Rectification of Instrument that Did Not Accurately Reflect Parties’ Agreement
1. Introduction
In the last few years, it has become abundantly clear that taxpayers cannot resort to equity to engage in retroactive tax planning. Thus, the equitable remedies of recission and rectification are unavailable to taxpayers if they want to change their prior agreement when it has led to unintended tax consequences. This is clear, inter alia, from the following cases: Canada (Attorney General) v Fairmont Hotels Inc[1] and its companion case, Jean Coutu Croup (PJC) Inc v Canada (Attorney General),[2] and from Canada (Attorney General) v Collins Family Trust.[3] However, these cases do permit these remedies to be used, even to avoid adverse tax consequences, if the parties satisfy the requirements for those remedies as set out in Fairmont, which are summarized below. Indeed, in subsequent cases courts have granted rectification in tax cases when those requirements have been met.[4] The more recent case, Slightham et al v AGC[5] is another such case and is worth a closer look.
2, Facts
The Applicants, Jeffrey and Christopher Slightham, and their mother, Wendy, were the shareholders of two-family trusts. In 2016 they reorganized their shareholdings in a family operating company, Signature, to implement an estate freeze and allow Signature to pay or reduce surplus assets in a tax-efficient way. As part of the process, a new company, Holdco, was created and designated as a beneficiary of the Trusts, and the Trusts would own the common shares of Holdco.
The Reorganization also accommodated the potential future sale of Signature, which could qualify Jeffrey and Christopher for an exemption (the lifetime capital gains exemption (‘LCGE’) under the ITA if and when they sold their shares in Signature in the future. The LCGE allows for a tax exemption of up to $890,000 of proceeds of sale of the shares of qualifying corporations, provided that all or substantially all of the fair market value of the corporation’s assets are used principally in an active business carried on primarily in Canada. The phrase ‘all or substantially all’ is generally considered to mean 90% or more. To meet the 90% test at the time of sale, a corporation can reduce its surplus assets, for example by paying excess cash in form of bonuses or dividends.
The parties drafted the Trust Deeds to take advantage of section 75(2) of the Income Tax Act,[6] the ‘Attribution Rule’ that applies when amounts received from a beneficiary of a trust may be paid out to that beneficiary. To prevent an inadvertent triggering of the rule the Trust Deeds provided that Holdco would not be entitled to receive any income or capital derived from itself. However, the Trust Deeds contained a drafting error. In addition to the prohibition against payment to Holdco of income or capital derived from itself, it also provided that no portion of the annual net income derived from Signature should be paid to Holdco. The latter erroneous addition was contrary to the parties’ intention and agreement. Several years later, the error was discovered when Signature paid dividends to the Trusts, which the Trusts then distributed to their beneficiary Holdco. Holdco then claimed the intercorporate dividend deduction on the amount it received pursuant to section 112(1) of the ITA. The Canada Revenue Agency (‘CRA’) reassessed the Trusts because the Trust Deeds prohibited the distribution of dividends from Signature to Holdco. This meant that the Trusts had to pay tax on the dividends received from Signature.
The Applicants filed Notices of Objection and informed the CRA that it intended to bring an application for rectification. Then it brought this application to have the Trust Deeds rectified to fix the drafting error by deleting the offending words. The Attorney General on behalf of the CRA had taken the position that it would accept changes to the Trust Deeds only if made pursuant to a court order. Accordingly, the Attorney General did not oppose the remedy sought.
3. Analysis and Judgment
Justice Osborne began the analysis by considering the test for rectification. At paragraphs 14 and 38 of Fairmont, the Supreme Court listed the four requirements that must be satisfied before rectification can be granted:
- the parties had reached a prior agreement whose terms are definite and ascertainable;
- the agreement was still effective when the instrument was executed;
- the instrument failed to record accurately that prior agreement; and
- if rectified as proposed, the instrument would carry out the agreement.
His Honour noted that rectification, being an equitable remedy, is discretionary. It permits the court to give effect to the true intentions of the parties if the instrument giving effect to their agreement incorrectly expresses that agreement. In other words, it permits the court to ensure that the parties’ agreement and the instrument they used to give effect to their agreement correspond. In Fairmont and Collins, the parties sought to rectify their agreement because it resulted in adverse tax consequences. But rectification cannot be used to change the agreement.
The onus is on the parties to establish by clear and convincing evidence that the substance of their intention was not accurately reflected in the Trust Deeds. The Applicants submitted affidavits from: the three Trustees, the original settlor of the Trusts, the tax lawyer who drafted the Trust Deeds, the former partner in the same law firm who was involved in the preparation of the Trust Deeds and the Reorganization documents, and the Chartered Professional Accountant and Certified General Accountant who provided accounting services to the family and advice with respect to the Reorganization. Justice Osborne noted that the evidence was clear, consistent, and provided by all the parties and their professional advisors. Moreover, it was corroborated by the contemporaneously created documents, as well as by the subsequent conduct of the parties and their professional advisors. Consequently, he was satisfied on the basis of this evidence that all four of the Fairmont requirements were satisfied. In particular it was clear that the prior agreement did not restrict the Trusts from being able to pay amounts received from Signature to Holdco.
His Honour emphasized in paragraph 50 that the rectification remedy ‘is limited to cases where a written instrument has incorrectly recorded the parties’ antecedent agreement. Rectification is not available where the basis for seeking it is that the one or both of the parties wishes to amend not the instrument recording their agreement, but the agreement itself.’
Since the parties did not seek to amend their original agreement but only the instrument that was inconsistent with the agreement, the case was distinguishable from Fairmont and from Collins. Accordingly, by an order with immediate effect, the court ordered that the offending provisions in the Trust Deeds were rectified.
—
[1] 2016 SCC 56 (‘Fairmont’).
[2] 2016 SCC 55.
[3] 2022 SCC 26 (‘Collins’).
[4] See, e.g. 5551928 Manitoba Ltd v Canada (Attorney General), 2018 BCSC 1482, affirmed 2019 BCCA 376; and Sleep Country Canada Holdings Inc and Sleep Country Canada Inc v Attorney General of Canada, 2022 ONSC 6103.
[5] 2023 ONSC 6193.
[6] RSC 1985, c 1 (5th Supp) (‘ITA’).
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Written by: Albert Oosterhoff
Posted on: April 25, 2024
Categories: Commentary, WEL Newsletter
1. Introduction
In the last few years, it has become abundantly clear that taxpayers cannot resort to equity to engage in retroactive tax planning. Thus, the equitable remedies of recission and rectification are unavailable to taxpayers if they want to change their prior agreement when it has led to unintended tax consequences. This is clear, inter alia, from the following cases: Canada (Attorney General) v Fairmont Hotels Inc[1] and its companion case, Jean Coutu Croup (PJC) Inc v Canada (Attorney General),[2] and from Canada (Attorney General) v Collins Family Trust.[3] However, these cases do permit these remedies to be used, even to avoid adverse tax consequences, if the parties satisfy the requirements for those remedies as set out in Fairmont, which are summarized below. Indeed, in subsequent cases courts have granted rectification in tax cases when those requirements have been met.[4] The more recent case, Slightham et al v AGC[5] is another such case and is worth a closer look.
2, Facts
The Applicants, Jeffrey and Christopher Slightham, and their mother, Wendy, were the shareholders of two-family trusts. In 2016 they reorganized their shareholdings in a family operating company, Signature, to implement an estate freeze and allow Signature to pay or reduce surplus assets in a tax-efficient way. As part of the process, a new company, Holdco, was created and designated as a beneficiary of the Trusts, and the Trusts would own the common shares of Holdco.
The Reorganization also accommodated the potential future sale of Signature, which could qualify Jeffrey and Christopher for an exemption (the lifetime capital gains exemption (‘LCGE’) under the ITA if and when they sold their shares in Signature in the future. The LCGE allows for a tax exemption of up to $890,000 of proceeds of sale of the shares of qualifying corporations, provided that all or substantially all of the fair market value of the corporation’s assets are used principally in an active business carried on primarily in Canada. The phrase ‘all or substantially all’ is generally considered to mean 90% or more. To meet the 90% test at the time of sale, a corporation can reduce its surplus assets, for example by paying excess cash in form of bonuses or dividends.
The parties drafted the Trust Deeds to take advantage of section 75(2) of the Income Tax Act,[6] the ‘Attribution Rule’ that applies when amounts received from a beneficiary of a trust may be paid out to that beneficiary. To prevent an inadvertent triggering of the rule the Trust Deeds provided that Holdco would not be entitled to receive any income or capital derived from itself. However, the Trust Deeds contained a drafting error. In addition to the prohibition against payment to Holdco of income or capital derived from itself, it also provided that no portion of the annual net income derived from Signature should be paid to Holdco. The latter erroneous addition was contrary to the parties’ intention and agreement. Several years later, the error was discovered when Signature paid dividends to the Trusts, which the Trusts then distributed to their beneficiary Holdco. Holdco then claimed the intercorporate dividend deduction on the amount it received pursuant to section 112(1) of the ITA. The Canada Revenue Agency (‘CRA’) reassessed the Trusts because the Trust Deeds prohibited the distribution of dividends from Signature to Holdco. This meant that the Trusts had to pay tax on the dividends received from Signature.
The Applicants filed Notices of Objection and informed the CRA that it intended to bring an application for rectification. Then it brought this application to have the Trust Deeds rectified to fix the drafting error by deleting the offending words. The Attorney General on behalf of the CRA had taken the position that it would accept changes to the Trust Deeds only if made pursuant to a court order. Accordingly, the Attorney General did not oppose the remedy sought.
3. Analysis and Judgment
Justice Osborne began the analysis by considering the test for rectification. At paragraphs 14 and 38 of Fairmont, the Supreme Court listed the four requirements that must be satisfied before rectification can be granted:
His Honour noted that rectification, being an equitable remedy, is discretionary. It permits the court to give effect to the true intentions of the parties if the instrument giving effect to their agreement incorrectly expresses that agreement. In other words, it permits the court to ensure that the parties’ agreement and the instrument they used to give effect to their agreement correspond. In Fairmont and Collins, the parties sought to rectify their agreement because it resulted in adverse tax consequences. But rectification cannot be used to change the agreement.
The onus is on the parties to establish by clear and convincing evidence that the substance of their intention was not accurately reflected in the Trust Deeds. The Applicants submitted affidavits from: the three Trustees, the original settlor of the Trusts, the tax lawyer who drafted the Trust Deeds, the former partner in the same law firm who was involved in the preparation of the Trust Deeds and the Reorganization documents, and the Chartered Professional Accountant and Certified General Accountant who provided accounting services to the family and advice with respect to the Reorganization. Justice Osborne noted that the evidence was clear, consistent, and provided by all the parties and their professional advisors. Moreover, it was corroborated by the contemporaneously created documents, as well as by the subsequent conduct of the parties and their professional advisors. Consequently, he was satisfied on the basis of this evidence that all four of the Fairmont requirements were satisfied. In particular it was clear that the prior agreement did not restrict the Trusts from being able to pay amounts received from Signature to Holdco.
His Honour emphasized in paragraph 50 that the rectification remedy ‘is limited to cases where a written instrument has incorrectly recorded the parties’ antecedent agreement. Rectification is not available where the basis for seeking it is that the one or both of the parties wishes to amend not the instrument recording their agreement, but the agreement itself.’
Since the parties did not seek to amend their original agreement but only the instrument that was inconsistent with the agreement, the case was distinguishable from Fairmont and from Collins. Accordingly, by an order with immediate effect, the court ordered that the offending provisions in the Trust Deeds were rectified.
—
[1] 2016 SCC 56 (‘Fairmont’).
[2] 2016 SCC 55.
[3] 2022 SCC 26 (‘Collins’).
[4] See, e.g. 5551928 Manitoba Ltd v Canada (Attorney General), 2018 BCSC 1482, affirmed 2019 BCCA 376; and Sleep Country Canada Holdings Inc and Sleep Country Canada Inc v Attorney General of Canada, 2022 ONSC 6103.
[5] 2023 ONSC 6193.
[6] RSC 1985, c 1 (5th Supp) (‘ITA’).
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