Implementation errors can be rectified in certain circumstances
TAX ALERT |
What recourse do taxpayers have when a transaction was incorrectly implemented, resulting in adverse tax consequences? The recent case of Crean vs. Canada (Attorney General) (2019 BCSC 146) highlights the importance of taking the time upfront to flesh out tax plans with enough specifics that a court may be willing to intervene afterwards to fix any implementation errors.
Mike and Tom Crean are brothers who each owned 50 per cent of a funeral services business. When Tom decided to retire, Mike agreed to buy him out and become sole owner of their group of private companies.
The brothers entered into an Agreement in Principle pursuant to which Tom was to receive $3.2 million “structured to the extent possible, so that Tom receives capital gains treatment for tax purposes,” implying a direct sale of Tom’s shares to Mike. The Creans then consulted a tax advisor who created and implemented a detailed plan to carry out the transaction.
Unfortunately, the plan was structured improperly. Tom was advised to sell his shares to a holding company controlled by the family group of companies rather than directly to his brother Mike. This resulted in Tom’s proceeds of the sale being deemed to be dividends pursuant to subsection 84.1(1) of the Income Tax Act rather than capital gains. Capital gains are taxed at a lower effective rate than dividends and certain capital gains may be eligible for the lifetime capital gains exemption. Achieving capital gain characterization is thus generally preferred as compared to dividend treatment.
The brothers applied to court to rectify the transactions on the basis that they did not accurately reflect their prior Agreement in Principle as a result of their tax advisor’s error.
Rectification is a legal remedy that allows a court to intervene to correct mistakes in rare circumstances where a written contract has incorrectly recorded a prior agreement between the parties.
The Supreme Court of Canada had previously elaborated a four-part test for rectification in two 2016 companion decisions Attorney General (Canada) v. Fairmont Hotels (2016 SCC 56) and Jean Coutu Group (PJC) Inc. v. Canada (Attorney General) (2016 SCC 55):
- Is there evidence of a “definite and ascertainable” prior agreement?
- Was there a prior agreement in effect at the time the instrument sought to be corrected was executed?
- Is the written instrument inconsistent with the prior agreement?
- Can the precise form of the written agreement be amended to carry out the prior agreement?
In Fairmont, the SCC stated, “rectification is not equity’s version of a mulligan”. Rectification is not a free pass for a do-over because the parties want to do some after the fact tax planning. The SCC found that rectification could permit a court to fix errors only where there was a mistake in implementing a prior written agreement. The taxpayer’s intention of achieving tax neutrality was not enough to merit rectification because it was merely an unspecified wish unsupported by any actual detailed plan. Similarly, in Jean Coutu the court further noted that there was little scope for rectification where sophisticated business people have had their agreements written and reviewed by lawyers.
Application of the test
In finding for the taxpayers, the Supreme Court of British Columbia held that the Agreement in Principle was their prior agreement and clearly evidenced their intention to execute a direct sale, rather than an indirect sale to the holding company. An indirect sale was ultimately carried out, but the taxpayers’ tax adviser conceded that he had misrepresented the parties' true intentions in the transaction documents.
Accordingly, the court rectified the legal documents to accomplish a direct sale and also added a subsequent step to give effect to the brothers' full Agreement in Principle.
Takeaways for middle market businesses
- Facts matter - The court was willing to rectify because the Creans’ Agreement in Principle was sufficiently detailed and clear and the tax advisor admitted to making an implementation error.
- Put the details in writing - The taxpayers prevailed because the mistake was in implementing their prior written agreement, not because they had failed to adequately consider the tax consequences.
- Poor strategic planning will not be rectified by the court – Rectification may not be limited to clerical errors and could also bridge gaps between a legal instrument and the parties' true intentions. However, contracts provide certainty to the marketplace, so courts are very reluctant to change contractual language after the fact. Parties are responsible for thinking through the tax consequences of their actions before they sign.