January 10, 2017
The Supreme Court of Canada is clamping down on the use of a legal tool that has allowed some taxpayers to lower their tax bills.
In two separate decisions, one involving Fairmont Hotels and the other Jean Coutu, the Supreme Court has restricted access to a legal remedy called “rectification” to prevent people from using it as a backhanded way to cut their taxes.
Rectification allows parties to fix mistakes in written contracts. The tool is supposed to be used when parties discover that a written contract doesn’t reflect the terms they thought they had agreed to. Yet some have tried to argue that unintended tax consequences be included in the scope of mistakes that can be corrected by rectification. The Supreme Court of Canada says that’s stretching the use of the tool too far.
“Rectification is not equity’s version of a mulligan,” writes Justice Russell Brown on behalf of the 7-2 majority in Fairmont Hotels.
Rectification can be a powerful legal tool. It’s not limited to simple typos. Courts have the discretion to fix a written agreement that incorrectly records a prior deal between the parties. But to do so, the court needs strong evidence that shows a high degree of clear intention on those missing or incorrect terms before rewriting the agreement. Unintended consequences alone aren’t grounds to make the change, the court says.
This is important because until now “continuing intention” was enough to grant the remedy of rectification in situations involving unintended tax consequences. The court is imposing a stricter position that requires firm evidence on the balance of probabilities that the written contract doesn’t reflect the prior agreement, and that rectification is necessary to carry out the prior agreement.
In both the civil law (Quebec) and common law systems (the rest of Canada), rectification was historically available when a written contract did not accurately reflect specific terms to which the parties had agreed. Of late, however, some judges deciding Canadian tax cases have allowed parties to rectify where the written document correctly reflected the agreed terms but did not achieve the desired tax result.
“Rectification was granted because the agreement as recorded did not carry out the parties’ continuing intention to undertake a transaction on a particular tax basis, even though it correctly recorded the legal relationships that the parties intended,” says Alexander Cobb of Osler, Hoskin & Harcourt LLP in Toronto.
It fell upon the Supreme Court of Canada to decide the scope of the rectification doctrine in twin cases involving Fairmont Hotels and Jean Coutu, a Montreal-based retail pharmacy chain.
Both cases involved transactions structured to hedge the companies’ exposure to exchange rates. In each instance, the transactions were intended to be tax neutral. As it turned out, the Canada Revenue Agency determined they were not. Fairmont and Jean Coutu both accepted the CRA’s determinations, but applied to the court to rectify the transactions in a manner that would make them tax neutral.
In Jean Coutu’s case, the Quebec Court of Appeal refused rectification, finding that the company’s “general intention” to avoid tax was “not sufficiently determinate” to invoke the doctrine. In Fairmont’s case, the Ontario Court of Appeal came to the opposite conclusion, ruling that rectification was appropriate where the parties had a “common continuing intention” to effect a transaction without attracting tax liability.
The Supreme Court opted for the traditional view of rectification, denying the remedy in both cases before it. In so doing, the Supreme Court overruled the broader approach and found that rectification was limited to cases in which an agreement had not been recorded correctly in a written document.
“The written or oral expression of a contract can be amended if there is a discrepancy between it and the contracting parties’ true agreement. It cannot be amended where there is no such discrepancy but that true agreement merely produces unintended or unanticipated consequences,” writes Justice Richard Wagner in the Jean Coutu decision.
Rectification, then, is available to give effect to parties’ real intention by amending the written agreement, but not when the goal was to amend the agreement itself. In both the Fairmont and Jean Coutu cases, rectification was not available because the written agreement, although it did have unintended tax consequences, did in fact carry out the parties’ intended transaction. The mistake, then, was not in the way that the agreements were expressed, but rather in the nature of the agreements themselves.
“The result is that rectification is now an extremely limited remedy,” says David Rotfleisch of Rotfleisch & Samulovitch P.C. in Toronto. “You’ll need to have a lot of documents that demonstrate that what you wrote down is not what you intended.”
All of which does not mean that rectification is never available when unintended tax consequences follow. “Rectification may still be available to remedy unexpected tax liabilities, provided the circumstances warrant rectification under the traditional equitable rectification doctrine,” Cobb says.