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Rectification: The evolving landscape

S & D International Group Inc. v. Canada1 is another recent case on rectification which represents a significant win for taxpayers.2 In S&D International Group Inc., the Court broadly interpreted its equitable jurisdiction to allow taxpayers to correct transactions producing unintended tax consequences and granted a rectification order despite scant evidence of intent to avoid tax, and despite the fact that the taxpayers were under no misapprehension about the basic nature of the transaction (share repurchase).

S&D International Group Inc. (“S&D” or the “Corporation”) was in the business of developing and marketing real estate in Alberta.  It was owned by three businessmen and their wives. The wives held 75% of S&D’s common shares.3 The businessmen owned the remaining 25% shares through other corporations. When S&D came under investigation by the Alberta Securities Commission (in relation to the sale of interests in land to various investors), the businessmen decided to distance their wives from the Corporation. The wives’ accordingly sold their common shares back to the Corporation in consideration for land. S&D did not report the disposition of the land on the basis that the adjusted cost base (ACB) of the land was equal to its fair market value (FMV). Moreover, S&D erroneously transferred 100% of the lands to the wives when it should have only transferred 75%. The CRA reassessed S&D for capital gains, alleging that the FMV of the transferred lands far exceeded the ACB. Moreover the wives were reassessed for a deemed dividend on a repurchase of their shares. A subsequent Cancellation Agreement, drafted without tax advice, which purportedly cancelled the share repurchase and land transfer by S&D, did not have the desired effect of correcting the unintended tax consequences.

As the primary remedy, the taxpayers argued that the unintended tax consequences constituted a fundamental mistake, and thus sought to have the Court declare the share repurchase and property transfer to be void ab initio, i.e. the rescission of the transactions.  Alternatively, the taxpayers sought rectification of the transactions, whereby S&D would pay for the wives’ shares with cash or reduced land consideration.4

The Crown appeared to make persuasive arguments in this case. It argued that neither rescission nor rectification were available as there had been no fundamental mistake. There was no mistake about who was transferring the lands, who it was being transferred to, or why it was being transferred. The reason for the transfer was to avoid liability with the Alberta Securities Commission and that purpose was accomplished. The Crown stated there was no evidence that the parties intended to effect the transactions on a no-tax basis. It is cautioned that rectification should not to be used as means for retroactive tax planning.

The Court found that the taxpayers were mistaken as to the value of the land being transferred to the wives, mistaken in transferring more than 75% of the lands to the wives, and also mistaken as to the effect of the Cancellation Agreement. The issue was whether such mistakes entitled the taxpayers to the remedies they sought.

The Court started its analysis by observing that remedies for mistake have developed and are continuing to expand. The Courts’ jurisdiction to grant equitable relief, it stated, is always discretionary and “hesitated to place same strictures around equitable remedy for as there are for common law mistake.” Importantly, the Court went on to state that the leading authority on rectification, Juliar, should not be interpreted as requiring that the parties demonstrate that the mistake was “a primary and continuing objective of the applicants from the inception of the transaction.” There were no impediments to granting equitable relief in this case, because the taxpayers’ mistake was honest, the transactions were not entered into for any improper purpose, no advantage had been gained by the taxpayers in relation to the transactions, no alternative legal remedy was available to them, and no fault could be attributed to them. The fact that the applicants were not mistaken about the nature of the transaction (i.e. to repurchase the wives’ shares) and the fact that, “as in Juliar”, there was “little evidence” of intention to proceed on a no-tax basis, did not prevent the Court from granting equitable relief. The mistake as to the value of the lands was fundamental and the transactions would not have proceeded in the fashion that they did but for the mistake.

The Court stated that the appropriate remedy in this case was to reduce the amount of land transferred to the wives. The judge writes “a fair interpretation of the Agreement is that it only intended to transfer $5,594,336.25 worth of lands to the wives.” The Cancellation Agreement was declared void ab initio.

Although no discussed in the case, the Court’s reducing the amount of land transferred to the wives only reduces the amount of corporate tax, rather than eliminating it completely.  Furthermore, there remains the issue of the deemed dividends on the repurchase of the wives’ shares.  Indeed, there seems to be some unexplained disconnect between the repurchase of 75% of the common shares (i.e. the wives’ shares) for the intended consideration of $5.6M, which is arguably less than 75% of the aggregate FMV of the corporation’s shares on the date of repurchase (assuming the CRA’s valuation of the land was correct).  Nonetheless, the case still represents a significant win for taxpayers.

 

1. 2011 ABQB 230

2. Rectification is a court-ordered remedy allowing applicants to correct a written instrument which does not accord with the true intention of the parties. In tax, rectification orders allow taxpayers to correct transactions producing unintended tax results.

3. There was some contradiction in the case about who held the 75% S&D shares, the wives, or their holding corporation.

4. If the FMV of the land far exceeded its ACB, it is not clear in the case how reducing the amount of land transferred would entirely eliminate the capital gains tax incurred by the Corporation on the land transfer. Moreover, it is not clear how a cash payment would eliminate the wives’ deemed dividend.