Canada s Supreme Court concludes general intention of tax neutrality insufficient for rectification in common law and civil law

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1 13 December 2016 Global Tax Alert News from Americas Tax Center Canada s Supreme Court concludes general intention of tax neutrality insufficient for rectification in common law and civil law EY Global Tax Alert Library The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: Tax/Americas-Tax-Center---borderlessclient-service Executive summary On 9 December 2016, the Supreme Court of Canada (SCC) released its decisions on two cases regarding rectification in the tax context: Canada (Attorney General) v Fairmont Hotels Inc., 2016 SCC 56 (Fairmont), and Jean Coutu Group (PJC) Inc. v Canada (Attorney General), 2016 SCC 55 (Jean Coutu). Both decisions agree that a general intention of tax neutrality is insufficient to justify a rectification order. Rectification applies to tax and non-tax contexts in the same way. It is only available when there is an error in an instrument that incorrectly records the parties agreement. It is not available to rectify an agreement that led to unintended tax consequences. When designing and implementing tax plans, taxpayers no longer have the luxury of retroactively redoing agreements should the intended planning fail to achieve their goal of tax neutrality, regardless of how benign such tax planning may be. It is only if the agreement of the parties can achieve tax neutrality or other legitimate tax objectives through definite and ascertainable terms that errors in the underlying instruments may be rectified to align with the parties intentions.

2 2 Global Tax Alert Americas Tax Center In Fairmont and Jean Coutu, the SCC finally settled the question of whether a general intention to complete a transaction on a tax-free or tax-neutral basis is sufficient as a grounds for rectification. The Court confirmed that it is not. Rather, the parties must show there was an agreement with definite and ascertainable terms reflecting their intended steps, and they must provide evidence that the existing written documents do not properly reflect those steps in order to make use of the remedy. Detailed discussion Facts and judicial history Fairmont In Fairmont, Fairmont Hotels Inc. (Fairmont) was involved in a US currency financing arrangement with a Canadian real estate investment trust (REIT). Through its subsidiaries, Fairmont entered into reciprocal loan arrangements with the Canadian REIT, also in US currency, intending to achieve foreign exchange neutrality. The later acquisition of Fairmont frustrated this intention, and the parties agreed to a modified plan to fully hedge Fairmont against foreign exchange exposure. However, the Canadian subsidiaries foreign exchange exposure was not taken into account; rather, their potential tax exposure was deferred, without any specific plan as to how the tax exposure would be mitigated. Subsequently, on short notice in order to allow for an asset sale, the reciprocal loans were terminated by transactions which included the redemption of Fairmont s shares of the subsidiaries, resulting in an unhedged foreign exchange gain to the Canadian subsidiaries, a result which had not been expected. This liability was discovered on an audit by the Canada Revenue Agency (CRA). Fairmont sought rectification of the Canadian subsidiaries directors resolutions approving the redemption by converting the share redemption into a loan to Fairmont, thereby achieving tax neutrality. Both lower courts granted the order for rectification on the basis that Fairmont had intended the original financing arrangement and unwinding of the loans to be tax neutral, and the share redemption was incorrectly chosen as the method to achieve the goal. Both the Ontario Superior Court and the Ontario Court of Appeal considered themselves bound by the 1999 Ontario Court of Appeal decision in Juliar v Canada (Attorney General), 50 O.R. (3d) 728, which many commentators have considered to be the high water mark of rectification. Jean Coutu Jean Coutu Group (PJC) USA Inc. (PJC USA), a Delaware corporation and a subsidiary of Jean Coutu Group (PJC) Inc. (PJC Canada), acquired a chain of pharmacies in the United States. The value of the investment was recorded in US dollars, the value of which fluctuated depending on foreign exchange rates and caused negative perceptions of PJC Canada to its investors. PJC Canada sought to neutralize the fluctuations through a series of transactions that involved reciprocal interest-bearing loans between PJC Canada and PJC USA that were intended to be tax neutral. However, because PJC USA was a controlled foreign affiliate of PJC Canada, the interest PJC USA earned on its loan to PJC Canada was taxable to PJC Canada as foreign accrual property income (FAPI), and PJC Canada was assessed for CA$2.2 million in unpaid tax. PJC Canada sought to correct the inconsistency between its original intention for tax neutrality and the transaction steps actually undertaken through an application under article 1425 of the Civil Code of Quebec (CCQ) (considered to be the civil code equivalent of rectification) by inserting certain two new steps which would have the result of the FAPI earned by PJC USA being offset completely by interest payable on a loan to PJC Canada. The Quebec Superior Court granted the application, but the Quebec Court of Appeal overturned its decision. The decisions In 7-2 decisions (in both cases Justices Abella and Côté dissenting), the SCC allowed the appeal in Fairmont and dismissed the appeal in Jean Coutu. Both cases include strong dissenting judgments critical of the majority decisions for unduly restricting the availability of rectification to a relatively narrow class of cases where there have been errors in documenting the antecedent agreement of the parties. Neither of these cases involved aggressive (or bold ) tax planning, nor is there anything in either case to suggest bad faith or an abuse of rights on the part of the taxpayers. Rather, in both cases there were unanticipated and unintended tax consequences that were not discovered until an audit of the transactions by the CRA. The majority decisions in both cases have effectively removed the availability of rectification in both common law and civil law jurisdictions in Canada where taxpayers

3 Global Tax Alert Americas Tax Center 3 have documented transactions that themselves give rise to unforeseen and unintended tax consequences. In doing so, the SCC affirmed that the equitable remedy of rectification (in common law jurisdictions) and civil law rectification pursuant to CCQ article 1425 have the same purpose and will typically lead to similar results, albeit from different legal sources: in common law jurisdictions, based on the equitable jurisdiction of judges, and under the civil code based on principles of contract formation and interpretation. However, the remedy is available only in limited circumstances. The decision in Fairmont holds that rectification is an equitable remedy reserved for cases where written instruments incorrectly record the intentions of the parties involved. It is not available for curing an error in judgment in entering into a particular agreement. In circumstances where the transactions as written give rise to adverse tax consequences, the taxpayer must show that the parties reached an agreement with definite and ascertainable terms to achieve their intention (which included the avoidance of tax) and the documents simply failed to accurately record this agreement. A court requires evidence with a high degree of clarity, persuasiveness and cogency before substituting the terms of a written instrument with those said to form the parties true, if only orally expressed, intended course of action. In reaching this conclusion, the SCC specifically overruled the Juliar decision, considering it to be a case in which the court incorrectly allowed for impermissible retroactive tax planning. According to the majority of the SCC (at para. 39), [r]ectification is not equity s version of a mulligan. Courts do not rectify agreements where their faithful recording in an instrument has led to an undesirable or otherwise unexpected outcome. In Jean Coutu, the Court dismissed the appeal, holding that courts can only correct contractual errors if there exists a common intention between parties that is clearly defined with objectives that are determinate or determinable. A general intention to minimize tax cannot be the objective of an agreement because it is not sufficiently determinate or determinable. As such, it cannot be the basis upon which to modify a written agreement that supposedly expresses such an objective. The Court distinguished the object of a contract from the effect of a contract. Having an intention as to the effect of a contract does not constitute grounds for modification of a contractual document. Generally, rectification may be granted in two circumstances. First, if an error arises where both parties mistakenly believed an instrument accurately memorialized their agreement, then a court may rectify such instrument if the court is satisfied that the following conditions are met: 1. There exists a prior agreement whose terms are definite and ascertainable 2. At the time the instrument was executed, that agreement was still in effect 3. The instrument does not accurately reflect such prior agreement 4. If the instrument were rectified, it would properly execute the prior agreement Second, rectification may be granted if only one party claims there is a mistake in the instrument and the other disagrees. In such cases, in addition to the above requirements, the claimant must also show the other party knew or ought to have known about the mistake, and allowing the other party to be advantaged by such a mistake would amount to fraud or the equivalent of fraud. Implications In these two decisions, the SCC has severely limited the remedy of rectification in tax cases, under both equitable principles and under the civil code, to correct only documents that fail to accord with the parties true agreement. While both cases recognize that rectification can include the insertion of steps not previously documented by the parties, rectification will only be available in cases where the written agreement of the parties has incorrectly reflected the parties antecedent agreement. It is not available where that antecedent agreement itself gives rise to unintended tax consequences. And while the SCC acknowledged in both cases that a third party (such as the CRA) should not be unjustly enriched by mistakes of the parties in memorializing the terms of their agreement, where the tax consequences either were not taken into account or through poor advice were incorrectly understood in the antecedent agreement, rectification is not available. According to the majority in Jean Coutu, the appropriate remedy in such cases is not rectification, but [r]ather, if the mistakes are of such a nature as to warrant it, taxpayers can bring a claim against their advisors, who generally have professional liability insurance, and try to prove that claim in the courts.

4 4 Global Tax Alert Americas Tax Center While these two decisions will undoubtedly lead to a reduction in the number of rectification applications brought in tax cases, they will have a chilling effect on the ability of taxpayers to obtain tax advice concerning the interaction of increasingly complex provisions of the Income Tax Act. As the dissenting judgment in Jean Coutu indicated (at para. 93), I would think that rectifying the agreement, in line with the innocent party s duty to mitigate, is preferable to the promotion of claims against that party s advisors. On this front, the majority s position ignores the important role played by tax professionals in the modern business world, which represents a stark departure from this Court s recent recognition that [i]ncome tax law is notoriously complex and many taxpayers rely on tax advisors to help them comply (Guindon v Canada, 2015 SCC 41, [2015] 3 S.C.R. 3, at para. 1). For additional information with respect to this Alert, please contact the following: Ernst & Young LLP (Canada), Toronto Daniel Sandler daniel.sandler@ca.ey.com Ernst & Young LLP (Canada), Montréal Louis Tassé louis.tasse@ca.ey.com Ernst & Young LLP (Canada), Ottawa Roger Taylor roger.taylor@ca.ey.com Ernst & Young LLP (Canada), Calgary David Robertson david.d.robertson@ca.ey.com

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