The recent decision of the Court of Queen's Bench of Alberta in Graymar Equipment (2008) Inc v Canada (Attorney General), 2014 ABQB 154 is an important reminder of the limited nature of the equitable remedy of rectification in tax avoidance cases.
In Graymar, Graymar Equipment (2008) Inc (Graymar) and FRPD Investments Limited Partnership (FRPDI), applied for approval of a Plan of Arrangement pursuant to the Alberta Business Corporations Act, RSA 2000, c B-9, which contemplated the rectification of a prior transaction due to unanticipated tax consequences. The Attorney General of Canada opposed the application.
In 2008, FRPDIP acquired a business through a partnership. A substantial amount of the purchase price was funded in part by bank debt. The business did not perform as well as expected and was not able to abide by its bank covenant. A debt restructuring agreement under which the partners of FRPDI would contribute additional partnership capital to reduce the debt owed to the bank was negotiated (the "Debt Restructuring").
Implementing the Debt Restructuring entailed a complex series of transactions comprising at least 141 steps among various related entities, including the Applicants, and concluded with an increased subscription by FRPDI in Graymar's common shares, and a corresponding increased amount of debt owed by FRPDI to Graymar.
The stated intention of the Debt Restructuring was twofold: to increase the capital contribution in order to repay a portion of the business's external debt; and to reduce the interest rate on loans owed by FRPDI to its partners.
FRPDI failed to repay the shareholder's loan to Graymar prior to December 31, 2011. As FRPDI was the sole shareholder of Graymar, and not all partners of FRPDI were corporations resident in Canada, the unpaid loan had to be included in the income of the shareholder in the year the loan was received by operation of section 15(2) of the Income Tax Act, RSC 1985, c 1.
The evidence of the Applicants was that they did not recall being advised that FRPDI needed to repay the loan by December 31, 2011, and had they been advised as to the effect of section 15(2), they would have repaid the loan before December 31, 2011.
Rectification in the Tax Avoidance Context
The Court reviewed the case law on rectification in the tax avoidance context and confirmed that, for there to be rectification, the terms of the instrument (in this case, the transactions comprising the Debt Restructuring) must be shown to not accord with the parties' true intention. In this case, the Applicants needed to show that they erred in how the Debt Restructuring was implemented because it did not conform to the intention that drove them to undertake it.
The Court then reviewed the law on rectification in the tax avoidance context and confirmed that tax avoidance is achievable by way of a rectification order. The Court emphasized that rectification will not be granted in cases that amount to an attempt to rewrite history in order to obtain more favourable tax treatment. Consequently, while, therefore, rectification is available in order to avoid a tax disadvantage that the parties had originally transacted to avoid, it is not available to avoid an unintended tax disadvantage that the parties had not anticipated at the time of transacting.
The Court went on to state that the questions what did the parties originally intend to do? and what would they have done had they known about this unanticipated tax outcome? were not equitable. The first question is the driver in a rectification application. The answer to the second question is not relevant in a rectification application, as the answer will clearly be ˜something else'. This was particularly the situation in the present case where the tax disadvantage was incurred unnecessarily.
No Rectification in this Case
The Court denied the Applicants' request for rectification, as it was not satisfied there was sufficient evidence to establish that avoiding that tax disadvantage was the original motivation for the Debt Restructuring. The Court emphasized the importance of having such evidence because, in cases where the transaction sought to be rectified could have been motivated by concerns other than tax avoidance, courts should be slow to infer a driving motivation of tax avoidance solely on the basis of the taxpayer's own evidence. This is particularly so when that evidence is given in response to a negative income tax consequence.
In this case, the evidence spoke exclusively to a completely different motivation than that of tax avoidance. The Applicants' intention in undertaking the Debt Restructuring was to reduce the business's external debt owed to its lending syndicate, which would then reduce the interest rate on loans owed by FRPDI to its partners. Thus, there was no evidentiary basis to support the inference that the Applicants had a specific and common tax avoidance intention underlying the Debt Restructuring; the fact that timely repayment of the shareholder's loan would have been effected had the Applicants been advised as to the tax disadvantage they would incur by failing to repay it by December 31, 2011 does not establish that tax avoidance originally drove the Debt Restructuring. Thus, the Court concluded the Applicants were attempting to engage in retroactive tax planning and not the rectification of a failure to record an original intention of tax avoidance.
This decision again confirms that the equitable remedy of rectification cannot be used to engage in retroactive tax planning, and emphasizes the need for clear and sufficient evidence of an original intention of tax avoidance. The Court cautions against the reliance on judicial inference of intent, stressing there must be direct evidence that the intent of the original transaction and its structure was tax avoidance. Absent evidence of the original intention, rectification should not be granted, as to do so would be to engage in retroactive tax planning. Consequently, in those cases in which the parties intend that the transaction be carried out in a tax efficient manner, this intention should be recorded and preserved. Then, if that purpose is somehow frustrated due to how the transaction was carried out and unintended tax consequences result, sufficient evidence to show a primary and continuing objective to avoid income tax from the inception of the transaction will be available.