Introduction: Rectification and Its Tax Implications

Rectification allows parties to fix mistakes in their legal documents. For instance, if by mistake a legal instrument fails to capture the agreement that it was intended to document, the parties may ask a court to rectify the instrument so that it aligns with their intended agreement. In other words, rectification allows a court to preserve the parties’ true intentions in the face of an erroneous transcription of those intentions.

Rectification boasts one important difference from a mere amendment. Unlike a document amended by the parties themselves, a rectified document can undo a tax consequence resulting from its pre-rectified form. In other words, the CRA must abide by Canadian court’s rectification order (see: Dale v Canada, [1977] 3 FC 235 (FCA)).

So, it’s no surprise that rectification jurisprudence is rife with applicants seeking relief from unintended tax consequences. This trend raises the concern that taxpayers may use the remedy as a means of retroactive tax planning.

The CRA says that rectification amounts to retroactive tax planning if “the taxpayer is asking the court not to rectify the transaction back to its intended form, but to undo the intended transaction and put in place a new one formed after the original transaction.” Put differently, rectification may permit a taxpayer to re-characterize the initial transaction so as to preempt pending tax litigation.

Rectification alters tax obligations because it speaks to the private-law relationships underlying those obligations. In other words, a person’s tax obligations depend on that person’s rights or duties under, say, contract law, property law, corporate law, and so forth. In particular, tax law generally respects the instruments purporting to create these private-law rights and duties. So, by altering these instruments, rectification alters the private-law rights and duties these instruments create, which, in turn, undoes the tax obligations resulting from these instruments as originally executed.

As a result, if a rectified document were to put in place a transaction that the taxpayer did not intend until after executing the impugned document, rectification would, in effect, re-characterize the initial transaction. And any pending tax litigation based on the transaction’s original characterization becomes redundant.

This concern prompted the Supreme Court of Canada to tighten the reins on rectification in tax cases. Until the Supreme Court’s 2016 decision in Canada v Fairmont Hotels Inc. (2016 SCC 56), some provincial courts had seemingly allowed parties to rectify, not simply the instrument recording their transaction, but the transaction itself. In Fairmont, the Supreme Court clarified that “rectification is unavailable where the basis for seeking it is that one or both of the parties wish to amend not the instrument recording their agreement, but the agreement itself (ibid, at para 13, emphasis in original). In other words, where parties seek rectification, a court’s task is “to restore the parties to their original bargain, not to rectify a belatedly recognized error of judgement by one party or the other” (ibid, quoting Performance Industries Ltd. v Sylvan Lake Golf & Tennis Club Ltd., 2002 SCC 19, at para 31).

To this end, the Supreme Court concluded that rectification is available only if:

  1. there was a prior agreement with definite and ascertainable terms;
  2. the agreement was still in effect at the time that the instrument was executed;
  3. the instrument fails to accurately record the agreement; and
  4. the instrument, if rectified, would carry out the parties’ prior agreement (Fairmont, supra, at para 38).

In short, the CRA must comply with a Canadian court’s rectification order. But does the CRA need to abide by the rectification order of a foreign court? This question lay at the center of the dispute in Canadian Forest Navigation Co. Ltd. v The Queen.

Canadian Forest Navigation Co. Ltd. v Canada

Canadian Forest Navigation Co. Ltd., a Montreal-based, Canadian private corporation, had two wholly owned subsidiaries: a Cyprus corporation and a Barbados corporation. Each subsidiary carried on an active international-shipping business.

In 2005 and 2006, the two subsidiaries declared a total of $250 million in dividends to Canadian Forest, which reported the amounts on its Canadian T2 tax returns as dividend income. As such, Canadian Forest deducted the dividends from its income under paragraph 113(1)(a) of the Income Tax Act, which essentially allows a Canadian corporation to receive tax-free dividends stemming from the active business income of qualifying foreign corporations.

In 2008, the Canada Revenue Agency commenced an audit of Canadian Forest’s 2005 and 2006 tax years. It seems that the audit raised concerns that the CRA might deny Canadian Forest the deduction under paragraph 113(1)(a). So, not long after the CRA audit began, Canadian Forest and its subsidiaries sought rectification orders in the subsidiaries’ respective jurisdictions—i.e., Cyprus and Barbados. The parties asked each foreign court to retroactively rectify the relevant subsidiary’s 2005 and 2006 resolutions to identify the advanced funds as a loan instead of a dividend. Each court granted the requested order. Canadian Forest didn’t notify the Canada Revenue Agency about either foreign proceeding, and the CRA therefore didn’t participate in these proceedings.

The CRA reassessed Canadian Forest and disallowed the deductions claimed under paragraph 113(1)(a). Canadian Forest appealed to the Tax Court of Canada and argued, on the basis of the foreign rectification orders, that the proceeds from its subsidiaries weren’t dividends.

Prior to the appeal hearing, Canadian Forest filed a motion to have the Tax Court of Canada determine a single question of law: Do the foreign rectification orders preclude the Minister of National Revenue from treating payments from Canadian Forest’s subsidiaries as dividends in the appeal? (Canadian Forest’s appeal itself was held in abeyance pending the court’s determination of this question.)

The Tax Court of Canada held that the foreign rectification orders didn’t preclude the Minister from taking the appeal position that the payments were dividends (2016 TCC 43). The court pointed out that a foreign judgment isn’t automatically enforceable in Canada; it must first be recognized as enforceable by a Canadian court. This required Canadian Forest to pursue a recognition order in Canada for the two foreign judgments. Because Canadian Forest hadn’t sought such an order, the Tax Court reasoned, the foreign rectification judgments didn’t bind the Minister. That is, to bind the Minister, the foreign rectification judgments would need to be recognized by a Canadian court. The Minister could thus disregard the foreign judgments. Although the foreign judgments didn’t bind the Minister, the Tax Court clarified, they still constitute facts, which the court hearing the taxpayer’s appeal couldn’t ignore even if the orders themselves weren’t enforceable in Canada.

In sum, the Tax Court’s decision was two-fold. First, the foreign rectification orders didn’t force the Minister to treat the payments to Canadian Forest as loans because those orders weren’t enforceable in Canada. Second, even though they weren’t enforceable in Canada, the foreign rectification orders still served to evidence the fact that the resolutions were rectified, providing for loans instead of dividends.

Canadian Forest appealed the Tax Court’s decision to the Federal Court of Appeal.

The Federal Court of Appeal not only allowed the appeal and set aside the Tax Court’s judgment, but also declined to answer the question per Canadian Forest’s original motion and dismissed that motion altogether (2017 FCA 39).

The appellate court agreed with both the lower court and Canadian Forest that the foreign judgments were facts that the court hearing the appeal couldn’t disregard—even if the foreign orders hadn’t been recognized in Canada. According to the Federal Court of Appeal, the foreign orders were proof that the corporate resolutions were rectified, transforming the dividend payments into indebtedness.

But the Federal Court of Appeal ultimately concluded that the Tax Court should have refused to answer the question put forth by Canadian Forest in its motion. The appellate court rejected the Tax Court’s premise that the foreign rectification orders would bind the Minister if they were recognized by a Canadian court. Because the Minister wasn’t a party to the foreign proceedings, the appellate court reasoned, a recognition order in Canada wouldn’t have any bearing on whether those proceedings could bind the Minister. This issue was best left with the Tax Court judge who heard the underlying appeal and considered all the evidence.

New Questions

In Canadian Forest, the Federal Court of Appeal suggested that Canada’s federal tax courts can determine whether a foreign rectification order will bind the Canada Revenue Agency. Given the concern that a rectification order might condone retroactive tax planning, the Canadian Forest decision leaves Canada’s tax community with several questions:

  • How will Canada’s tax courts deal with orders from foreign jurisdiction with lower requirements for rectification than those in Canada? In Canada, rectification is an equitable remedy, and thus it falls outside the jurisdiction of the federal tax courts. But Canadian Forest seemingly requires a federal tax court to assess whether the facts underlying the foreign order justify rectification in Canada.
  • In Canadian Forest, both the Tax Court and the Court of Appeal held that a foreign rectification order is a fact for the purpose of the tax appeal. What if the foreign jurisdiction contains self-help remedies with the same effect as rectification but without the need for a court order?
  • Will the CRA attempt to participate in foreign proceedings with Canadian tax implications? Or will taxpayers need to give the CRA notice of foreign proceedings with Canadian tax implications?

Tax Tips: Rectification & the Importance of Tax Planning

Canada imposes arduous requirements on a party seeking rectification. In particular, you must demonstrate that the documented transaction or agreement wasn’t the one that you intended. Evidence of your intended transaction or agreement could consist of, say, a tax-planning memorandum that was previously prepared by an experienced Canadian tax lawyer.

The Canadian Forest decision suggests that a taxpayer should consider pursuing rectification in a foreign jurisdiction with less strenuous requirements if the remedy is indeed available in such a jurisdiction.

Regardless, taxpayers bear a heavy burden when asking a court to rectify erroneous documents that resulted in unfavorable tax consequences. You don’t want to find yourself in this position. Instead, seek the assistance of an experienced Canadian tax lawyer, who can plan your transaction to foresee and minimize tax liability and draft the related instruments to ensure that they match your intentions.