, the taxpayer incorporated Beamtech Optronics Co. Ltd. (“Beamtech”), a B.C. company. The accountant suggested that the shares of LABest be transferred to Beamtech. The taxpayer sought and obtained regulatory approval for the share transfer from the Chinese government, and such approval included a transfer value (determined by the government) of $150,000 USD. Beamtech paid $150,000 USD cash to the taxpayer, and no section 85 rollover of the shares was undertaken.

The CRA subsequently reviewed and assessed the transaction on the basis that the fair market value of the LABest shares was $661,164 CDN, resulting in a capital gain of $221,950 for the taxpayer in 2003.

The taxpayer sought rectification of the share transfer to substitute a section 85 rollover of the LABest shares to Beamtech.

The Court stated that the “proper approach” to rectification under B.C. law is as follows:

  1. The focus of the analysis in tax cases is on the intention of the related parties when they entered the transaction. This is because the “mistake” in the written instrument is usually a mistake as to the tax consequences of the transaction. It matters not if the mistake was caused by misinformation from the taxpayer to his advisors, or mistaken advice provided by a professional advisor to the taxpayer.
  2. There is nothing objectionable about taxpayers attempting to avoid tax.
  3. The real question which must be considered is whether the taxpayer is able to establish a specific continuing intention to avoid the particular tax in question. A general intention to avoid taxes is not sufficient. The determination of what constitutes sufficient specificity of intention will depend on the context and the circumstances of each case.
  4. Where rectification is aimed at a wholly distinct kind of tax avoidance, which was not specifically contemplated at the time the written instrument was formed, rectification will not be granted.
  5. A common specific intention is one which existed before the formation of the instrument in question and continued since that time. It must be a “precise” and “clearly-defined object” before rectification will be granted.

In the present case, the Court was concerned that there were significant inconsistencies in the evidence of the taxpayer and his accountant. Further, the evidence established only that the taxpayer intended to implement a corporate structure (i) for the tax-efficient movement of funds from LABest to Beamtech, and (ii) that was acceptable to the Chinese government. The taxpayer had only consulted his accountant about discrete tax issues, but never retained his accountant to provide a comprehensive review of all tax issues that may arise in respect of the transaction. The Court held that the taxpayer had no specific intention to avoid capital gains tax on the share transfer.

The Court dismissed the taxpayer’s application.

The more challenging aspect of Zhang is the Court’s discussion of the requirements for rectification – i.e., whether a specific or general intention to avoid tax must exist for rectification to be granted. The B.C. Court referred to the leading tax rectification case, Juliar v. A.G. (Canada) ((2000), 50 O.R. (3d) 728 (Ont. C.A.), leave to appeal to the Supreme Court of Canada dismissed (File No. 28304)) (Dentons was counsel for the successful taxpayer), and the B.C. cases that have interpreted Juliar (see, for example, McPeake v. Canada (A.G.) (2012 BCSC 132)). The Court stated that, in B.C., “Rectification will not be granted where there is only a general intention to avoid taxes.”

The Alberta Court of Queen’s Bench reached a similar conclusion in Graymar Equipment (2008) Inc. v A.G. (Canada) (2014 ABQB 154) and Harvest Operations Corp. v. A.G. (Canada) (2015 ABQB 237)).

This may conflict with the reasoning in Juliar and other Ontario cases (see TCR Holding Corporation v. Ontario (2010 ONCA 233) and Fairmont Hotels Inc. v. A.G. (Canada)(2015 ONCA 441) in which the Ontario Court of Appeal has clearly stated that rectification was available where the taxpayers had a general intent to carry out their transactions on a tax-efficient (or tax-neutral) basis and had no expectation as to the specific manner in which the transaction would be carried out.

However, Zhang raises the question as to whether the distinction between specific and general intent is meaningful at all. On any rectification application, a court’s focus will always be on the nature of the mistake, the circumstances of the error, and the evidence of the taxpayer’s intent. Whether their intent is described as “specific” or “general”, taxpayers who are careless or cavalier about the Canadian tax implications of a transaction likely cannot establish that they intended to minimize or avoid taxes and cannot expect to obtain relief from the courts.

As of the time of the writing of this post, the taxpayer had not appealed to the B.C. Court of Appeal.

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Zhang: BC SC Refuses to Rectify Share Transfer

Fairmont: OCA Dismisses Crown’s Appeal in Rectification Case

The Ontario Court of Appeal has dismissed the Crown’s appeal in Fairmont Hotels Inc. v. A.G. (Canada) (2015 ONCA 441).

In Fairmont (2014 ONSC 7302), the taxpayer was successful on an application for rectification of certain corporate transactions (see our previous post here).

On appeal, the Crown argued that the lower court had misapplied the test for rectification because the parties had not determined the specific manner in which their intention to avoid tax would be carried out. In the Crown’s view, the lower court’s judgment sanctioned retroactive tax planning.

The Court of Appeal disagreed:

[8]          In these circumstances, relying on this court’s decision in Juliar, the application judge held that the respondent was entitled to rectify the relevant corporate resolutions to correct the mistaken share redemptions.  This result, the application judge noted, would avoid the imposition of an unintended tax burden that the respondent had sought to avoid from the outset, as well as an unintended tax revenue windfall to the CRA arising from the mistaken share redemptions.

[9]          On the factual findings of the application judge, set out above, and the binding authority of Juliar, we see no basis for intervention with the application judge’s discretionary decision to grant rectification.

[10]       Juliar is a binding decision of this court.  It does not require that the party seeking rectification must have determined the precise mechanics or means by which the party’s settled intention to achieve a specific tax outcome would be realized. Juliar holds, in effect, that the critical requirement for rectification is proof of a continuing specific intention to undertake a transaction or transactions on a particular tax basis.

[11]       In this case, on the application judge’s findings, the respondent had a specific and unwavering intention from the outset of its dealings with Legacy to ensure that the Legacy-related transactions were tax neutral and, to that end, that no redemptions of the relevant preference shares should occur.  Nonetheless, by mistake, the redemptions were authorized by corporate resolutions.

[12]       Contrary to the appellant’s argument, in these circumstances, it was unnecessary that the respondent prove that it had determined to use a specific transactional device – loans – to achieve the intended tax result.  That the respondent mistakenly failed to employ an appropriate transactional device to achieve the intended tax result does not alter the nature of the respondent’s settled tax plan: tax neutrality in its dealings with Legacy and no redemptions of the preference shares in question.

[13]       At the end of the day, therefore, Juliar and the application judge’s factual findings, described above, are dispositive of this appeal.  It is not open to a single panel of this court to depart from a binding decision of this court.

[14]       The appeal is dismissed. …

The Court of Appeal’s decision in Fairmont is an important affirmation of the result and reasoning in Juliar v. A.G. (Canada) ((2000), 50 O.R. (3d) 728 (Ont. C.A.)) (Dentons was counsel for the successful taxpayer).

Recently, the Crown has been aggressively arguing in rectification cases that Juliar was either wrongly decided or should be narrowly applied (two Alberta cases have followed this argument – see, for example, Graymar Equipment (2008) Inc. v A.G. (Canada) (2014 ABQB 154) and Harvest Operations Corp. v. A.G. (Canada) (2015 ABQB 237)).

However, in TCR Holding Corporation v. Ontario (2010 ONCA 233) and Fairmont, the Ontario Court of Appeal has clearly rejected those arguments. This should put an end to the Crown’s arguments about Juliar – at least in Ontario.

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Fairmont: OCA Dismisses Crown’s Appeal in Rectification Case

Mac’s: Quebec CA Affirms Denial of Rectification

In Mac’s Convenience Stores Inc. v. Canada (2015 QCCA 837), the Quebec Court of Appeal affirmed a lower court decision (2012 QCCS 2745) denying rectification of corporate resolutions that had declared a dividend that unintentionally put the company offside the “thin-cap” rules in subsections 18(4)-(8) of the Income Tax Act.

Facts

Mac’s, an Ontario corporation, was a wholly-owned subsidiary of Couche-Tard Inc. (“CTI”). In April 2005, Mac’s borrowed $185 million from Sidel Corporation, a related Delaware corporation.

In April 2006, Mac’s participated in several transactions with various related entities, including the declaration of a $136 million dividend on the common shares held by CTI. A similar series of transactions had been undertaken in 2001. However, in 2006, Mac’s professional advisors failed or forgot to take proper account of the $185 million owed by Mac’s to Sidel.

While the $136 million dividend itself was generally without tax consequences, the dividend had the effect of putting Mac’s offside the (then) 2:1 ratio in the “thin-cap” rules in the Income Tax Act. This resulted in the reduction of deductible interest paid by Mac’s to Sidel in the years following the dividend payment (i.e., 2006, 2007 and 2008).

Rectification

After Mac’s was reassessed by the CRA to disallow the interest deduction, Mac’s sought rectification of the corporate resolution declaring the dividend, and additionally sought to substitute a reduction of its stated capital and the distribution of cash to CTI. This would have had the same effect of paying an amount to CTI while maintaining the proper ratio for interest deductibility.

The Quebec Superior Court dismissed the application on the basis that the Mac’s directors never had any specific discussions regarding the deductibility of interest on the Sidel loan after the payment of the dividend. The various steps in the 2006 transactions reflected the intentions of the parties, and thus there was no divergence between the parties agreement and the documents carrying out the transactions.

Appeal

The taxpayer appealed to the Quebec Court of Appeal. The Court described the taxpayer’s position as not invoking any error in the lower court judgment but simply alleging that, if the taxpayer’s advisors had made a mistake, then the lower court decision must be reversed on the basis of the Supreme Court of Canada’s decision in Quebec v. Services Environnementaux AES Inc. (2013 SCC 65) (“AES“) (see our previous post on AES here).

The Court of Appeal stated that it understood the Supreme Court’s decision in AES to stand for the proposition that parties who undertake legitimate corporate transactions for the purpose of avoiding, deferring or minimizing tax and who commit an error in carrying out such transactions may correct the error(s) in order to achieve the tax results as intended and agreed upon. The Court of Appeal cautioned that AES does not sanction retroactive tax planning.

In the present case, the Court of Appeal held there was no common intention regarding the “thin-cap” implications of the dividend payment, and thus there was no agreement that should be given effect by the courts.

The Court of Appeal held there was no error by the lower court and dismissed the taxpayer’s appeal.

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Mac’s: Quebec CA Affirms Denial of Rectification

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

Lau: BC SC Corrects Articles of Incorporation After $17.3 Million Reassessment

Many tax rectification cases address situations in which certain transaction documents contain errors that do not accord with the parties’ intent to minimize or avoid taxes. However, there are several cases in which the courts are asked to correct errors in a company’s constating documents – errors that lead to unintended and adverse tax results for the company or its shareholders.

In Lau v. A.G. (Canada) (2014 BCSC 2384), the British Columbia Supreme Court considered whether a mistake in the drafting of a company’s Articles of Incorporation could be corrected under BC corporate law and/or the doctrine of rectification.

0777020 B.C. Ltd. was incorporated in 2006. The Articles of the company stated, among other things, that the Class E preferred shares could be issued (i) as a stock dividend, or (ii) in exchange for property. The directors of the company could establish the redemption amount of the Class E shares, but the Articles stated that this power of the directors existed only in respect of the issuance of the shares for property (i.e., no redemption amount could be determined where such Class E shares were issued as a stock dividend).

In 2008, the company issued 100 Class E shares as a stock dividend. The directors determined the redemption value to be $17,635,000. There were several subsequent transfers of these Class E shares among the individual shareholders and companies in the corporate group, and certain pre-existing liabilities were cancelled as a result of the Class E share transfers.

Subsequently, the CRA alleged the Class E shares had never been validly issued because no power to determine a redemption value existed in the company’s Articles. The CRA reassessed an individual shareholder to include $17.3 million in his income for 2008.

The individual shareholder objected and eventually appealed to the Tax Court. In the meantime, the company brought proceedings in the British Columbia provincial court to correct certain errors in the corporate documents, including the provision in the Articles addressing the directors’ power to determine the redemption value of the Class E shares. There were several proceedings that addressed the various errors:

  • May 21, 2013 – Taxpayers initiate first proceeding to correct various corporate documents
  • September 17, 2013 – Court grants requested relief in first proceeding
  • December 4, 2013 – Taxpayers initiate second proceeding to correct various corporate documents and Articles
  • April 10, 2014 – Taxpayer amends second proceeding to remove requested relief in respect of Articles
  • April 30, 2014 – Court grants requested relief in second proceeding
  • May 2, 2014 – Taxpayers initiate third proceeding to correct provision in Articles addressing Class E share redemption value

In the third proceeding, the taxpayers had revived the relief originally requested in the second proceeding in respect of the Articles. However, they adduced and relied on more extensive evidence concerning the drafting error. In response, the CRA argued that (i) the issue was barred by cause of action estoppel, (ii) the BC Court should decline jurisdiction, and (iii) rectification should not be granted.

On the first two issues, the BC Court held that (i) cause of action estoppel did not apply to prevent the taxpayers from seeking rectification of the Articles, and (ii) the BC provincial courts have exclusive jurisdiction to consider the requested relief (i.e., under the British Columbia Business Corporation Act or the doctrine of rectification) and it was not appropriate to decline jurisdiction in favour of the Tax Court of Canada.

On the third issue, the BC Court noted that the taxpayers had sought relief based on ss. 229 and 230 of the BC BCA and the court’s equitable jurisdiction. The BC Court held that the evidence of the individual shareholders and their counsel clearly established that the parties intended for the company’s directors to have the power to determine the redemption price of the Class E shares when issued as a stock dividend and in exchange for property. The absence of language in the Articles in respect of this power was a result of an error by the company’s solicitor.

The BC Court stated that ss. 229 and 230 of the BC BCA provide a court with the ability to correct any corporate mistake. Further, the BC Court was satisfied that the taxpayers had proven they had a common intention to empower the directors to determine the redemption amount and that the company’s Articles did not reflect this true intention.

The BC Court ordered that the Articles were corrected nunc pro tunc from 2006 to include language that established the proper powers of the directors.

On a sub-issue, the BC Court considered whether the CRA should have been named as a party in the third proceeding (the taxpayers had named the CRA as a party in the first two proceedings, but had refused to name the CRA as a party in the third).

The BC Court noted that there did not appear to be any consensus or consistent approach on this issue. The BC Court stated that the CRA need not be named as a party in every BC BCA or rectification proceeding. In the appropriate circumstances, the CRA may apply to be named as a party, and a court may exercise its discretion to join the CRA as a party. In this case, it was appropriate that the CRA be named as a party.

In light of the mixed success on the application, the BC Court did not award costs to either party.

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Lau: BC SC Corrects Articles of Incorporation After $17.3 Million Reassessment

Fairmont: Ont SCJ Unwinds Share Redemption and Substitutes Loan Arrangement

The common law doctrine of rectification operates to correct mistakes in transactions that produce (or may produce) unintended and adverse tax results. This was established in the landmark case of Juliar et. al. v A.G. (Canada) (50 O.R. 3d 728) (Ont. C.A.) (Dentons was counsel to the successful taxpayers).

In Fairmont Hotels Inc. et al. v A.G. (Canada) (2014 ONSC 7302) the Ontario Superior Court of Justice has provided another example of the manner in which rectification can be used to unwind certain impugned steps in a transaction and substitute the proper steps that accord with the parties’ intention to avoid tax.

Legacy Hotels REIT owned a collection of hotels, which were purchased from Fairmont in or around 1997. Fairmont continued to manage these hotels. In 2002 and 2003, Fairmont was involved in the financing of Legacy’s purchase of two hotels in Washington and Seattle. Through the use of several reciprocal loans between Legacy, Fairmont and several subsidiary companies, Legacy purchased the Washington hotel for $67 million USD and the Seattle hotel for $19 million USD. Fairmont hedged its loans to eliminate or reduce its foreign exchange tax exposure in Canada.

In 2006, Fairmont was acquired by two companies and its shares ceased to be publicly traded. This acquisition of control could have frustrated the parties’ intention that no entity would realize a foreign exchange gain or loss in connection with the reciprocal loan arrangements. A tax and accounting plan was created that would have allowed the companies to complete the acquisition and continue the full hedge of the foreign exchange exposure. However, this plan was modified before implementation with the result that certain foreign exchange exposure was not hedged.

In 2007, Legacy asked Fairmont to terminate the reciprocal loan arrangements on an urgent basis so that the Washington and Seattle hotels could be sold. A Fairmont officer mistakenly believed that the original 2006 plan had been implemented (i.e., the plan that continued the full hedge of the foreign exchange exposure) and agreed to the unwinding of the loans (which involved the redemption of certain preferred shares of the subsidiaries involved in the loan arrangements). Subsequently, the CRA reviewed the transactions and reassessed Fairmont on the basis that the 2007 share redemptions triggered a foreign exchange gain.

Fairmont brought an application to rectify the 2007 share redemptions and to substitute a loan arrangement. Fairmont argued that its intent from 2002 was to have the original reciprocal loan arrangements unwound on a tax-neutral basis. In response, the Crown argued that Fairmont had never intended the proposed substituted loan arrangement and thus was engaged in retroactive tax planning.

Fairmont relied on the Ontario Court of Appeal decision in Juliar for the principle that the exact method to achieve a common intention to avoid tax is not required at the time of the transaction. In response, the Crown argued that the Alberta Court of Queens’ Bench in Graymar Equipment (2008) Inc. v A.G. (Canada) (2014 ABQB 154) had been critical of Juliar and had stated that rectification is granted to restore a transaction to its original purpose and not to avoid an unintended effect.

However, in the present case, the Ontario Superior Court of Justice stated that, unlike the Alberta court, Ontario courts “do not have the luxury of ignoring” the Ontario Court of Appeal’s decision in Juliar. Further, the Ontario court stated that the Alberta court had not accurately described what happened in Juliar, and that another recent Alberta decision had in fact followed the reasoning in Juliar.

In the present case, the Ontario Court held that Fairmont’s intention from 2002 was to carry out the reciprocal loan arrangements on a tax- and accounting-neutral basis so that any foreign exchange gain would be offset by a corresponding foreign exchange loss. This intention remained unchanged when Fairmont was sold in 2006 and when the reciprocal loans were unwound in 2007. A mistake had caused the unintended tax assessments.

The Court also stated that this was not a situation in which the taxpayer was engaging in retroactive tax planning after a CRA audit. The parties intended to unwind the loans on a tax-free basis.

The Court allowed the application and rectified the corporate resolutions as requested. The Court awarded $30,000 of costs to the Applicants.

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Fairmont: Ont SCJ Unwinds Share Redemption and Substitutes Loan Arrangement