Rectification Requires Prior Agreement to Succeed: Intention Alone Insufficient

Taxation

12/13/2016       By Christopher B. Norton

In two recent decisions - Canada (Attorney General) v. Fairmont Hotels Inc., 2016 SCC 56 (36606) and Jean Coutu Group (PJC) Inc. v. Canada (Attorney General), 2016 SCC 55 (36505) - the Supreme Court of Canada held (by a 7-2 majority) that rectification of a written instrument requires the existence of a prior agreement amongst the parties, with definite and ascertainable terms. Courts may rectify an instrument if it fails to accurately record the agreement and the rectification of the instrument would record the parties’ prior agreement.

As a result of the decisions in Fairmont and Jean Coutu, the availability of rectification relief to cure or avoid unintended tax results will be significantly curtailed.

Fairmont

The Fairmont decision overturns the long-relied upon decision of the Ontario Court of Appeal in Juliar,1 which held that in the case of a common mistake regarding an intended result, it is unnecessary for the party seeking rectification to prove a prior agreement concerning the terms for which rectification is sought. The focus in Juliar, and in cases which followed the Juliar decision, including the lower courts in Fairmont, was on whether there was a continuing specific intention to obtain a particular result (e.g., no adverse tax result). This line of cases generally held that if the intended result was not achieved by the parties, rectification can be available, even where the executed documents reflected the transaction agreed to by the parties. In overturning the decision in Juliar, Brown J., for the majority stated:

Rectification is not equity’s version of a mulligan. Courts rectify instruments that do not correctly record agreements. Courts do not rectify agreements where their faithful recording in an instrument has led to an undesirable or otherwise unexpected outcome.2

No longer will it be possible for taxpayers to obtain rectification orders solely on the basis of the parties establishing a common continuing intention to implement a transaction to obtain a desired tax result. It will be necessary to establish that the signed documents contain errors which do not reflect the parties agreement regarding the transaction.

The anticipated reduced availability of rectification may result in an increase in requests for correction of mistakes under governing corporate statutes (such as section 265 of the CBCA, which is limited to correcting errors in articles, a notice, a certificate or other document). Relief based on the equitable principle of unjust enrichment may also be pursued in limited circumstances. See Lust v. The Queen, 2007 D.T.C. 5155 (FCA) as support for its application in the tax context.

Rectification is an equitable remedy which allows a Court to rectify a legal instrument so as to make it accord with the parties’ true agreement. This can arise if, by mistake, a legal instrument does not accord with the true agreement it was intended to record - because a term has been omitted, an unwanted term included, or a term incorrectly expresses the parties’ agreement.

Rectification will not be available where the basis for seeking it is that one or both of the parties wish to amend not the instrument recording their agreement, but the agreement itself. Citing Performance Industries3, the Court stated that “the court’s task in a rectification case is ... to restore the parties to their original bargain, not to rectify a belatedly recognized error of judgment by one party or the other.”4

Rectification will not be permitted simply because an agreement failed to achieve an intended effect (tax neutrality) - irrespective of whether the intention to achieve that effect was “common” and “continuing.”

The Court in Fairmont held that two types of error may support an order for rectification:

The first arises when both parties subscribe to an instrument under a common mistake that it accurately records the terms of their antecedent agreement. In such a case, an order for rectification is predicated upon the applicant showing that the parties had reached a prior agreement whose terms are definite and ascertainable; that the agreement was still effective when the instrument was executed; that the instrument fails to record accurately that prior agreement; and that, if rectified as proposed, the instrument would carry out the agreement.5

The second arises “where the claimed mistake is unilateral - either because the instrument formalizes a unilateral act (such as the creation of a trust),” or where “the instrument was intended to record an agreement between parties, but one party says that the instrument does not accurately do so, while the other party says it does.”6 In Performance Industries, the Court also required that “the party resisting rectification knew or ought to have known about the mistake” as a precondition to allowing rectification of unilateral mistake; and that “permitting that party to take advantage of the mistake would amount to ‘fraud or the equivalent of fraud.”7

Fairmont’s application for rectification was in the context of a share redemption in 2007 relating to a financing transaction with Legacy REIT. The redemption gave rise to a tax liability which, at the time the shares were issued in 2006, Fairmont recognized would arise on a share redemption and intended to avoid, although it had no specific plan on how to avoid such tax liability. The redemption by Fairmont of shares in its subsidiaries was done on the mistaken assumption that no adverse tax consequences would arise on such redemption.

Fairmont’s rectification application was successful in the lower courts on the basis of Juliar and the finding of a common intention of Fairmont and its subsidiaries to unwind the Legacy financing transaction in a tax neutral manner (although the specific manner to implement such unwind was not then identified). However, the SCC rejected the premise that a common intention is sufficient in the absence of an antecedent agreement of the parties. The SCC stated that a party seeking to correct an erroneously drafted written instrument on the basis of a common mistake must first demonstrate its inconsistency with an antecedent agreement with respect to that term. In Shafron8, a non-tax case, the SCC unambiguously rejected the sufficiency of showing mere intentions to ground a grant of rectification, insisting instead on erroneously recorded terms.

The rejection by the majority in Fairmont of the Juliar decision will materially narrow the scope of rectification in the tax context; allowing parties to correct instruments only to reflect what the parties agreed to do, and not what, with the benefit of hindsight, they should have agreed to do to obtain an intended result. This should bring tax rectification in line with the broader application of rectification in a non-tax context.

In Fairmont the SCC also confirmed that the correct standard of proof in rectification applications is a balance of probabilities; the same as any other civil standard of proof at common law. This is consistent with recent SCC decision in F.H. v. McDougall.9 However, the Court noted that a party seeking rectification faces a difficult task in meeting this standard, because the evidence must satisfy a court that the true substance of the party’s unilateral intention or agreement with another party was not accurately recorded in the instrument to which it nonetheless subscribed. The Court also noted that

“A court will typically require evidence exhibiting a high degree of clarity, persuasiveness and cogency before substituting the terms of a written instrument with those said to form the party’s true, if only orally expressed, intended course of action.”10

It should be noted that two Justices in Fairmont dissented, siding with the lower courts findings that a common, continuing, definite, and ascertainable intention to pursue a transaction in a tax-neutral manner can satisfy the threshold for granting rectification. In the view of the minority, “the additional requirement that the parties clearly identify the precise mechanism by which they intended to achieve tax neutrality, and how that mechanism was mistakenly transcribed in a document, has the effect of raising the threshold and frustrating the purpose of the remedy.”11

Jean Coutu

The taxpayer in Jean Coutu requested, under Quebec civil law, to modify executed documents after unintended tax consequences (an income inclusion under the FAPI rules) was assessed by the CRA. Jean Coutu succeeded at the Quebec Superior Court, but lost at the Quebec Court of Appeal.

The SCC dismissed the appeal and held that the taxpayer’s intention that “the agreement be tax-neutral ... is not sufficiently determinate or determinable [to] permit the documents recording and implementing the transactions to be amended to give effect to that intention, in accordance with art. 1425 of the Quebec Civil Code.”12 The parties “agreed on the precise set of prestations they wanted to execute, and there was no error in the way their agreement was expressed or executed.”13 The transaction merely resulted in unintended tax consequences for Jean Coutu.

Although Jean Coutu was decided under Quebec civil law and Fairmont was decided under common law, the Court in both cases arrived at the same conclusion. The Court in Fairmont, acknowledging this convergence, stated:

As is apparent from the reasons of my colleague Justice Wagner in [Jean Coutu], on this question both equity and the civil law are ad idem, despite each legal system arriving at that same conclusion via different paths - the former being concerned with correcting the document, and the latter focusing on its interpretation. This convergence is undoubtedly desirable in the context of applying federal tax legislation.14

Similarly, in Jean Coutu, the Court held that the equity remedy and art. 1425 of the Quebec Civil Code“ share similar principles and lead to similar results” and the result of the appeal “aligns with the result that would be reached in the common law provinces under the equitable remedy of rectification. Both have the same purpose: to ascertain that the true agreement between the contracting parties is accurately expressed in the written instruments reflecting either the terms of the agreement or the execution of the obligations themselves.15 To illustrate the similarities in both legal systems, the Court examined the facts in Fairmont and stated that if Fairmont’s request had been made under Quebec civil law, it would also have been denied.16 Similarly, the Court noted that even in equity, Jean Coutu’s requested amendments would not be permissible.

Additionally, the decision in Jean Coutu supports two important tax policy concerns. First, “tax consequences flow from the legal relationships or transaction established by taxpayers”17 and second, “allowing the amendment of written documents in this instant appeal would amount to retroactive tax planning”18.

For further information regarding this matter, please contact James G. Morand, Chris Norton, Tera Li or any other members of the Taxation Group.

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1 Juliar v. Canada (Attorney General) (1999), 46 O.R. (3d) 104, aff’d (2000), 50 O.R. (3d) 728.
2 at para 39.
3 Performance Industries Ltd. v. Sylvan Lake Golf & Tennis Club Ltd., 2002 SCC 19, [2002] 1 S.C.R. 678.
4 at para 13.
5 at para 14.
6 at para 15.
7 at para 15.
8 Shafron v. KRG Insurance Brokers (Western) Inc., 2009 SCC 6, [2009] 1 S.C.R. 157 .
9 F.H. v. McDougall, 2008 SCC 53, [2008] 3 S.C.R. 41.
10 at para 36.
11 at para 45.
12 at para 4.
13 at para 29.
14 at para 33.
15 at para 5.
16 at para 50.
17 at para 41.
18 at para 42.