Introduction: The Tax Consequences of A Rectification Order
Rectification gives parties a means of fixing mistakes in a written agreement or other legal document. For instance, if a drafting error renders a legal instrument incompatible with the agreement that it was meant to document, the contracting parties may ask a court to rectify the instrument so that it aligns with their intended agreement. In other words, a court will rectify an erroneously drafted document to preserve the parties' true intentions.
Granted, to correct the mistake, the parties need not apply for a rectification order. They can simply agree to amend the mistaken document.
Yet a court rectification order offers one advantage that an amendment doesn't. 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, a rectification order also binds the CRA (e.g., see: Dale v Canada,  3 FC 235 (FCA)).
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. Canada's tax law generally respects the instruments purporting to create these private-law rights and duties. A rectification order effectively puts the parties into the position that they'd occupy had the impugned document been drafted correctly from the start. 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.
Tax-Policy Concerns: Rectification as Retroactive Tax Planning—"Another Kick at the Can"
Because rectification can undo tax consequences, it's no surprise that rectification jurisprudence is flooded with applicants who seek relief from unintended tax consequences stemming from purported drafting mistakes. The concern, however, is that taxpayers may use rectification for 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." That is, if a rectified document were to put in place a transaction that the taxpayer had not intended until after executing the impugned document, the rectification order would essentially re-characterize the original transaction. And any pending tax litigation based on the transaction's original characterization becomes pointless. The risk, in other words, is that taxpayers may use rectification to move the goalposts in the tax game.
The Evidentiary Burden for Rectification: Proof of the Intended Agreement or Transaction
This concern prompted the Supreme Court of Canada to tighten the reins on rectification in tax cases. In Canada v Fairmont Hotels Inc. (2016 SCC 56), 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 articulated a four-point test that applicants must satisfy before a court will grant rectification. Specifically, rectification is available only if:
- there was a prior agreement with definite and ascertainable terms;
- the agreement was still in effect at the time that the instrument was executed;
- the instrument fails to accurately record the agreement; and
- the instrument, if rectified, would carry out the parties' prior agreement (Fairmont, supra, at para 38).
In practice, this test means that, to be successful, rectification applicants typically need to produce documentary evidence of the intended transaction—e.g., a tax-planning memorandum, prior drafts of agreements, letters and emails to and from tax advisors, etc.
Crean v Canada illustrates how prior documents can make or break a tax rectification case. After examining the Crean case in detail, this article extracts the lessons from that case in the form of tax tips that our expert Canadian tax lawyers believe that taxpayers should find useful.
Crean v Canada, 2019 BCSC 146
Crean demonstrates not only the value of documenting your agreements but also the necessity of receiving tax-planning advice from an experienced Canadian tax lawyer (as opposed to relying solely on an accountant, who may overlook the more obscure or technical rules in Canada's Income Tax Act).
The Crean Brothers & the Crean Company Group
Two brothers, Mike and Tom Crean, ran a funeral-service business. Until August 2016, they had each equally owned the business using a holding-company/operating-company structure. Specifically, Mike and Tom each owned 50% of a holding company, which in turn owned 100% of the operating company through which the brothers ran the funeral business. These related corporations comprised the Crean Group.
The Agreement in Principle
By summer of 2016, Tom had sought to retire from the business and sell his interest to Mike. As a result, in May 2016, the Tom and Mike entered a written agreement in principle whereby the two roughly set out their intentions that Mike would purchase Tom's interest in the family business for $3.2 million. The first term of that agreement contained the following clause: "Mike to purchase all of Tom's interests in the Crean Group, direct or indirect, for the sum of $3,200,000 CDN. The full amount shall be payable to Tom in cash or by way of certified cheque, bank draft or solicitor's trust cheque on closing."
The Accountant's Plan & The Impugned Transactions
After the brothers entered the agreement in principle, they approached their accountant for advice on structuring the $3.2 million transaction. The accountant told the brothers that Mike should create a new corporation to purchase Tom's shares in the holding company. (It's not entirely clear why the accountant preferred this structure over one involving a direct sale from Tom to Mike. But this seemingly inconsequential decision would generate the entire dispute.)
So, in August 2016, per the advice of their accountant, the Crean brothers did the following:
- Mike incorporated a numbered company and subscribed for 50 shares for $50;
- Mike's and Tom's holding corporation paid a tax-free capital dividend to Tom in the amount of $450,000 (which went towards the purchase price of Tom's shares);
- Mike transferred all his shares in the holding company to the numbered company, and, in exchange, Mike received another 50 shares in the numbered company (this transfer occurred on a rollover basis under section 85 of the Income Tax Act);
- Tom sold all his shares in the holding company to the numbered company, and, in exchange Tom received a promissory note from the numbered company in the amount of $2.75 million (i.e., the remainder of the $3.2 million purchase price).
As a result of these transactions, Mike became the sole shareholder of the numbered company, and the numbered company became the sole shareholder of the holding company, which in turn owned the operating company.
When Tom filed his 2016 tax return, he reported his $2.75 million proceeds as a capital gain. (Under Canada's Income Tax Act, a capital gain is only one-half taxable. Other sources of income—such as business income or dividends—are fully taxable.)
The Problem: The Anti-Surplus-Stripping Rule under Section 84.1 & Deemed Dividends
The problem with the accountant's plan was that Tom's sale to the numbered company had triggered section 84.1 of the Income Tax Act. Section 84.1 is an anti-avoidance rule that seeks to bar individuals from surplus stripping corporations. Basically, surplus stripping is when, by using non-arm's-length transactions, an individual shareholder extracts a corporation's retained earnings as a capital gain or tax-free return of capital rather than as a taxable dividend.
Section 84.1 applies if:
- an individual taxpayer sells shares to a corporation;
- the individual doesn't deal at arm's length with the purchasing corporation; and
- after the sale, the purchasing corporation controls the corporation whose shares it purchased.
If the rule applies, then the individual seller is deemed to receive a dividend to the extent that the non-share consideration from the purchasing corporation exceeded the greater of (i) the seller's adjusted cost base (ACB) of the shares sold and (ii) the paid up capital (PUC) of the shares sold.
For a detailed explanation of adjusted cost base (ACB) and paid up capital (PUC), see our article: "Taxation of Shareholders: The Basic Deemed-Dividend Tax Rules"
Tom triggered section 84.1 when he sold his half of the shares in the holding company to his brother's numbered company: he was an individual that sold shares to a corporation; the purchasing corporation was non-arm's length because his brother owned it; and, after the sale, the purchasing corporation controlled the corporation whose shares it purchased.
As a result, the $2.75 million promissory note from the numbered company resulted in a deemed dividend to Tom. So, rather than incurring a half-taxable $2.75 million capital gain, Tom was deemed to receive a fully taxable $2.75 million dividend. (To make matters worse, the deemed dividend under section 84.1 doesn't qualify for a dividend tax credit. The standard section 84 deemed-dividend rules, however, do qualify for a dividend tax credit.)
The Rectification Application
Ironically, had Tom sold his shares in the holding company directly to Mike (rather than to Mike's numbered company), section 84.1 wouldn't apply. And Tom's proceeds would retain their capital-gains characterization.
For this reason, Tom, Mike, the holding company, and the numbered company applied to the Supreme Court of British Columbia for rectification. In particular, they asked the court to rectify two documents: (1) the August 2016 agreement under which Tom sold his holding-company shares to Mike's numbered company; and (2) the $2.75 million promissory note from the numbered company to Tom.
The August 2016 agreement, they claimed, should have been drafted to record a transaction by which Tom sells his holding-company shares directly to Mike, who in turn sells those shares to his own numbered company. Likewise, the $2.75 million promissory note from the numbered company to Tom should have been a note from Mike to Tom.
After a through examination of rectification principles in the tax context, the court granted the rectification application. The court's decision relied heavily on Tom and Mike's May 2016 agreement in principle—and, in particular, the following clause from that agreement:
Mike to purchase all of Tom's interests in the Crean Group, direct or indirect, for the sum of $3,200,000 CDN. The full amount shall be payable to Tom in cash or by way of certified cheque, bank draft or solicitor's trust cheque on closing.
This clause, the court observed, constituted evidence of a definite and ascertainable prior agreement whereby the parties intended that Tom sell his interest in the Crean Group directly to Mike. In particular, the clause suggested that the transaction was intended as one between Mike and Tom. The clause's reference to "direct or indirect" spoke not to the manner of the sale—i.e. directly to Mike or indirectly through Mike's numbered company; it spoke to the subject of the sale—i.e., Tom would sell his direct or indirect interests in the Crean Group.
Moreover, Tom and Mike's accountant testified that, when he drafted the August 2016 purchase agreement (!), he mistakenly listed Mike's numbered company as the purchaser. Although this didn't explain why the accountant had suggested the creation of the numbered company in the first place, the accountant insisted that his clients' instructions were "Mike wanted to purchase Tom's shares and that they wanted it to be a direct sale" (Crean, supra, at para 48).
Because the Crown didn't press the issue of the numbered company's existence (or, for that matter, cross-examine the Creans on whether they in fact intended a direct transfer), the B.C. Supreme Court sided with the Creans and granted rectification.
Tom therefore managed to dodge the bullet on the fully taxable $2.75 million deemed dividend.
Tax Tips: Tax Rectification & the Importance of a Tax-Planning Memo by an Experienced Canadian Tax Lawyer
Canada imposes onerous requirements on a party seeking rectification. In particular, you must demonstrate that the documented transaction or agreement wasn't the one that you had intended. The Crean decision illustrates the importance of supporting your intentions with documentary evidence.
It also demonstrates the importance of turning to an experienced Canadian tax lawyer to ensure that you avoid planning mistakes in the first place. Even experienced accountants may overlook the more obscure or technical rules in Canada's Income Tax Act—like the section 84.1 anti-surplus-stripping rule that played a role in Crean. A tax-planning memorandum by an experienced Canadian tax lawyer will not only help you evade unintended tax consequences but also serve as evidence of your intended transaction or agreement. Consult one of our experienced Canadian tax lawyers, who can plan your transaction to minimize tax liability and draft the related instruments so that they match your intentions.