Restricted scope for rectification addressing adverse tax consequences

A recent decision^[1] of the Ontario Court of Justice demonstrates the restricted scope for rectification to address adverse tax consequences. The two applicants were Sleep Country Canada Holdings Inc. and Sleep Country Canada Inc. As is typical for applications seeking rectification, the respondent was the Attorney General of Canada, effectively representing the Canada Revenue Agency ("CRA"), who was the only party who could be adversely impacted by the relief sought yet did not oppose the application. As an equitable remedy, applications seeking rectification are made in provincial superior courts, which have jurisdiction to grant equitable relief. The Court granted rectification, which avoided an unintended adverse tax result, in the context of a share exchange transaction. This article discusses the background facts, how the Court applied the test for rectification to render its decision and finally some conclusions.

Background facts

The applicants are significant players in the retail mattress business. They entered into a share exchange transaction with one another, which was one component of a reorganization that was implemented to facilitate an initial public offering of certain equity interests in their business on a tax efficient basis.  In the Share Exchange Agreement, the number of certain shares to be issued was incorrectly recorded as about 12 and a half million shares, whereas the correct number was just over 124 million shares. This had the effect of omitting the intended consideration of the difference between these two amounts, or about 111 and a half million shares. This error was then simply transposed into other transaction implementation documents, as well as the corporate documents recording the transaction. Subsequent tax filings, however, reflected the correct number of shares, which the applicants relied on as further evidence of their true intentions and agreement throughout.

Test for rectification applied

In deciding whether to rectify the documents to reflect the correct number of shares, the Court applied the four requirements test from the Supreme Court of Canada's ("SCC") 2016 decision in the well-known Fairmont^[2] case, which is a leading case on rectification:

1. The parties had reached a prior agreement whose terms are definite and ascertainable;
2. The agreement was still effective when the instrument was executed;
3. The instrument failed to record accurately that prior agreement; and
4. If rectified as proposed, the instrument would carry out the agreement.

The Court found that all four requirements were met. Referencing the Fairmont decision, the Court summarized that rectification allows a Court to achieve correspondence between the parties' agreement and the substance of the legal instrument intended to record that agreement, when there is a discrepancy between the two. The Court went on to explain that the applicants bear the onus of establishing, with evidence that is sufficiently clear, convincing and cogent, satisfactorily to the Court that the true substance of the unilateral intention or agreement with another party was not accurately recorded in the instrument to which it nonetheless subscribed.

The Court held that the evidence was overwhelming that the parties had reached an agreement, with definite, ascertainable terms and a clear intention, which was consistent with the subsequent conduct, including the tax filings. Similarly, there was no doubt that the documents sought to be rectified did not accurately record the agreement between the parties and that rectification would result in the documents carrying out the agreement that had been reached. Finally, the Court agreed with the applicants' submission that rectification can be available, if the four requirements are met, even if it would have the effect of allowing a party to avoid adverse tax consequences.

Conclusions

This case illustrates how the SCC's decision in Fairmont, as well as other similar cases, have significantly reduced the scope for rectification in a tax context. Previously, and for many years, the leading case on rectification, at least in Ontario, was the Ontario Court of Appeal's well-known decision in Juliar.^[3]  The test from Juliar applied much more broadly. Essentially, it boiled down to two elements, intention and mistake. Importantly, in the tax context, intention could include an intention to achieve favourable tax consequences.  Mistake was interpreted broadly, to include the manner in which transactions were structured. One other element of the test was that there also had to be no alternative legal remedy available. Therefore, before the Fairmont decision, rectification could avoid unintended tax consequences in a much broader range of circumstances. Once such an intention for tax efficiency and a mistake were satisfactorily established, the Court was willing to do much more than merely rectify an instrument that recorded an agreement. The relief the Court granted could include significantly restructuring transactions, such as replacing a merger by wind-up with an amalgamation

After Fairmont, rectification has been applied much more strictly and much more like the traditional illustration, where two parties agree to the purchase and sale of a cow, but the written instruction to effect the transaction mistakenly says it's a horse and the Court rectifies the written instrument to say cow instead of horse. The case being discussed in this article is something like that, with simply the wrong number having been mistakenly transposed throughout the documents. Is there a future for a more broadly based rectification doctrine, along the lines of the Juliar decision, in the tax context? This could be accomplished through amendments to provincial legislation. While there is at least one instance where submissions have been made to a provincial government regarding amendments that would have that effect, only time will tell whether such legislative amendments will ever be implemented. For now, taxpayers suffering from unintended adverse tax consequences arising from various kinds of mistakes will need to live with the current, more restrictive rectification regime.