The courts continue to delineate the scope and operation of rectification following the Supreme Court of Canada’s decision in Canada (Attorney General) v. Fairmont Hotels Inc. (2016 SCC 56) (“Fairmont”), which significantly curtailed the availability of the remedy. Most recently, on August 31, 2018, the British Columbia Supreme Court (“BCSC”) granted an order to rectify a directors’ resolution declaring a capital dividend, the amount of which had been erroneously inflated, in its decision in 5551928 Manitoba Ltd. (Re) (2018 BCSC 1482) (“5551928 Manitoba”).
In 5551928 Manitoba, following a sale of property by the taxpayer corporation (the “Sale”) in 2015, the directors sought to distribute the maximum amount of capital dividends that could be distributed to the shareholders in the year of sale. Capital dividends are advantageous in that they can be distributed to shareholders without triggering any tax payable by the corporation or its shareholders. The taxpayer’s accountants calculated the capital dividend account (“CDA”) to be $298,092 immediately before December 31, 2015. The accountants therefore advised that a capital dividend payable on December 31, 2015 in the amount of $298,000 could be declared.
The material mistake in this transaction lay in the calculation of the CDA: the accountants had incorrectly calculated the CDA amount available in 2015 to include the amount of $184,880 arising from the disposition of eligible capital property on the Sale. However, subsection 14(1) and the definition of “capital dividend account” in paragraph 89(1)(c.2) of the Income Tax Act have the effect of adding such amount to the CDA only after the end of the taxpayer’s taxation year, which would have been August 31, 2016.
Based on this mistaken advice that $298,092 was the CDA amount that could be distributed for the 2015 year without resulting in any tax payable, the directors issued a resolution (the “Resolution”) providing for the declaration of a capital dividend in the amount of $298,000 payable on December 31, 2015. The requisite filings with the Canada Revenue Agency (the “CRA”) were made on the basis of this amount, as well as the actual payment of the dividend to the shareholders. The BCSC noted (at paragraph 9) that, when the CRA became aware of the erroneously calculated CDA amount, a Notice of Assessment was issued for further tax payable “in an amount equal to 60% of the amount by which the dividend declared by the Resolution exceeded the Corporation’s actual CDA immediately before the time of the dividend (i.e., 60% of $184,789, or $110,873.10).”
Subsequently, the taxpayer sought an order rectifying the Resolution to amend the amount of the declared capital dividend such that it would be reduced from $298,000 to $113,212 (i.e., the correct CDA balance). This order was opposed by the Attorney General of Canada.
The BCSC held that the Fairmont test for rectification was met in this case. The Court found that there was a precise, definite, and ascertainable agreement between the directors to effectively “empty” the CDA and that this was clearly what the directors intended to do, based on the undisputed evidence provided by one director and the accountants. The Court also relied on the Resolution itself, stating that it clearly established that the essence of the agreement was to distribute to the shareholders the maximum amount that could be distributed on a tax-free basis by means of the CDA: the Resolution made explicit reference to what was believed to be the full amount of the CDA, as well as the specific tax consequences of distributing from the CDA. As such, the Court found (at paragraph 25) that “the directors' agreement was clear and definite throughout — to fully exhaust the tax-free capital dividend account, whatever it may be. The only flaw was in the figure, a figure that was provided by an expert third party. Collectively, this evidence is sufficiently clear convincing and cogent as to the true terms of the agreement.”
Additionally, the Court canvassed the policy concerns expressed in Fairmont that rectification is frequently used to engage in retroactive tax planning. The BCSC found that none of those policy concerns applied to the case at bar: the taxpayer was not attempting to engage in “bold tax planning” or seeking to modify the instrument “merely because a party has discovered that its operation generates an unplanned tax liability”; there was no evidence to suggest that the taxpayer was reckless, failed to act with due diligence, or “should have known better;" the issue did not arise from an “error in judgment;” and there was “no concern that the request for rectification requires the court to wholly rewrite or unwind a complex mechanism or series of business transactions.”[1]
The Court granted the order for rectification as requested by the taxpayer.
Commentary
Following the narrowing of the scope of rectification by Fairmont and the denial of rescission in Canada Life Insurance Company of Canada v. Canada (Attorney General) (2018 ONCA 562) (“Canada Life”)[2], the BCSC decision in 5551928 Manitoba may provide helpful guidance for taxpayers and tax advisors wishing to rely on the remedy of rectification.
The facts of 5551928 Manitoba were well-suited for a successful rectification application.[3] Indeed, the operation of the doctrine appears to be a straightforward application of the test for rectification set out by the Supreme Court in Fairmont, which stated (at paragraph 38):
To summarize, rectification is an equitable remedy designed to correct errors in the recording of terms in written legal instruments. Where the error is said to result from a mistake common to both or all parties to the agreement, rectification is available upon the court being satisfied that, on a balance of probabilities, there was a prior agreement whose terms are definite and ascertainable; that the agreement was still in effect at the time the instrument was executed; that the instrument fails to accurately record the agreement; and that the instrument, if rectified, would carry out the parties’ prior agreement.
We may distinguish 5551928 Manitoba and the Fairmont and Canada Life decisions on the basis that relief was denied because the courts were concerned about a specific, discrete action taken by the taxpayer (or the professional advisors) which effectively caused the unintended tax consequence. In Fairmont, the mistakenly implemented share redemption frustrated the parties’ common intention to unwind the loan structure on a tax-neutral basis. In Canada Life, the general partner was mistakenly wound up at the same time as the partnership, frustrating the taxpayer’s intention to realize an accrued loss on the partnership interest.
In contrast, in 5551928 Manitoba, there was no such distinct action which brought about the unintended tax consequence – there was a calculation error. It may be the case that, as would be consistent with the abovementioned policy concerns, courts are more willing to allow rectification in situations where there has not been a specific, discrete action performed by a sophisticated taxpayer that must be reversed in the context of a complex series of transactions.
Interestingly, 5551928 Manitoba seems to be the first case we have seen in a while (if at all) in which a taxpayer’s application to correct an excessive capital dividend election has been opposed by the CRA or the Attorney General. It has been the general administrative practice of the CRA and the Department of Justice for many years to not oppose rectification applications involving the correction of CDA errors. Perhaps 5551928 Manitoba was a test case for the CRA in light of Fairmont, as a means to see just how extensively the Supreme Court’s restrictive re-writing of rectification could be applied. At the very least, 5551928 Manitoba confirms – barring a reversal of that decision if appealed – that the scope of the remedy of rectification has not been so narrowed as to disallow the correction of CDA miscalculations.
About the author
Seth Lim is an associate in the Toronto office of PwC Law. Seth advises clients on a variety of tax planning, tax litigation, and corporate law matters. Prior to joining PwC Law, Seth worked as a tax law legal research associate at Blue J Legal.
[1] Fairmont, at paras 33, 3, 13, 23, 19.
[2] A detailed discussion of this case is beyond the scope of this article.
[3] In contrast, the facts of Harvest Operations Corp. v. Attorney General of Canada (2017 ABCA 393) were ill-suited for rectification. That decision is also part of the anthology of cases that substantially restricted the availability of equitable remedies in the tax context. In that case, the Alberta Court of Appeal, also following the Fairmont test, held that the instruments the appellant was seeking to rectify reflected the true agreement of the parties and therefore the doctrine of rectification could not be applied. The appellant could not point to any agreement that contained terms different than those to which the parties had agreed. The Court confirmed that “[r]ectification is not available just because the means the parties adopted to execute their business objective had unanticipated adverse tax consequences. The means that the parties utilized in pursuit of their goal of a tax-neutral transaction - and not the goal of tax neutrality - are the primary focus of a rectification application” (para 66-67.).
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