If implementing a plan to save tax turns around and instead causes an unintended tax liability, it may be possible to fix the problem with a rectification order. The Court can retroactively alter documents or agreements with a rectification order to actualize the taxpayer's real intention and thereby prevent the Canada Revenue Agency ("CRA") from benefiting from the taxpayer's (or the advisor's) mistake and enjoying an unexpected windfall. What is the doctrine of rectification and how can it be used in tax cases?
A rectification order is an equitable remedy that has been applied in contract law for centuries to fix mistakes in legal instruments that do not reflect the true intentions of the parties. Historically, the classic scenario was where the parties agreed on one word, but accidentally wrote down another. In the modern tax context, any time the taxpayer demonstrably intended to achieve a particular tax result, rectification of the transaction will be permitted, if the mechanism chosen to obtain the tax result turns out to be wrong. In the leading case of Juliar v. The Queen, the Court adopted the modern principal of rectification in the tax context to fix a mistake in a document intended for tax planning purposes. Thereby, an unintended tax liability arising from an unanticipated deemed dividend was avoided. With great relief for the taxpayers (and their advisors), the rectification order was granted, based on the taxpayers' consistent intention to avoid those immediate tax consequences.
The Court must distinguish between a mistake as to an unintended legal effect and a mistake as to undesirable legal consequences. The Court must be vigilant and ensure the parties are not merely changing their minds to escape what turned out to be a plan they would rather not carry out for commercial or other reasons. Since a rectification order is a discretionary remedy, the facts are critical and the Court must be convinced that rectification would achieve fairness. The doctrine is not designed to rewrite history, but to get history right.
Generally, a taxpayer seeking rectification files affidavit evidence with the Court asserting the requisite intention, with supporting documents supporting that intention. The taxpayer must prove three essential elements:
- a common intention by the parties prior to preparing the document or instrument alleged to be deficient;
- this common intention remained unchanged at the date the document or instrument was made; and
- the challenged document or instrument, by mistake, did not conform to the parties' prior common intention.
The Provincial Superior Courts have inherent equitable jurisdiction and are therefore the appropriate forum to seek a rectification order. Such courts will rectify a document or instrument even if the taxpayer's only purpose in applying for the remedy is to avoid an adverse tax consequence. An application for rectification may be made even if an appeal is pending in the Tax Court of Canada to determine the tax consequences relating to the same document or instrument. While it seems the Tax Court may decide whether to treat a document or instrument as in effect having been rectified in the course of deciding a tax case, the Tax Court prefers that taxpayers apply first to the Provincial Superior Court for rectification. The Tax Court does not have inherent jurisdiction to grant equitable remedies, like a rectification order.
The CRA generally accepts rectification orders and agrees that it should not be allowed to "persecute the misguided". However, like the Court, the CRA distinguishes between an error in implementation and an error in tax planning and will vigorously oppose rectification orders becoming a form of retroactive tax planning. Further, the CRA's position is that a taxpayer requesting rectification should provide the CRA with notice of the application and that the CRA will consider itself bound by rectification orders only where such notice is given. Moreover, the CRA's position is that where a rectification application is being made on the basis that the transaction results in alleged unintended tax consequences, it should properly be made a party to the application. While there is no provision in the Income Tax Act that requires notice to be given to the CRA, nor is there any provision in the Canada Customs and Revenue Agency Act that automatically grants the CRA status as an intervener in a rectification application, it is prudent to give the CRA notice and agree to make it a party. Moreover, it usually benefits the taxpayer to provide notice, because if the CRA does not oppose the application, it corroborates that rectification is fair and just. That can go a long way towards getting the desired rectification order.
An application for a rectification order should be considered whenever adverse tax consequences are inadvertently triggered by a mistake in implementing a transaction. The intention is key. There must be evidence of a continuing intention to avoid tax that was frustrated by the mistaken document or instrument. In the right case, a rectification order can avoid substantial tax (and aggravation) for taxpayers and their advisors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.