Rectification Saves Taxpayers from Adverse Tax Consequences arising from Drafting Error: Sleep Country Canada Holdings & Sleep Country Canada Inc v AGC, 2022 ONSC 6103 – A Canadian Tax-Litigation Lawyer’s Analysis

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Rectification Saves Taxpayers from Adverse Tax Consequences arising from Drafting Error: Sleep Country Canada Holdings & Sleep Country Canada Inc v AGC, 2022 ONSC 6103 – A Canadian Tax-Litigation Lawyer’s Analysis

Introduction: Rectification & Its Tax Consequences

Rectification is an equitable remedy. It allows parties to correct drafting errors that would otherwise render a legal instrument incompatible with the agreement that the instrument was meant to document. In these cases, the contracting parties may ask a court to rectify the instrument so that it aligns with their intended agreement. To secure rectification, the parties must demonstrate each of the following:

  • there was a prior agreement with definite and ascertainable terms;
  • the agreement was still in effect at the time that the instrument was executed;
  • the instrument fails to accurately record the agreement; and
  • the instrument, if rectified, would carry out the parties’ prior agreement

If the error qualifies for rectification, the court will grant a rectification order correcting the language of the erroneously drafted document so that the document reflects the parties’ true intentions.

Of course, the parties could simply agree to amend the mistaken document; they need not apply for a rectification order. Yet a court rectification order offers one advantage that an amendment doesn’t. Unlike a document amended by the parties themselves, a rectified document can undo a tax consequence resulting from its pre-rectified form. In other words, a tax-rectification order also binds the Canada Revenue Agency (e.g., see: Dale v Canada, [1977] 3 FC 235 (FCA); 5551982 Manitoba Ltd. v Canada (Attorney General), 2018 BCSC 1482, aff’d 2019 BCCA 376).

A tax-rectification order affects the parties’ tax obligations because rectification speaks to the private-law relationships underlying those tax obligations. A person’s tax obligations depend on that person’s rights or duties under, say, contract law, property law, corporate law, and so forth. Canada’s tax law generally respects the legal instruments purporting to create these private-law rights and duties. If the legal instrument contains a mistake, the Canada Revenue Agency can use that mistake against the parties when assessing the parties’ tax liabilities. A rectification order, however, puts the parties into the position that they’d occupy had the impugned document been drafted correctly from the start. So, by correcting these instruments, rectification amends the private-law rights and duties that these instruments purport to create. This, in turn, bars the CRA from relying on the initial, mistaken document that the parties originally executed.

In Sleep Country Canada Holdings & Sleep Country Canada Inc v AGC, 2022 ONSC 6103, the Canadian taxpayers obtained a tax-rectification order allowing them to avoid adverse tax consequences. After examining the Sleep Country case, this article extracts the lessons from that case in the form of pro tax tips from our expert tax lawyers in Toronto.

Sleep Country Canada Holdings & Sleep Country Canada Inc v AGC, 2022 ONSC 6103

Sleep Country Canada and its holding company entered a share-exchange transaction with one another. This share-exchange transaction was one component of a complex reorganization that the parties underwent to facilitate an initial public offering of certain equity interests on a tax-efficient basis.

The accounting firm KPMG structured the overall reorganization and had prepared a detailed tax-planning memorandum setting out each transaction that Sleep Country and its holding company would undertake.

Step 25.1 of the tax-structured reorganization called for Sleep Country to issue about 124 million additional shares to its holding company.

But when drafting the share-exchange agreements, Sleep Country’s legal counsel mistakenly recorded only 12.4 million shares. This mistake not only appeared in the agreement that the parties executed, but also trickled down to the other transaction documents. It ended up in the resolution that was passed by Sleep Country’s Board of Directors, and it ended up in Sleep Country’s shareholders’ ledger when the ledger was updated to reflect the transaction.

Unbeknownst of the error, Sleep Country and its holding company proceeded as though the transaction had concluded as planned by KPMG. They even filed Canadian income-tax returns reflecting the intended issuance of 124 million shares. They also jointly filed a T2057 form whereby they recorded the 124 million shares as Sleep Country’s consideration in a transaction qualifying for rollover treatment under subsection 85(1) of Canada’s Income Tax Act.

When Sleep Country and its holding company discovered the drafting errors, they applied to the Ontario Superior Court of Justice for a tax-rectification order. They also notified Attorney General of Canada and the CRA’s Canadian tax-litigation lawyers at the Department of Justice’s Tax Law Services Division about the tax-rectification application.

Ontario Superior Court of Justice granted the tax-rectification order. Although the CRA’s Canadian tax-litigation lawyers didn’t oppose the application, the court also found that Sleep Country’s circumstances had satisfied the four-part rectification test.  In particular, the court reasoned that the KPMG tax-planning memorandum played a crucial role in demonstrating that the parties had a prior agreement with definite and ascertainable terms: “The evidence is overwhelming that the parties had reached an agreement. The terms, the most relevant of which are described as Step 25.1, are definite and ascertainable. The number of shares intended to be transferred was clear [para 29].” The court also pointed to the parties’ tax filings as “consistent with the conclusion that they had reached an agreement, since they acted in all respects as if their true intentions and their antecedent agreement had been properly reached and recorded. Various tax filings, including jointly filed Forms T2057, for elections made pursuant to subsection 85(1) of the Income Tax Act to effect the tax deferral components of the share exchange, reflect this [para 30].” In light of these findings, the court concluded that rectification was the appropriate remedy and granted Sleep Country’s application.

Case Commentary: Rectification as Retroactive Tax Planning, The Evidentiary Burden for Rectification & The Importance of a Tax-Planning Memo by an Experienced Canadian Tax Lawyer

Because rectification can undo tax consequences, it’s no surprise that rectification jurisprudence is flooded with applicants who seek relief from unintended tax consequences stemming from purported drafting mistakes. The concern, however, is that taxpayers may use rectification for retroactive tax planning.

The Canada Revenue Agency says that rectification amounts to retroactive tax planning if “the taxpayer is asking the court not to rectify the transaction back to its intended form, but to undo the intended transaction and put in place a new one formed after the original transaction.” That is, if a rectified document were to put in place a transaction that the taxpayer hadn’t intended until after executing the impugned document, the rectification order would essentially re-characterize the original transaction. And any pending tax litigation based on the transaction’s original characterization becomes pointless. Although Canadian tax law allows taxpayers to organize their affairs to minimize tax, the corollary is that “taxpayers should be taxed based on what they actually agreed to do and did, and not on what they could have done or later wish they had done.”: Canada (AG) v Collins Family Trust, 2022 SCC 26. The risk, in other words, is that taxpayers may use tax rectification to move the goalposts in the tax game.

This concern prompted the Supreme Court of Canada to tighten the reins on rectification in tax cases. In Canada v Fairmont Hotels Inc., 2016 SCC 56, the Supreme Court clarified that “rectification is unavailable where the basis for seeking it is that one or both of the parties wish to amend not the instrument recording their agreement, but the agreement itself” (ibid, at para 13, emphasis in original). In other words, where parties seek rectification, a court’s task is “to restore the parties to their original bargain, not to rectify a belatedly recognized error of judgement by one party or the other” (ibid, quoting Performance Industries Ltd. v Sylvan Lake Golf & Tennis Club Ltd., 2002 SCC 19, at para 31).

To this end, the Supreme Court articulated a four-point test that applicants must satisfy before a court will grant rectification. Specifically, rectification is available only if:

  • there was a prior agreement with definite and ascertainable terms;
  • the agreement was still in effect at the time that the instrument was executed;
  • the instrument fails to accurately record the agreement; and
  • the instrument, if rectified, would carry out the parties’ prior agreement (Fairmont, supra, at para 38).
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In practice, this test means that, to be successful, rectification applicants typically need to produce documentary evidence of the intended transaction—e.g., a tax-planning memorandum, prior drafts of agreements, letters and emails to and from tax advisors, etc. Indeed, in Sleep Country, the tax-planning memorandum played a crucial role in demonstrating that the parties had a prior agreement with definite and ascertainable terms.

The Sleep Country case therefore demonstrates the importance of turning to an experienced Canadian tax lawyer to ensure that you avoid tax-planning mistakes in the first place.  A tax-planning memorandum by an experienced Canadian tax lawyer will not only help you evade unintended tax consequences but also serve as evidence of your intended transaction or agreement. Consult one of our knowledgeable Canadian tax lawyers, who can plan your transaction to minimize tax liability and draft the related instruments so that they match your intentions.

Pro Tax Tips & Expert Canadian Tax-Litigation Lawyer Tax Guidance: Procedural Issues Concerning Tax Rectification

The Sleep Country case illustrates several important lessons about seeking rectification to correct drafting mistakes that might lead to adverse tax consequences.

First, you’ll notice that, although Sleep Country applied for rectification to avoid an adverse tax consequence, the application went to Ontario’s Superior Court of Justice, not to the Tax Court of Canada. This is because rectification is an equitable remedy, which falls outside the Tax Court’s jurisdiction: Kufsky v The Queen, 2019 TCC 254, at para 26. So, if you seek rectification, your knowledgeable Canadian tax-litigation lawyer must apply to a provincial superior court, like Ontario’s Superior Court of Justice, which has the jurisdiction to grant an equitable remedy. Thus, if your Tax Court appeal would fail because a legal instrument contains an error, you should consider pursuing a rectification order from a provincial superior court before proceeding to a hearing at the Tax Court of Canada. A successful rectification order will bind the Canada Revenue Agency for the purposes of the Tax Court appeal.

You’ll also notice that Sleep Country notified the Attorney General of Canada and the CRA’s Canadian tax-litigation lawyers at the Department of Justice’s Tax Law Services Division about the rectification application. This is because a provincial court will generally refuse to even hear a rectification application if the order affects the applicant’s tax payable, yet the CRA hasn’t been notified of the application: Columbia North Realty Company, Re, 2005 NSSC 212. If the CRA’s Canadian tax-litigation lawyers oppose the tax-rectification order, the court will want to hear those submissions. As a result, if you seek a tax-rectification order that might affect your tax payable, you should notify the Attorney General of Canada and the CRA’s Canadian tax-litigation lawyers at the Department of Justice’s Tax Law Services Division about your intention to apply for rectification.

Although the Tax Court of Canada doesn’t hear tax-rectification applications, these applications still form a part of Canada’s tax-litigation landscape. Tax-rectification applications involve numerous procedural rules governing almost every aspect of the lawsuit, including specific deadlines, acceptable evidence, and the contents of pleadings. As a result, those seeking a tax-rectification application should contact an experienced Canadian tax-litigation lawyer.

Frequently Asked Questions

Question: I executed a written agreement containing a typo. Now, the Canada Revenue Agency is relying on that typo to increase my tax payable. What can I do?

Answer: You might qualify for tax rectification. Tax rectification is an equitable remedy allowing parties to correct drafting errors that would otherwise render a legal instrument incompatible with the agreement that the instrument was meant to document. Unlike a document amended by the parties themselves, a rectified document can undo a tax consequence resulting from its pre-rectified form. In other words, a tax-rectification order also binds the Canada Revenue Agency. Hence, if your expert Canadian tax-litigation lawyer successfully obtains a tax-rectification order, the CRA can no longer rely on the typo to increase your tax payable.

Question: How do I know whether I qualify for tax rectification? What do I need to prove?

Answer: To obtain a tax-rectification order, you must demonstrate each of the following:

  • there was a prior agreement with definite and ascertainable terms;
  • the agreement was still in effect at the time that the instrument was executed;
  • the instrument fails to accurately record the agreement; and
  • the instrument, if rectified, would carry out the parties’ prior agreement

In practice, this test means that, to be successful, you need to produce documentary evidence of the intended transaction—e.g., a tax-planning memorandum, prior drafts of agreements, letters and emails to and from tax advisors, etc. For example, in Sleep Country Canada Holdings & Sleep Country Canada Inc v AGC, 2022 ONSC 6103, the taxpayers produced a tax-planning memorandum, which played a crucial role in demonstrating that the taxpayers had a prior agreement with definite and ascertainable terms. To determine whether you might qualify for tax rectification, consult with one of our top Canadian tax lawyers today.

Question: I entered an agreement whereby I sold equity to an investor. I now realize that I would have enjoyed more favourable tax treatment had I taken a loan from my investor instead. Can I use tax rectification to replace the equity agreement with a loan agreement?

Answer: No. In Canada v Fairmont Hotels Inc., 2016 SCC 56, the Supreme Court clarified that “rectification is unavailable where the basis for seeking it is that one or both of the parties wish to amend not the instrument recording their agreement, but the agreement itself.” Tax rectification would be available if, for instance, you had sought to correct a drafting error in the document recording the equity agreement. But you seemingly want to change the agreement itself. This is called retroactive tax planning, and you cannot obtain a tax-rectification order on this basis. Although Canadian tax law allows taxpayers to organize their affairs to minimize tax, the corollary is that “taxpayers should be taxed based on what they actually agreed to do and did, and not on what they could have done or later wish they had done.”: Canada (AG) v Collins Family Trust, 2022 SCC 26. Consult one of our expert Canadian tax lawyers today to discuss the remedies that might be available to you.

Question: I want to apply for tax rectification. Is the process the same as filing an appeal with the Tax Court of Canada?

Answer: No. Tax rectification is an equitable remedy, which falls outside the Tax Court’s jurisdiction. So, if you seek tax rectification, your top Canadian tax-litigation lawyer must apply to a provincial superior court, which has the jurisdiction to grant an equitable remedy. For example, you’ll need to file the tax-rectification application with Ontario’s Superior Court of Justice if the impugned legal instrument is governed by Ontario law.

In addition, a provincial court will generally refuse to even hear a tax-rectification application if the Canada Revenue Agency hasn’t been notified of the application. If the CRA’s Canadian tax-litigation lawyers oppose the tax-rectification order, the court will want to hear those submissions. As a result, if you seek a tax-rectification order, you should notify the Attorney General of Canada and the CRA’s Canadian tax-litigation lawyers at the Department of Justice’s Tax Law Services Division about your intention to apply for rectification.

Tax-rectification applications involve numerous procedural rules governing almost every aspect of the lawsuit, including specific deadlines, acceptable evidence, and the contents of pleadings. Consult one of our skilled Canadian tax-litigation lawyers who can simplify the tax-rectification process, review your evidence, prepare your tax-rectification application for court, notify the CRA about the tax-rectification application, and represent you before the provincial superior court.