ARTICLE
18 November 2011

SCC To Consider Rectification Of Contracts

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McCarthy Tétrault LLP

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The Supreme Court of Canada has granted leave to appeal in a case involving the rectification of contracts.
Canada Litigation, Mediation & Arbitration

The Supreme Court of Canada has granted leave to appeal in a case involving the rectification of contracts. The appeal in Services Environnementaux raises the question of whether Quebec law permits the rectification of agreements, in a manner that is retroactively enforceable against tax authorities, when their written terms diverge from the common intentions of the parties.

As part of a reorganization of the first respondent, Centre technologique, the second respondent, AES, decided to sell some of its shares in Centre technologique to a third party. AES and Centre technologique the entered into a reorganization agreement in which AES exchanged its 1,217,029 class A shares in Centre technologique for both: a) class B shares having an aggregate value of $1; and b) a promissory note in the amount of $1,217,028.

The share exchange tax provisions in s.86 of the Income Tax Act (Canada) and ss. 541 and 543 of the Taxation Act (Quebec) permitted the parties to defer the tax consequences of this share exchange, but only if the consideration other than shares which AES received (i.e., the promissory note) was less than the adjusted cost base of the class A shares it transferred to Centre technologique. Owing to a mistake, the parties believed the adjusted cost base of the class A shares was $1,217,029 – the same as the promissory note. In fact, however, the adjusted cost base of the class A shares was only $96,001. The tax authorities therefore assessed AES for a $840,770 capital gain.

Decisions Below

AES and Centre technologique brought a motion before the Quebec Superior Court. They sought to rectify their agreement so that: a) the promissory note given to AES was only for $95,000; and b) instead of receiving class B shares with an aggregate value of $1, AES would receive class C shares having an aggregate value of $1,222, 029. In a judgment released on March 3, 2009, Borenstein J.C.S. allowed the application.

The tax authorities appealed, arguing that there was no jurisdiction to grant rectification under the Civil Code of Quebec, and that the lower court had erred by introducing the equitable doctrine of rectification into Quebec law. However, in a March 4, 2011 decision, the Quebec Court of Appeal found that there was an ability to correct a contract to reflect the true intentions of the parties, as the lower Court did here, pursuant to Art. 1425 of the Civil Code, which provides that "[t]he common intention of the parties rather than adherence to the literal meaning of the words shall be sought in interpreting a contract". While the Court of Appeal noted that this power could not be exercised where it would prejudice the rights of third parties, it reasoned that the rights of the tax authorities were not prejudiced, since the tax legislation itself permitted the parties to defer the tax consequences of their transaction by structuring it in the way which it was their common intention to effect.

Potential Significance

This case will be of great significance to the law of obligations in Quebec, since it will determine the extent to which the rectification of contracts is available under Quebec law. In addition, the case has the potential to be of significance for the law of contracts in common law Canada as well. It is possible that the Supreme Court will use the case to clarify the test for rectification in cases of common or mutual mistake, which the Court did not address in its earlier rectification judgment of Sylvan Lake. The Services Environnementaux appeal also raises the question of the relationship between rectification, as an equitable remedy, and the "interpretation" of contracts (as contemplated under Art. 1425 of the Civil Code). Finally, the case gives the Court the opportunity to address the retroactive effects of rectification – as distinct from other methods of altering a contract, such as variation or implied terms – and its impact upon third parties like taxation authorities.
The Services Environnementaux decision should be of interest to any business that is contract-intensive, or that makes use of sophisticated tax planning strategies.

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