Hanging by a Thread: Rescission in Collins Family Trust v Canada

The British Columbia Supreme Court ("BCSC") decision in Collins Family Trust v Canada (Attorney General)[1] ("Collins") grants at least a temporary reprieve for the equitable remedy of rescission in an income tax context. Although the BCSC granted rescission, the decision was firmly based in the singular factual circumstances and in particular their similarities with those in Pallen Trust, Re[2] ("Pallen"), a decision of the British Columbia Court of Appeal ("BCCA"). The Collins decision is important because the BCSC acknowledged that the authority of Pallen had been seriously undermined by the majority decision of the Supreme Court of Canada ("SCC") in Fairmont Hotels Inc. v Canada[3] ("Fairmont"), a rectification case. Nevertheless, the BCSC's decision threw a lifeline to the equitable remedy of rescission in tax matters. It remains to be seen how long this reprieve will last.

The BCSC granted rescission in Collins because of the virtually identical structure of the transactions to the transactions in Pallen. The transactions resulted in the tax-free payment of dividends by a corporation to a discretionary trust for the 2008 and 2009 taxation years. The same accounting firm designed the structure at issue in both Pallen and Collins. The structure intentionally triggered both subsections 75(2) (the reversionary attribution rule) and 112(1) (the inter-corporate dividend deduction) of the Income Tax Act[4] ("Act") to enable a corporation to issue dividends tax-free to the beneficiary of a trust. Generally, subsection 75(2) attributes to the transferor of property to a trust income and losses, and capital gains and loses, from the transferred property where the transferor can require that the property be returned or can direct to whom the property subsequently passes. Before Pallen, tax planners considered that subsection 75(2) would apply to beneficiaries who sold shares to a trust with a right of reversion. An efficient tax structure was to settle a trust with a holding company ("Holdco") as its beneficiary. Holdco would sell shares of an operating company ("opco") to the trust with a right of reversion. Subsection 75(2) would automatically attribute income from dividends issued by opco to Holdco. Subsequently, Holdco would deduct the income from the dividends under subsection 112(1). As a result, the trust would receive income from dividends issued on shares of opco tax-free.

What was once a workable tax avoidance strategy, however, has been gradually eroded at the federal level. The Federal Court of Appeal ("FCA") decided in Sommerer v Canada[5] ("Sommerer") that subsection 75(2) would not apply in circumstances such as in Pallen, where a share sale took place from the beneficiary to the trust. Instead, the FCA decided that the attribution rule did not apply to a beneficiary of a trust that transfers property to the trust by means of a genuine sale. The ruling in Sommerer significantly limited the ability to issue dividends to a trust tax-free. More recently, the majority of the SCC in Fairmont substantially narrowed the equitable doctrine of rectification to correct tax mistakes, holding that Courts amend legal instruments to accord with the parties' actual agreement and not rectify agreements that lead to undesirable outcomes. In other words, taxpayers are not entitled to a "do over" when their tax plans go awry. In Collins, however, the petitioner successfully sailed through these legal shoals by requesting the BCSC to grant the equitable remedy of rescission, rather than rectification.

The BCSC acknowledged that the petitioner sought a tax result through rescission that was no longer available through rectification. The BCSC stated that the petitioner would have to contend with the SCC decision in Fairmont if it sought to rectify its transaction. At law, the precedent in Pallen was the only available option for the petitioner in Collins to seek an equitable remedy for its mistake. The petitioner also benefited from the unsettled issue of whether the equitable remedy of rescission is available in tax matters after Fairmont. Importantly, the Ontario Court of Appeal ("OCA") did not consider Pallen in Canada Life Insurance Company of Canada v Canada[6] ("Canada Life"). In Canada Life, the OCA applied the principle in Fairmont to decide that rescission was not available. Nevertheless, the OCA decided Canada Life on facts that the BCSC distinguished from the facts in Collins.

The BCSC's decision in Collins illustrates the narrow scope of rescission after Fairmont. The SCC in Fairmont significantly limited the scope of rectification and the BCSC said it was not obvious that rectification and rescission, both being equitable remedies, should yield drastically different results. While thus acknowledging that Fairmont severely undermined Pallen, the BCSC decided that Pallen had not been expressly overruled. The BCSC determined that it was obliged to apply the provincial BCCA precedent, instead of following the federal SCC principle, and to provide comment. Arguably, the BCSC read Fairmont too narrowly, because Justice Brown of the SCC was concerned with preventing the application of equitable remedies to effect retroactive tax planning. The BCSC's fact-based decision-making appears to conflict with the principle in Fairmont. An appeal to the BCCA would likely determine how long the reprieve granted to rescission, to correct mistakes in tax planning, will last. This appears tenuous at best.