TaxMatters@EY - May 2013
Refusal to grant rectification results in an $11.8-million tax liability
Kanji et al. v AGC, 2013 ONSC 781
Al-Nawaz Nanji, Toronto, and Jennifer Smith, Ottawa
The equitable remedy of “rectification” has gained importance in the income tax context since the landmark decision of the Ontario Court of Appeal in Juliar (2000) (50 O.R. (3d) 728 (C.A.)). There are a now a myriad of provincial court decisions that address the issue of the circumstances under which a court will permit the rectification of documentation to reflect the parties’ intended tax consequences.
The Kanji decision is an interesting addition to this jurisprudence and highlights the importance of adducing direct evidence supporting the parties’ intentions to increase the chances of success on a rectification application in Ontario.
In this case, Mr. Kanji set up a family trust to allow for his wealth to pass to his children in a tax-efficient manner. Unfortunately, the preparers of the trust deed made some critical mistakes that resulted in adverse tax consequences. Under the terms of the trust, Mr. Kanji was the settlor, one of the two trustees and a capital beneficiary. Further, Mr. Kanji could remove any of the trustees and appoint substitute or additional trustees.
A number of years after the trust was settled, Mr. Kanji consulted with a different tax advisor who informed him that subsection 75(2) of the Income Tax Act (the Act), the so-called “revocable trust” rule, likely applied to Mr. Kanji’s initial $5,000 contribution to the trust.
The revocable trust rule applies where a person transfers property to a trust in circumstances where the property:
- Can revert to the transferor,
- Can pass to persons determined by the transferor, or
- Cannot be disposed of without the transferor’s consent or direction.
If one of these conditions is met, income and capital gains or losses from the property are attributed to the transferor.
The initial $5,000 contribution was used to purchase shares and investments. Under the 21-year rule, the trust would be deemed to dispose of and reacquire all of its assets on 26 March 2013. The value of the trust’s assets had reached approximately $62 million at that time, and it was estimated that on a deemed disposition of the trust’s assets, capital gains tax of about $11.8 million would become payable.
Mr. Kanji could avoid the deemed disposition if the trust were required to distribute its assets to him before 26 March 2013. However, that would frustrate the purpose of the trust, which was to allow for the transfer of the assets to his children on a tax-deferred basis.
Mr. Kanji, his children and the family trust applied to the Ontario Superior Court of Justice to rectify the family deed to conform to the alleged tax planning intention. They also sued the law firm that provided the initial advice. The attorney general of Canada opposed the rectification application.
Ontario Superior Court of Justice
The Ontario Superior Court of Justice found that to be successful for a rectification application, which is a discretionary remedy, the onus is on the applicants to show on a balance of probabilities that there was a common, specific intention to accomplish a particular result, and a mistake caused the document not to comply with their intention.
In this case, the court indicated that there was uncertainty about the intention based on the evidence. Only Mr. Kanji testified, and there was no evidence from his accountant, the lawyer who prepared the trust deed or the lawyer who provided subsequent advice. There were also no experts called to establish the reasons such a trust would be created.
Because of this lack of direct evidence, an adverse inference was drawn. Mr. Kanji failed to establish that at the time he settled the trust he intended to structure it in a tax-efficient manner to allow for a tax-deferred transfer of assets to his children in the future. There was no independent evidence supporting this intention, and it was only after almost 21 years after the creation of the trust that the rectification was being sought.
The court was not willing to infer the specific tax motivation in creating the trust, since the creation of a trust may or may nor not be tax motivated. Accordingly, the court dismissed the rectification application.
The result in this case should be contrasted with that in McPeake et al v The Queen (2012 BCSC 132), in which the British Columbia Superior Court was prepared to make such an inference from the evidence and granted a remission which allowed the taxpayer to avoid the application of subsection 75(2).
A distinguishing factor in the Kanji case may be the long period of time between the establishment of the trust and the rectification application. That being said, it would appear that the Ontario courts are less likely to grant a rectification order without direct evidence of intention.
Keep in mind that remission is a discretionary remedy and you have to convince the court to grant it.
There are some lessons to be learned from this decision:
- Document your intention contemporaneously with the transaction so that if a mistake is discovered later, your chances for rectification are higher. This is more effective than relying on people’s memory of what happened and why.
- Evidence is critical. If there is a mistake, the evidence of third parties, such as tax advisors who can acknowledge the common intention, may be crucial. In this respect, check correspondence, email, internal memos and draft step plans if they exist to see if you can establish a common intention.