Rectification – what is it?
Rectification has emerged as an important remedy for certain taxpayers faced with unintended tax consequences of transactions in which they participate. If certain conditions are met, the remedy allows taxpayers essentially to 'fix' transaction documents (or even transactions themselves) in order to achieve the intended tax consequences. The law in this area has expanded dramatically since 2000, when the Ontario Court of Appeal confirmed in Canada (Attorney General) v Juliar(1) that the taxpayers in that case could replace an exchange of shares for debt (taxable in the circumstances) with an exchange of the shares for other shares (not taxable in the circumstances) in order to achieve the taxpayers' presumed intention that the transfer not attract tax. The Supreme Court of Canada subsequently refused leave to hear the appeal of Juliar.
On January 26 2012 the British Columbia Supreme Court released its decision in McPeake v Canada (Attorney General).(2) The court granted the taxpayers a second rectification of a trust deed that had contained several flaws.
The case is significant because it contains a discussion of the precise nature of the tax intent required to support a successful rectification application and a discussion of the standard of proof placed on a taxpayer seeking an order of rectification.
Rectification – what is it?
Rectification is a remedy that courts have developed in order to restore parties to a transaction to their intended bargain. In its traditional form, rectification was used mainly to correct documents containing errors that gave rise to consequences that the parties did not intend. Courts were careful to assert that they were not correcting transactions, but correcting documents that did not accord with the parties' intentions. One leading scholar has described rectification as follows:
"Where the terms of a written instrument do not accord with the true agreement between the parties, equity has the power to reform, or rectify, that instrument so as to make it accord with the true agreement. What is rectified is not a mistake in the transaction itself, but a mistake in the way in which that transaction has been expressed in writing."(3)
More recently, and particularly since the Juliar decision, courts have appeared willing to rectify transactions as well, in circumstances where the transactions achieve unintended tax consequences. In other words, courts have acknowledged that tax avoidance is a legitimate intention for purposes of determining whether rectification is available, and that transactions themselves (if they resulted in clearly unintended tax consequences) can sometimes be modified or changed in order to achieve the tax intention.
In order to obtain rectification, the party seeking it must show all of the following:
- The parties had a common intention before the document or instrument containing the alleged error was made;
- The common intention remained unchanged at the time that the document or instrument was made; and
- The document or instrument does not conform to that common intention.
Typically, the person seeking rectification brings an application in the superior court of the relevant province.(4) If the rectification is to correct a tax mistake, the decision must be made whether to give notice (or whether notice must be given) to counsel acting for the Canada Revenue Agency and/or the relevant provincial tax authority. Many rectification applications are unopposed, if the tax authority can be convinced that the relevant taxpayers are restoring their bargain rather than rewriting fiscal history to achieve a better tax result.
In McPeake, a family trust owned a significant portion of Mr McPeake's software business. The business was sold for proceeds of C$4 million, a portion of which was distributed to beneficiaries of the trust. This structure was tax efficient in part because several individuals were entitled to claim a capital gains exemption in connection with the sale.
The taxpayers sought to rectify the relevant trust deed, the terms of which fell foul of the so-called revocable trust attribution rule in Section 75(2) of the Income Tax Act. In essence, Section 75(2) applies to attribute to a person who transfers property into a trust, income and capital gains or losses from the property, if the property:
- can revert to the transferor;
- can pass to persons determined by the transferor; or
- cannot be disposed of without the transferor's consent or direction.
In 2003 the Canada Revenue Agency issued reassessments to the trust and to McPeake on the basis that the trust in question was a revocable trust because property that McPeake had contributed to the trust could revert to him. In May 2009 the trustees brought a successful (and unopposed) application for rectification.
Later in 2009, the Canada Revenue Agency informed the trustees that the trust deed contained two other errors that had not been rectified. The trust was still a revocable trust (and Section 75(2) of the Tax Act still applied), because trust property could pass to persons determined by McPeake and could not be disposed of but for the consent or direction of McPeake. As a result, the trustees brought a second rectification application (this time opposed), arguing again that the trust deed continued not to reflect their intention that income and capital gains from property transferred to the trust not be attributed to the transferor (Mr McPeake).
The court was satisfied, based on the affidavit evidence in the application, that "the trust deed as it stands now does not reflect the true intentions of the petitioners in forming the trust". It was satisfied that the common specific intention of the creators of the trust was "to avoid tax payable on capital gains from the sale of shares [in the trust] by maximising tax exemptions that could be multiplied across the trust's many beneficiaries". The court was also satisfied that this common specific tax intention existed before the formation of the trust deed and continued after the trust deed was created.
The McPeake case is consistent with several prior cases in which rectification was granted in circumstances where the taxpayers were able to show an intention to avoid tax but where the documents or transactions did not accord with the intention. The case is also significant in three other ways.
First, the court attempted to reconcile two lines of authority in Ontario with respect to rectification. In Juliar (as noted above), rectification was granted because the court was prepared to infer that the taxpayers in question wished to transfer shares without paying income tax on the transfer. However, in 771225 Ontario Inc v Bramco Holdings Co,(5) Ontario trial and appellate courts denied rectification because they were not convinced that the taxpayer had a specific intention to avoid land transfer tax. The cases can be reconciled because in Bramco, there was no or insufficient evidence presented of a specific intention to avoid land transfer tax. In fact, there was evidence of an intention to avoid income tax, and the transaction that occurred in order to avoid income tax gave rise to a land transfer tax liability. Accordingly, Bramco does not stand for the proposition that tax avoidance itself is not a legitimate intention for purposes of a rectification, but for the proposition that the specific kind of tax avoidance intention must be proven.
Second, the court clarified the standard of proof in rectification cases. In other cases the courts have held that the person seeking rectification must show "convincing proof" or meet a convincing standard, being something more than a simple balance of probabilities and something less than the criminal standard of 'beyond reasonable doubt'. In McPeake, the court pointed out that the Supreme Court of Canada had rejected any intermediate or higher standard of proof in civil cases than the balance of probabilities. Accordingly, an applicant for rectification should not have to meet a higher test than the balance of probabilities.
Third, McPeake serves as a reminder that rectification is an 'equitable' remedy. The court stated that:
"the inequities which Mr McPeake would face if the court were not to rectify the trust are also aligned with the facts in favour of rectification. Mr McPeake would suffer the tax liabilities of ownership of the trust's property without having any of its benefits".
One of the factors that a court will consider in a rectification application is what unfairness or harm would flow from a decision not to correct relevant documentation.
McPeake confirms that rectification remains an important tool in the arsenal of taxpayers confronted with unintended tax consequences arising from transactions or documents. It also confirms that it is wise for taxpayers and their advisers to document the specific tax avoidance intention clearly and unambiguously – that is, to document as clearly as possible that the avoidance of a particular kind (or kinds) of tax was a motivating or non-incidental feature of the transaction or document in question.
For further information on this topic please contact Salvatore Mirandola or Patrick Lindsay at Borden Ladner Gervais LLP by telephone (+1 416 367 6000), fax (+1 416 361 7090) or email ([email protected] or [email protected]).
(3) John McGhee (ed). Snell's Equity, 32nd ed (London: Sweet & Maxwell, 2011), para 16-001 (footnotes omitted).
(4) The Tax Court of Canada does not have jurisdiction to grant equitable remedies. Accordingly, applications for rectifications usually proceed before provincial superior courts.
(5) (1994), 17 OR (3d) 571 (Gen Div), affirmed at (1995), 21 OR (3d) 739 (CA).