Written by Alison Gray
On December 9, 2016, the Supreme Court released its decisions in two tax rectification cases: Jean Coutu Group (PJC) Inc. Canada (Attorney General), 2016 SCC 55 and Canada (Attorney General) Fairmont Hotels Inc., 2016 SCC 56. These decisions provide needed clarification as to when rectification will be granted in tax cases. In particular, these decisions answer the question as to whether a general intention to structure a transaction on a tax neutral basis is enough to permit rectification. The answer we now know is no.
In Jean Coutu, a US subsidiary of a Canadian corporation acquired a chain of American pharmacies in 2004. Due to fluctuations in the exchange rate, a problem with the accounting presentation of the acquisition arose. In an attempt to find a tax-neutral solution, a series of transactions were carried out, the net effect of which was to transform the net US investment into a net debt. The anticipated and agreed upon tax consequences of the transactions were set out in the documentation formalizing the transactions. In 2010, CRA assessed the Canadian corporation for $2.2 million in additional taxes for the years 2005, 2006 and 2007.
Jean Coutu Canada sought rectification of the documents related to the agreement, which was granted by the motion judge on the basis that there was a disparity between the common intention of the parties and the documents drawn up to give effect to that intention. The Court of Appeal allowed the appeal, holding that the general intention of contracting parties that an agreement be tax neutral was insufficient to authorize the modification of the written documents underlying the agreement so they reflect that intention.
In Fairmont Hotels, Fairmont Hotels Inc. was involved in financing the purchase of two hotels in the U.S. The financing arrangement was intended to operate on a tax neutral basis. When Fairmont was later acquired, that intention was frustrated because the acquisition would cause Fairmont to realize a deemed foreign exchange loss. The parties agreed to a plan that allowed Fairmont to realize its accrued foreign exchange gains and losses and allowed its foreign exchange exposure to be hedged. The plan did not, however, address the foreign exchange exposure of Fairmont's Canadian affiliates. A year later, the financing arrangement was terminated, and Fairmont and the Canadian affiliates redeemed shares under the mistaken assumption no taxable foreign gains would be triggered. A CRA audit revealed the mistake, and Fairmont sought to avoid that liability by rectifying the directors’ resolutions redeeming the shares. Both the application judge and the Court of Appeal granted rectification on the basis of the parties’ general intention that the transaction be tax neutral.
The SCC dismissed the appeal in Jean Coutu and allowed the appeal in Fairmont Hotels. In so doing, the Court confirmed that in both common law and civil law, rectification in tax cases requires more than a general intention that an agreement or transaction be tax neutral.
Rather, there must be a clearly defined intention that a specific tax consequence be obtained. A written instrument cannot be rectified where it is the expression of an agreement merely because it produces unintended or unanticipated tax consequences. Rectification is only intended to align the written documents with the agreement they are meant to record and implement, not with the contracting parties’ motivations for entering into the agreement or their expectations as to its consequences.
In Jean Coutu, the Court held rectification under the Civil Code will only be allowed when unintended tax consequences result from a contract whose desired consequences, whether in whole or in part, are tax avoidance, deferral or minimization under two conditions. First, if the unintended tax consequences were originally and specifically sought to be avoided, through sufficiently precise obligations which objects, and the terms need to execute those objects, are determinate or determinable; and second, when the obligations, if properly expressed and the corresponding terms, if properly executed, would have succeeded in doing so. This is because the focus is 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.
In Fairmont Hotels, the Court confirmed that rectification can correct an inaccurately recorded agreement respecting what was to be done, but it cannot change the agreement in order to salvage what the parties hoped to achieve. Thus, in the tax context, a court cannot modify an instrument merely because a party discovers it operates to create an adverse and unplanned tax liability.
Thus, the Court concluded two types of errors may allow for rectification. First, where both parties have executed an instrument under the common mistake that it accurately records the terms of their agreement. In this case, it must be shown that the parties reached a prior agreement whose terms are definite and ascertainable, was still effective when the instrument was executed, the instrument fails to record the prior agreement accurately, and if rectified, the instrument would carry out the agreement.
Rectification is also available where the mistake is unilateral – either because the instrument formalizes a unilateral act, or where the instrument was intended to record an agreement between parties, but one party says that the instrument does not accurately do so, while the other party says it does. In the latter case, rectification will be granted where the party resisting rectification knew or ought to have known about the mistake, and permitting that party to take advantage of the mistake would amount to “fraud or the equivalent of fraud”.
A party seeking rectification must show not only the error in the instrument, but also the way in which the instrument should be rectified in order to correctly record what the parties intended to do. The party seeking rectification must identify terms that were omitted or recorded incorrectly and which, correctly recorded, are sufficiently precise to constitute the terms of an enforceable agreement.
The SCC's decisions in Jean Coutu and Fairmont Hotels now settles the question of whether a general intent to have a transaction be tax neutral is sufficient to obtain rectification where unanticipated tax consequences are encountered. The result is an overwhelming no. The SCC has made clear that an applicant seeking rectification must establish a prior agreement to achieve a specific tax consequence, and the specific means by which to realize that intended tax outcome. It is only when there is a mistake in implementing the agreement to achieve the intended tax consequences that rectification will be allowed.
The Court held that a party seeking rectification must bring "evidence exhibiting a high degree of clarity, persuasiveness and urgency" to show the written instrument does not reflect the parties' true intended course of action. As a result, going forward, the parties to an agreement and any professionals providing tax advice are advised to ensure the intention to obtain a specific tax consequence is recorded, along with a detailed "step plan" setting out how to achieve the intended tax consequences. It will only be if the instruments used to achieve the specific tax consequences are missing a step or contain a mistake that rectification will be permitted.