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Resolving Unintended Tax Consequences – Rectification, Rescission and Mistake

Income tax is complicated.  As such, mistakes in transactions are liable to occur from time to time, especially when professional advisors do not consult tax specialists prior to undertaking transactions.  The Court of Queen’s Bench of Alberta (“QBA”) has added another arrow to taxpayers’ quivers when mistakes lead to unintended tax consequences.  In Stone’s Jewellery Ltd. v. Arora 2009 ABQB 656, a well thought out and structured judgment by Madam Justice Strekaf, the taxpayer sought an order to rectify or rescind two transactions involving the transfer of land that resulted in the unanticipated assessment of more than $6 million in taxes.  The Canada Revenue Agency (“CRA”) opposed the taxpayer’s action. 

The facts in this case are as follows: two siblings – Ashok Arora and Saroj Arora (the “Aroras”) – were directors and shareholders of Stone’s Jewellery Ltd. (“Stone’s”).  In 1996 Stone’s entered into a real estate purchase agreement and a caveat against the land was filed on Stone’s behalf.  The purchase transaction did not close until 2004, (the “2004 transfer”) by which time the land’s value had substantially increased.  At the time of closing and, based on advice from their lawyer and accountant, the Aroras registered the land in their personal names instead of Stone’s.  This was done in an attempt to shield Stone’s assets from any potential creditors that might arise on the development of the land.

In 2006, the land had further increased in value and was then transferred (the “2006 transfer”) to an Alberta numbered corporation (“Alberta Ltd.”), a corporation wholly-owned by the Aroras.  The transfer was to occur on a tax deferred basis pursuant to section 85 of the Income Tax Act (the “Act”).

The CRA reassessed Stone’s for the 2004 transfer as a disposition of the land to the Aroras.  Indeed, the CRA was of the view that Stone’s had initially acquired the land.  The Aroras were also reassessed on the basis of a shareholder benefit as a result of the appropriation of the land from Stone’s.  The CRA further reassessed the Aroras for the 2006 transfer on the basis that the land was inventory and thus not “eligible property” and could therefore not be transferred on a tax deferred basis pursuant to section 85.

The Court seems to have been sympathetic to the fact that the transfers were made between siblings and wholly-owned corporations of the siblings.  The Court repeatedly points out that the transfers were between the Aroras and wholly-owned corporations, and thus no income was generated to offset the tax arising from the transactions.

In their application to the QBA, the taxpayers submitted that they were entitled to relief based on the principles of rectification, mistake (both at common law and equity), and failure of a condition precedent.  The CRA contested the application on the basis that rescission should not be granted where other legal remedies are available and where a taxpayer seeks to effect retroactive tax planning.

The taxpayers first argued that the transfer of land was conditional on no adverse tax consequences occurring.  As such there was failure of a condition precedent and thus no transaction ever took place.  The Court swiftly dealt with this issue by stating that lack of tax consequences was not a true condition precedent.

The Court then examined both the doctrine of equitable rectification and common law and equitable mistake.  The Court also proceeded with an in-depth examination of the two leading tax cases on the issue of rectification: 771225 Ontario Inc. v. Bramco Holdings Co. Ltd. (1995), 21 O.R. (3d) 739 (C.A.) and Attorney General of Canada v. Juliar (A.G.) (2001), 50 O.R. (3d) 728 (C.A.).

The Court first examines the 2006 transfer.  Based on the evidence presented to the Court, Madame Justice Strekaf concludes that the transaction was undertaken on the mistaken belief, by all the parties, that it could be done on a tax deferred basis pursuant to section 85 of the Act.  Justice Strekaf notes that rectification is not the proper form of relief in the case at hand as “[t]he Court does not have the power to direct that the 2006 Transfer proceed on a tax free basis pursuant to section 85 of the Income Tax Act in accordance with the parties’ intentions.”  The Court concludes that if relief can be obtained it must be obtained either by a declaration that the transaction is void ab initio at common law or rescinded in equity as a result of the mistake made by the parties in respect of the transaction.

The Court summarizes the doctrine of common law mistake as follows:

At common law, a distinction was drawn between a mistake that constituted an error which went to the identity of the contract and caused the contracting party to obtain something other than what they had intended and a lesser error where the contracting party obtained what they had intended but it turned out to be less valuable.  Only the former was considered to be a fundamental mistake which went to the root of the contract, or the intention to contract, so as to render the contract void ab initio.  Any lesser mistake that went only to the motivation to contract or to questions of quality would only give rise to damages.

The Court concludes that the ineligibility of the land for the section 85 rollover constitutes a “fundamental mistake that went to the root of the contract.”  As such the 2006 transfer was void ab initio at common law.

The Court continues its analysis by stating that even if it had not found the contract void at common law, it would have exercised its equitable discretion to rescind the transfer agreement because:

(a) the mistake was to the effect of the transaction itself and not merely as to its consequence or the advantage to be gained by entering into the transaction;

(b) there is no alternate adequate legal remedy available.  On this point it is interesting to note that the CRA’s contention that the taxpayers could appeal the assessment was rejected by the Court because “if the taxes claimed by CRA are properly owing unless the transaction is rescinded, how can appealing the assessment ever provide an adequate legal remedy to address the problems created by the transaction?“;

(c) rescission of the transfer does not result in retroactive tax planning.  In this respect the Court distinguishes the case of Bramco in which the Ontario Court of Appeal declined to provide equitable relief on the basis that “…courts do not look with favour upon attempts to rewrite history in order to obtain more favourable tax treatment“.  The Court points to the Juliar decision as evidence that given the proper circumstances courts may exercise their equitable discretion to offer relief in tax cases; and

(d) granting equitable relief did not prejudice third parties in this case.

The Court also examined the 2004 transfer in light of the same criteria.  The Court also found that the 2004 transfer was void ab initio at common law, but that it would have applied its equitable discretion to rescind the transfer had common law not applied.

As a result of the above, both the 2004 and 2006 transfers were declared void ab initio by the Court, with the result that the land remained registered in the name of Stone’s.  Presumably, as the Court found the transaction to never have occurred, there was no transaction on which the taxpayers could be taxed.

This decision is good news for taxpayers who are caught in the unenviable situation of having to remedy unforeseen tax consequences.  While the Juliar decision allowed a taxpayer to rectify a transaction, the doctrine of mistake, as explained in this case, provides more flexibility in restoring the parties to the situation that existed pre-transaction.  Indeed, in this case rectification could not have saved the taxpayer from more than $6 million of tax liability.