Taxpayers do not have a general license to “travel back to through time” with the benefit of hindsight to reverse or correct unintended tax consequences of commercial dealings, held the Quebec Court of Appeal in two separate but related rulings.
The rulings effectively limit the scope of the so-called rectification remedy in a tax context under civil law, according to tax experts. A powerful legal instrument, rectification essentially allows taxpayers, under certain conditions, to correct errors in legal documents or instruments that do not reflect the true intention of the parties, and which lead to unintended consequences. Rectification allows the parties to “fix” the terms of the transaction so that the intended tax consequences are achieved. Its effect is retroactive.
Rectification has been available to taxpayers living in common law provinces since the turn of the century, following a decision in 2000 by the Ontario Court of Appeal in Canada (Attorney General) v. Juliar. The SCC turned down the leave to appeal in Juliar.
But following two rulings by the Supreme Canada in Québec (Sous-ministre du Revenu) v. Services Environnementaux AES Inc. and Riopel v. Agence du revenu du Canada that found that it is possible under civil law to rectify an agreement that gave rise to unintended tax consequences, some tax advisors believed they had carte blanche to use rectification to correct tax planning mistakes, noted Étienne Gadbois, the head of the taxation group at De Grandpré Chait LLP in Montreal.
“Following the judgments by the Supreme Court, a lot of people saw this as an insurance policy for advisors working in tax planning,” said Gadbois. “That as soon as they make a mistake in one of their planning’s then it’s not a problem because they could apply to the court and have a rectification order. The Quebec Court of Appeal rulings makes it clear that rectification is not an insurance policy.”
In both cases, Mac’s Convenience Stores inc. v. A.G. Canada and Canada (Attorney General) v. Groupe Jean Coutu (PJC) inc., the parties maintained that the agreements that they had executed did not reflect their common intention. In the Jean Coutu case, the pharmacy retailer consulted with its accounting experts and examined two scenarios to offset the effects of the fluctuating exchange rate on the value of its U.S. investment on its balance sheet. After opting for one scenario and executing a series of transactions, Jean Coutu achieved its intended purpose of “neutralizing” the effect of the exchange fluctuations. But following an audit in 2010, the Canada Revenue Agency considered the interest income paid to be foreign accrual property income, and assessed the company with $2.2 million of unpaid income tax. The company then wanted to retroactively rectify the transactions according to the second scheme that would reduce the interest payable to nothing.
In the Mac’s case, the convenience store retailer took out a loan for $185 million from an American company. It deducted the interest paid on the loan from its income. A year later, it performed a series of transactions involving several interwoven legal entities, including the payment of a $136 million dividend to its parent company, Couche-Tard Inc. That triggered the application of the so-called thin capitalization rules, which prevented the interest paid under the loan from being deductible which in turn triggered the elimination of over $22 million of interest deduction and assessments for 2006, 2007, and 2008 by federal and provincial tax authorities. Mac’s too sought to remedy the unintended tax consequences by asking the court to replace the declaration of the $136 million dividend by a reduction of its stated capital and the distribution of cash equivalent to the sole shareholder.
“A taxpayer is obliged to pay tax arising from the transaction it effected and not the transaction that it would have preferred to have effected given the benefit of hindsight regarding unintended tax consequences,” held Quebec Court of Appeal Justice Mark Schrager in both rulings. “Taxpayers must live with the consequences of the contract they chose to put in place.”
According to Martin Delisle, a Montreal tax lawyer with De Grandpré Chait LLP, the rulings underscores the dangers of trying to “re-write the tax history” of transactions. “Perhaps since the SCC rulings in AES and Riopel, tax advisors interpreted the notion of rectification too broadly. You cannot rewrite the tax history of what a party in retrospect would have rather done.”
Heeding guidance from the SCC, the Quebec Court of Appeal found that in civil law, the law of contract is premised on the principle of consensualism, and a contract is formed by a “meeting of the minds of the parties.” A distinction is to be drawn, however, between the agreement that the parties intended (negotium) and the declaration – be it oral or written – of that intended agreement (instumentum), noted Justice Schrager. Parties are free to acknowledge a common error and to agree to correct it to what it should have been in circumstances where there was no mistake in the transaction itself but rather a rather a mistake in the way the transaction had been expressed in writing, as long as it does not prejudice any rights acquired by third parties, added Justice Schrager. “Correcting a transaction is not the same as changing it,” said succinctly Justice Schrager. The appeal court concluded that in the Mac’s case there was “no common intention” of the parties because the thin capitalization rules were never contemplated and so it “cannot be the object of a meeting of the minds to which a court can give effect.”
The appeal court came to similar conclusions in the Jean Coutu case, holding that it intended to conduct a series of transaction to neutralize the effect of exchange fluctuations, did so, achieved its objective, and were taxed on that basis even though they did not foresee the tax consequences.
“The two decisions of the Quebec Court of Appeal are important because they provide guidance as to the limitations of the application of the doctrine of rectification in civil law,” observed Louis Tassé, a tax litigator with Couzin Taylor LLP in Montreal. “The Quebec Court of Appeal considerably narrowed the application of rectification in civil law and declined the possibility of substituting a transaction with another, as is possible under the common law doctrine of rectification.”
The appeal court also putd to rest the perception that it is necessary to go before the courts to seek rectification. While the courts can intervene to declare the amendments legitimate and necessary by way of the motion for rectification, Justice Schrager said that parties have the power to correct the documents without the intervention of the court. But that is not something that tax lawyer Alexandre Dufresne would advise clients to do.
“In most cases, even if you don’t have to ask for judicial rectification, it’s probably appropriate to do so,” noted Dufresne, the managing partner of Spiegel Sohmer’s Montreal office. “It’s a question of getting clarity. You also want to make sure that the tax authorities will be on side or aware of what you are doing. So it’s advisable to bring them into the case as interveners. Otherwise you run the risk that the tax authorities will contest it down the line.”