Rectification is not Equity’s Version of a “Mulligan” – Words to Heed After Fairmont and Coutu

December 2016 | Robert Graham

Introduction

In Canada’s common law jurisdiction, rectification has historically been a powerful equitable remedy which, if granted, enables applicants to “travel back through time” to correct the documentary basis of transactions that have resulted in unintended detrimental tax or other consequences.  Thus, the doctrine has a retroactive effect, permitting the unwinding of a transaction, and subsequently, the reversal of such unintended consequences.

Rectification has posed as a useful tool to the taxpayer or legal practitioner who was not paying attention or perhaps didn’t “know the rules;” in other words, who closed their eyes, swung their club and struck a ball directly into the water.  It represents a do-over, or in the recent words of Justice Russell Brown of the Supreme Court of Canada (“SCC”), and for those golfing enthusiasts who resort to such measures, a “mulligan.”[1]

Jurisprudential History – Juliar and Other Matters

Common Law Jurisdictions

Historically, the application of the equitable doctrine of rectification has largely been restricted to circumstances in which the documentary record of a transaction contained errors, which in turn, produced a negative result. Lord Justice Denning, in Frederick E Rose (London) Ltd v William H Pim Jnr & Co Ltd, described the remedy, stating:

[r]ectification is concerned with contracts and documents, not with intentions. In order to get rectification it is necessary to show that the parties were in complete agreement on the terms of their contract, but by an error wrote them down wrongly; and in this regard, in order to ascertain the terms of their contract, you do not look into the inner minds of the parties – into their intentions – any more than you do in the formation of any other contract. [2]

In somewhat recent years, and pursuant to the Ontario Court of Appeal (“OCA”) decision, Juliar v. Canada (Attorney General)[3] in 2000 (“Juliar”), the scope of the doctrine was expanded by Justice Cameron, though tentatively. Unable to demonstrate an error in the respective written agreement or transactional documents, the applicant in Juliar was nonetheless granted the remedy, having cited a common intention to conduct the given transaction in such a fashion as to defer tax liability; an intention which had not been satisfied.

Although perhaps unintended by the court, Juliar presented advisors working in tax planning with an oversight mechanism; it rewarded carelessness and it legalized retroactive tax planning. Despite the attempts of the Canada Revenue Agency (“CRA”) to appeal the decision, the SCC denied leave to appeal.

In 2002, Performance Industries Ltd. v. Sylvan Lake Golf & Tennis Club Ltd.,[4] was handed down from the SCC. The SCC re-established the parameters of the doctrine, stating a “relaxed approach to rectification as a substitute for due diligence at the time a document is signed would undermine the confidence of the commercial world in written contracts,” and “[t]he court’s task in a rectification case is . . . to restore the parties to their original bargain, not to rectify a belatedly recognized error of judgment by one party or the other.”[5] Thus, it appeared as though order had been restored to the doctrine as applicants would have to prove that an actual agreement contemplated had not been carried out as planned; however, Juliar continued as “good” law.

Civil Law

In Quebec’s civil law system, the doctrine of judicial correction acts similarly to that of rectification. Conversely, it is founded in legislation; located in Article 1425 of the Civil Code of Québec (“CCQ”). Historically, judicial correction has been limited to the correction of clerical errors, but recently it too has been broadened to include the correction of errors of substance, where the common intention of the parties to a given transaction has been thwarted.

In 2013, the SCC delivered its decision in Quebec (Agence du revenu) v. Services Environnementaux AES inc.[6] (“AES”), a matter which had been heard together with Agence du Revenu du Quebec v. Jean Riopel.[7] Pursuant to AES, applicants were permitted to seek judicial correction to transactions, on the basis that they had resulted in “unintended tax consequences.” The SCC shrewdly specified that a taxpayer’s general intention to reduce his or her tax liability would not be specific enough to warrant judicial correction of a written contract, but that the taxpayer must also be able to identify a common mistake in the record of the agreement, even if oral, between the parties which had ultimately produced the unintended consequences.

Having expanded the doctrine of judicial correction to some degree, the court in AES provided caution, stating:

Taxpayers should not view this recognition of the primacy of the parties’ internal will – or common intention – as an invitation to engage in bold tax planning on the assumption that it will always be possible for them to redo their contracts retroactively should that planning fail. A taxpayer’s intention to reduce his or her tax liability would not on its own constitute the object of an obligation within the meaning of art. 1373 C.C.Q., since it would not be sufficiently determinate or determinable. Nor would it even constitute the object of a contract within the meaning of art. 1412 C.C.Q. Absent a more precise and more clearly defined object, no contract would be formed.[8]

Interestingly, although the Attorney General of Canada, who intervened in AES, requested that the court consider and reject the line of authority developed in Juliar, Justice LeBel explained that since AES was governed by Quebec civil law, it would not have been fitting for the court to consider the common law remedy of rectification at such time.

Thus, it is into the context of this jurisprudential environment that the litigants in Canada (Attorney General) v. Fairmont Hotels Inc.[9] (“Fairmont”) and Jean Coutu Group (PJC) Inc. v. Canada (Attorney General)[10] (“Coutu”) pled their cases before the SCC, seeking rectification and judicial correction, respectively.

Fairmont

If it could be said that Juliar “rolled away the stone” by relaxing the requirements for obtaining rectification and expanding the scope of cases in which the remedy may be sought and granted, then the decision in Fairmont will be considered the force that rolled the stone back into place.

Background Facts

In 2002, Fairmont Hotels Inc. (“FHI”) entered into a complex financing arrangement with Legacy Hotels REIT (“Legacy”), a Canadian real estate investment trust in which FHI owned a minority interest. The transaction exposed FHI to a potential foreign exchange tax liability. With the goal of ensuring foreign exchange tax neutrality, FHI, through certain subsidiaries, entered into reciprocal loan agreements with Legacy, all of which were transacted in U.S. dollars. In 2006, FHI was to be acquired by Kingdom Hotels International and Colony Capital LLC, an acquisition which would have resulted in a deemed foreign exchange loss for FHI. Thus, the parties agreed to allow FHI to realize both its gains and losses in 2006, thereby eliminating its exposure to the prospective foreign exchange tax liability. To achieve this goal, FHI redeemed its shares in the noted subsidiaries. When the transaction was reviewed by CRA they were assessed with an unanticipated tax liability.

FHI sought relief by way of rectification, requesting that the court permit them to exchange the share redemption transaction with a loan transaction involving the subsidiaries as lenders.

Ontario Superior Court Decision

Justice Newbould of the Ontario Superior Court applied Juliar in his analysis,[11] finding that FHI intended that the financing arrangement with Legacy was intended to be tax-neutral in effect, and that such intention continued after the acquisition of FHI by Kingdom Hotels and Colony Capital in 2006. In the words of his Honour, “[d]enial of the application to rectify would result in a tax burden which [FHI] sought to avoid from the inception of the 2002 reciprocal loan arrangement” while “giv[ing] CRA an unintended gain,”[12] and further, that the decision in Juliar was “binding on him in the circumstances.” [13] Thus, his Honour granted the remedy.

Ontario Court of Appeal Decision

In a unanimous judgment, Justices Simmons, Cronk and Blair of the OCA affirmed Justice Newbould’s decision,[14] adding that the evidentiary burden “does not require that the party seeking rectification must have determined the precise mechanics or means by which [its] settled intention to achieve a specific tax outcome would be realized.” Rather, the court stated, “the critical requirement for rectification is proof of a continuing specific intention to undertake a transaction or transactions on a particular tax basis.”[15]

Since the subsidiaries of FHI intended to loan the same amount of money to FHI that it would have received on the redemption, the OCA viewed rectification as an appropriate remedy and granted same.

Supreme Court of Canada Decision

In a 7-2 majority decision, the SCC overruled both the OCA decision and Juliar simultaneously. Justice Brown, for the majority, stated that Juliar had “relaxed the requirements for obtaining rectification, and correspondingly expanded the scope of cases in which rectification may be sought and granted beyond that which the governing principles allow.” His Honour added that “rectification is available not to cure a party’s error in judgment in entering into a particular agreement, but an error in the recording of that agreement in a legal instrument.”

Therefore, an applicant must identify a specific error in the documentary record of a transaction for which they seek rectification in addition to the manner in which an impugned instrument should be rectified in order to justify an imposition of the remedy. Furthermore, the remedy will only be available in circumstances where:

  1. both parties subscribe to an instrument under a common mistake that it accurately records the terms of their antecedent agreement; or
  2. where an instrument formalizes a unilateral act (such as the creation of a trust), or where the instrument was intended to record an agreement between parties, but one party says that the instrument does not accurately do so, while the other party says it does.

Since FHI could not demonstrate within the documentary record that it had reached a prior agreement with its subsidiaries, containing definite and ascertainable terms, and since they were only able to demonstrate a general intention to achieve tax neutrality, this was an insufficient basis upon which the court was willing to approve rectification, and resultantly, the lower court decisions were overturned.

Coutu

The decision in Coutu affirmed and clarified the decision in AES, solidifying the parameters of the doctrine of judicial correction, and mirroring that of Fairmont insofar as it brought judicial correction into alignment with the equitable doctrine of rectification, to the greatest extent possible.

Background Facts

In 2004, the Jean Coutu Group (PJC) Inc. (“PJC Canada”) was the sole shareholder of Jean Coutu Group (PJC) USA Inc. (“PJC USA”). During that year, PJC USA acquired a chain of pharmacies in the United States as an investment. Since the value of this investment fluctuated with the U.S. dollar to Canadian dollar exchange rates, PJC Canada sought to neutralize the effect of same through a loan transaction scheme with PJC USA. Although the parties were successful in neutralizing the effect of the exchange rate fluctuations, unforeseen tax consequences arose. As PJC USA had been charging interest on the monies loaned to PJC Canada, the latter party was thus assessed income tax on the basis that the interest monies in the hands of PJC USA constituted foreign affiliate property income (“FAPI”) to PJC Canada.

PJC Canada sought an order for judicial correction, requesting that the court allow them to correct the documentary record by inserting additional steps in the transaction which would serve to offset the interest payable by PJC Canada using reciprocal interest payable by PJC USA and thereby reducing the FAPI to zero.

Quebec Superior Court Decision

Justice Chabot granted PJC Canada’s request, finding that “there was a disparity between the common intention of the parties (negotium) and the legal documents drawn up to give effect to that intention (instrumentum). He held that he could therefore correct the series of documents to reflect the parties’ initial common intention.”[16] Notably, Justice Chabot did not have the benefit of the SCC’s judgment in AES in arriving at his decision.

Quebec Court of Appeal Decision

In a unanimous judgment, Justices Chamberland, Giroux and Schrager of the Quebec Court of Appeal (“QCA”) emphatically overturned Justice Chabot’s decision. Having had the benefit of the AES judgment, the QCA found the general intent of PJC Canada (i.e., that its transactional scheme be tax-neutral) to be an insufficient basis upon which to justify judicial correction of the transaction with retroactive effect. Rather, the court stated that, “[p]arties can restore their agreement to what it should have been where they made a mistake in expressing the transaction in writing, not where they made a mistake in the transaction itself.”[17]

Supreme Court of Canada Decision

Again, in a 7-2 majority decision, the SCC upheld the decision of the QCA, stating:

A taxpayer’s general intention of tax neutrality cannot form the object of a contract within the meaning of art. 1412 C.C.Q., because it is insufficiently precise. It entails no sufficiently precise agreed-on juridical operation. Nor can such a general intention in itself relate to prestations that are determinate or determinable within the meaning of art. 1373 C.C.Q. It says nothing about what one party is bound to do or not do for the benefit of the other. Therefore, a general intention of tax neutrality, in the absence of a precise juridical operation and a determinate or determinable prestation or prestations, cannot give rise to a common intention that would form part of the original agreement (negotium) and serve as a basis for modifying the written documents expressing that agreement (instrumentum). As a result, art. 1425 C.C.Q. cannot be relied on to give effect to a general intention of tax neutrality where the writings recording the contracting parties’ common intention produce unintended and unforeseen tax consequences.[18]

Under Quebec civil law, a contract is considered an “agreement of wills that is formed by the exchange of consents.”[19] Thus, a contract lies in the common intention of the parties, and not necessarily in the written documents themselves. This is where the doctrine of judicial correction diverges from that of rectification. Pursuant to an application of Art. 1425 CCQ, an applicant may seek to have written documents be amended with retroactive effect – to make them consistent with the true contract or agreement between the parties – even if such agreement was orally established.

In Coutu, however, the parties had not even contemplated the potential impact of FAPI, and therefore could not possibly have come to any sort of agreement as to how to mitigate the effect of same. Thus, the court could not possibly grant them the remedy and followed suit with the QCA.

Conclusion

The decision in Fairmont does much for the equitable doctrine of rectification, as it has restored the doctrine to the extent that Juliar had taken it off track. In the civil law context, the doctrine of judicial correction has been clarified by Coutu.

Although the civil and common law doctrines stem from varying legal sources, they share similar principles and lead to similar results. Such similar results are welcome in the tax context, since the same federal tax legislation applies throughout Canada. Both doctrines share the same purpose: to ensure that the true agreement between contracting parties is correctly recorded in the written instruments, reflecting either the terms of the agreement or the execution of the obligations themselves. Both doctrines are firm: only the expression or transcription of the contract can be amended; the spirit and purpose of the contract itself cannot be rectified. Further, in both legal systems, the true agreement between the parties is paramount, not its intended consequences or effects.

One of the fundamental principles of our tax system is that “tax consequences flow from the legal relationships or transactions established by taxpayers.”[20] The decisions in Fairmont and Coutu ensure that tax and other advisors will remain incentivised to produce good work, cogently and diligently. Without the “insurance policy” of a remedy in rectification, hopefully, inadvertence and mistakes will be reduced and avoided.

The art and elegance of tax planning, like the art and elegance of the game of golf in its true form, maintains its purity where there is no place for “mulligans.”

 

[1] In the game of golf, a mulligan is a second chance to perform an action, usually after the first chance went wrong through bad luck or a blunder. It is where a player is informally allowed to replay a stroke, even though this is against the formal rules of the game.

[2] [1953] 2 QB 450 (CA), at p 461.

[3] (1999), 46 OR (3d) 104, aff’d (2000), 50 OR (3d) 728.

[4] 2002 SCC 19, [2002] 1 SCR 678.

[5] Ibid at para 31.

[6] 2013 SCC 65, [2013] 3 SCR 838.

[7] Ibid.

[8] Supra, note 6  at para 54.

[9] 2016 SCC 56.

[10] 2016 SCC 55.

[11] Fairmont Hotels Inc. et al v. A.G. Canada, 2014 ONSC 7302, 123 OR (3d) 241.

[12] Ibid at para 44.

[13] Ibid at para 41.

[14] Fairmont Hotels Inc. v. Canada (Attorney General), 2015 ONCA 441, 45 BLR (5th) 230).

[15] Ibid at para 10.

[16] Supra, note 10 at para 10.

[17] Supra, note 10 at para 13.

[18] Ibid at para 23.

[19] Ibid at para 18.

[20] Ibid at para 41.

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