If, like me, you’re a fan of Canadian football you’ve seen a lot of a commercial by a Canadian hardware chain that uses the tag line “Doing it Right.” The idea behind the ad is that with the right tools and advice, you’ll do things right the first time. Makes sense for home repairs, and even more so for documenting transactions with tax consequences. But sometimes the documentation turns out to be inadequate for a variety of reasons and the parties are faced with unanticipated tax results. What to do in such a case? It’s one thing to reglue the bathroom tiles, but what if the documentation turns out to be wrong in some way? Can that be repaired after the fact so as to bind the tax agency?
There are a number of approaches to this problem, and which one works depends very much on the circumstances. In the simplest case the documentation is wrong because of a clerical error. For example, Mr. X incorporates Newco and gives instructions that 100 shares be issued to him in consideration of his payment of $100. Newco deposits $100 in its bank account and prepares its financial statements and tax returns on the basis that its paid-up capital is 100 shares issued for $100. However, the corporate solicitor prepares a share certificate for Mr. X which incorrectly indicates that only one share is issued. The error is obvious in the light of the objective evidence. Here, the appropriate correcting step is the cancellation of the original certificate and the issue of a new one for 100 shares, as of the date of the original transaction. This was essentially the situation in a recent Tax Court case (Twomey, 2012 TCC 310). The court said that the taxpayer acted appropriately in correcting the mistake, and that a formal application to the civil court for a rectification order was not required.
Suppose a more complicated case, such as one that might arise in the course of an estate freeze. Mr. X owns 100 shares of Opco with a tax cost to him of $100. The shares are worth $500 on transaction date and Mr. X transfers the shares to his wholly owned Holdco for that amount. Mr. X’s professional advisor assures him the transfer of the Opco shares will be done on a rollover basis for tax purposes. However, incorrectly believing that Mr. X’s tax cost of his Opco shares is $500, the advisor prepares the transfer documentation on the basis that Holdco will pay for the Opco shares with a promissory note for $500, instead of issuing shares worth that amount. This only comes to light a year or so later when the tax agency assesses Mr. X on the basis that he is deemed to have received a dividend of $400 as a consequence of the transfer. It is clear that no deemed dividend would have arisen if Holdco had issued Mr.X preference shares worth $500 instead of the promissory note of $500. It is also clear that the error went beyond a mere clerical mistake. Unless the form of the consideration is changed from debt to shares, for tax purposes Mr. X is deemed to have received a dividend. What to do in this situation? Another case indicates a possible solution.
In Juliar, (2000), 50 O.R. (3d) 728), The Ontario Court of Appeal upheld an order rectifying a somewhat similar transaction to substitute Holdco shares for the promissory note effective as of the original transaction date, on the basis that Mr. X only transferred his Opco shares believing that a rollover was available. Rectification goes beyond correcting clerical-type mistakes in the documentation, and addresses more fundamental errors that, if allowed to stand, would undermine the basis on which the parties intended to transact. It requires an order from the court and cannot be done by the parties acting on their own. When a rectification order is granted, it corrects the documentation nunc pro tunc” – that is, “now as then.” In other words, it is effective from the date of the original documentation. This is the key to avoiding the tax problem. There have been a number of cases involving rectification orders recently and, where appropriate, applying for one may be the preferred way out of an unintended tax consequence.
It is important to note, though, that the court will not rectify to implement a different arrangement than the one the parties intended to implement. In other words, if the parties intended to accomplish plan A, and the documentation gives effect to that intention, the court won’t be interested to hear that, after the fact, the parties realized that plan B would have given them more favourable tax results. In that event, the court will leave the parties to suffer the consequences of plan A.