The law of unintended consequences: Supreme Court of Canada speaks on the rectification of transactions in Jean Coutu Group (PJC) Inc. v. Canada (Attorney General) and Canada (Attorney General) v. Fairmont Hotels Inc.
December 14, 2016
By Raymond Adlington, former Lawyer at McInnes Cooper,
Brian Awad, Partner at McInnes Cooper,
Megan Seto, former Lawyer at McInnes Cooper
On December 9, 2016, the Supreme Court of Canada clarified when a court can rectify a transaction that has had unintended tax consequences for one or more parties. In two separate cases, Jean Coutu Group (PJC) Inc. v. Canada (Attorney General) and Canada (Attorney General) v. Fairmont Hotels Inc., the Supreme Court of Canada narrowed the historical circumstances in which a court may exercise its equitable jurisdiction to rectify a transaction, and denied rectification – leaving the parties to bear the significant tax consequences of their respective transactions.
Here are the lessons these decisions hold for taxpayers:
Document intentions. The decisions highlight the importance of recording intentions (typically in the opening recitals) in agreements. Other contemporaneous recording of tax intentions should also be undertaken, particularly in the context of related party transactions. Price adjustment provisions have been included for decades in the context of estate freeze transactions to avoid unintended tax consequences where fair market value is incorrectly initially determined by the parties. With these decisions, it may be time to consider broader “agreement adjustment” provisions in related party transactions so that the basic agreement is for a particular tax result rather than a particular commercial agreement.
Curtailed but not eliminated. The availability of rectification to cure unintended consequences was curtailed by the decisions in Jean Coutu and Fairmont, but not eliminated. Other statutory and common law remedial approaches through provincial superior courts exist to stitch together wounded plans or heal diseased documents before the affected taxpayers suffer a significant loss of cash.
Jean Coutu Background. Jean Coutu’s financial position was impacted by foreign exchange fluctuations. To address the problem, the company put in place a series of currency hedges to neutralize the fluctuations. The measures were intended to be tax neutral. Unfortunately for Jean Coutu, the foreign accrual property income rules operated to include interest income of its U.S. subsidiary in the annual income of Jean Coutu. Jean Coutu applied to the Quebec Superior Court, asking the court to rectify the relevant loan transactions in a manner such that the FAPI rules would not apply. Jean Coutu was successful before the Superior Court, where the judge was satisfied that Jean Coutu had intended to achieve tax neutrality. The CRA successfully appealed to the Quebec Court of Appeal, which found that the general intention of Jean Coutu was “not sufficiently determinate” to justify rectifying the transaction.
Fairmont Background. In 2002, Fairmont Hotels implemented a cross-border transaction that exposed the company to tax due to changes in the Canada-U.S. exchange rate. Fairmont structured the transaction to hedge its exposure to exchange rate fluctuations. Five years later in 2007, an entity that had been involved in the transaction indicated to Fairmont a desire to terminate the existing arrangement. In response, Fairmont redeemed certain shares. When Fairmont was later audited, the CRA determined that the redemption resulted in a taxable capital gain due to a change in the foreign-exchange rate. As with Jean Coutu, Fairmont did not dispute the CRA conclusion. Rather, Fairmont applied to the Ontario Superior Court of Justice, asking the court to rectify the 2007 redemption and recast it as a repayment of a loan. Fairmont was successful before the Superior Court, where the judge found that Fairmont intended to achieve tax neutrality. The CRA unsuccessfully appealed to the Ontario Court of Appeal.
THE SUPREME COURT OF CANADA DECISIONS
The two appeals were heard together by the Supreme Court of Canada. In its decisions in both cases, the majority of the Supreme Court of Canada narrowed the historical circumstances where a court may exercise its equitable jurisdiction to rectify a transaction.
In Jean Coutu, the Supreme Court found that there was no error with the transaction as implemented, only unforeseen consequences that Jean Coutu was retroactively trying to avoid. In Fairmont, the Supreme Court found that Fairmont’s desire to maintain a tax-neutral position was not sufficiently planned or precise to justify the court exercising its equitable jurisdiction.
Fairmont is likely to be the decision most cited in provinces outside Quebec. The key determinations of the court were as follows:
Purpose of rectification. Rectification is a judicial remedy available to give effect to the parties’ true intentions, rather than to allow an erroneous transcription of those true intentions to prevail. The remedy is not available where the basis of seeking it is that one or both of the parties wish to amend not the instrument recording their agreement, but the agreement itself.
Juliar overruled. The leading Ontario Court of Appeal decision Juliar v. Canada (Attorney General) stands for the proposition that rectification will be available upon proof of a continuing specific intention. The Fairmont decision effectively overruled Juliar and more narrowly confined the circumstances in which rectification can be obtained.
Intention is no longer determinative. The Supreme Court concluded that the lower courts erred in holding that the parties’ intention of tax neutrality could support a grant of rectification. Rectification corrects the recording in an instrument of an agreement. Rectification does not operate because an agreement failed to achieve an intended effect “irrespective of whether the intention to achieve that effect was ‘common’ and ‘continuing.’” Further, the remedy does not correct common mistakes in judgment that frustrate the contracting parties’ intentions or plans.
The nature of the mistake. Two types of error may support a grant of rectification: a unilateral mistake and a mistake where both parties subscribe to an instrument under a common mistake. A party, or parties, can avail themselves of rectification only in such circumstances.
A mistake in recording a prior agreement. Where the error is said to result from a mistake common to both or all parties to the agreement, rectification of the instrument is available on the court being satisfied on a balance of probabilities that:
- there was a prior agreement whose terms are definite and ascertainable;
- the agreement was still in effect at the time the instrument was executed;
- the instrument fails to accurately record the agreement; and
- the instrument, if rectified, would carry out the parties’ prior agreement.
The “test” to be met. It falls on the party seeking rectification to show both the error in the instrument, and the manner in which the instrument should be rectified to record correctly what the parties intended to do correctly. The court will 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 parties’ true intended course of action.”
Please contact your McInnes Cooper lawyer or any member of the Tax Law Team @ McInnes Cooper to discuss this topic or any other legal issue.
McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.
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