Rectification in Tax and Estate Matters Part I – Tax

Confucius said “A man who has committed a mistake and doesn’t correct it is committing another mistake.”

When we are dealing with tax and estate matters, even a simple mistake may have disastrous consequences. One way such a mistake may be corrected is by way of a rectification order.  Indeed, rectification is an important remedy that allows for the correction of errors or mistakes in legal instruments that have resulted in an unintended result.  This newsletter will review the doctrine of rectification as it applies to tax matters.  Our next newsletter will focus on rectification in estate matters.

What is Rectification?

A rectification order is an equitable remedy to correct errors in legal instruments that do not reflect the true intention of the parties resulting in unintended and, likely, unfortunate results.  A rectification order allows the affected parties to rectify the terms of a transaction as was initially intended by the parties. The effect of the rectification is retroactive.

The remedy of rectification is available only under certain defined circumstances; essentially to correct a mistake. However, rectification is not permitted if the intention of the parties is simply to alter the terms of an instrument nor can it be invoked in an attempt to correct every mistake in order to alter unwanted results.

In order for a rectification order to be granted, one must file an Application to the Superior Court of Ontario; only a court may grant such remedy.  Interestingly, the Tax Court of Canada cannot grant equitable remedies, and, as a result, rectification of a tax matter can only be heard by the appropriate forum, the Superior Court of Ontario.  The duty of the Court is to examine the evidence and assess the facts in order to determine whether the application is truly one to correct a mistake which result in an unintended legal effect or an undesirable legal consequence.  The Court must ensure that the parties are not just changing their minds “in the middle of a transaction.” The evidence is the key to the determination.

To be successful in obtaining a rectification order, one must establish:

1. the existence and nature of the common intention of the parties prior to preparation of the instrument alleged to be deficient;
2. that the common intention remained unchanged at the time the document was made; and
3. that the instrument, by mistake, does not reflect that initial common intention.

If one can prove the above, the Court may grant a rectification order thus restoring the party(ies) to their initial common intention.  Applicants should be aware that rectification orders are a discretionary remedy granted at the discretion of the Court and one should not anticipate the granting of an order.

Rectification in Tax Matters

In tax matters where unintended tax consequences arise as a result of a mistake, rectification may be a valuable tool, if not a “life saver,” for taxpayers who find themselves in a situation where their tax planning went awry.

Although the equitable doctrine of rectification is not new, it only truly emerged as a valuable tool in tax matters in the last decade or so.  The leading case, Canada v. Juliar, has been a key decision in establishing such remedy to taxpayers. Indeed, in Juliar, the Court granted a rectification order in a tax matter which ultimately fixed a mistake in a document intended for tax planning purposes. The granting of the rectification order enabled the taxpayer to avoid having to face a tax liability from an unanticipated outcome. Interestingly, the Court had no issue with the fact that the taxpayers’ intention throughout the transaction was to avoid immediate tax consequences.

Since the Juliar decision, the law and the doctrine of rectification in tax matters has expanded considerably.  Taxpayers appear to show a willingness to consider an application for rectification to correct/rectify transactions that achieved unintended tax consequences. Notably, the jurisprudence has acknowledged that the avoidance of tax is a legitimate intention in rectification matters involving a tax issue.  As a result, rectification may be available where transactions that resulted in unintended tax consequences might be altered in order to achieve the initial tax intention; that is the avoidance or minimization of tax.

A more recent decision from the Supreme Court of British Columbia, McPeake v. Canada, is also instructive as to how and when granting a rectification order may be appropriate in tax matters.  The McPeake decision is consistent with prior cases where the taxpayers demonstrate an intention to avoid tax but the documents or transactions failed to reflect their true intentions.

The McPeake decision stands out also on the basis that in tax matters, the taxpayers must convince the Court that their initial intention was to avoid tax.  Another interesting point of that decision is the fact that the Court accepted that it ought to consider the unfairness or harm the taxpayer may suffer should the rectification order not be granted (thus allowing a tax liability to arise although the avoidance of such liability is what gave rise to the transaction in the first place).

Rectification Application and the Crown

The Crown also distinguishes between an error in implementation and an error in tax planning and the Agency will vigorously oppose rectification orders disguised as an attempt to implement a form of retroactive tax planning.

The Crown’s position is that a taxpayer requesting a rectification order should provide the Agency with notice of the application; especially in instances where the rectification application is being made on the basis that the taxpayer is alleging unintended tax consequences.

However, whether or not the Crown should be notified of any particular application for rectification is a dilemma for the taxpayer and his lawyer to resolve.  There is a valid argument to be made that since the Crown may not be a party to the original instrument and the original transaction, it has no interest in the application to rectify the written instrument and the transactions. There is jurisprudence where the Court has said that notice to the Crown was “appropriate” or a matter of courtesy; however, the Court has never said it is mandatory.

In reality, the decision of whether to serve notice to the Crown or not is essentially a matter of assessing the basis of the application and ultimately, it is a strategic decision. Further, should one serve notice to the Crown, they risk having the Crown oppose the application.  However, opting not to serve notice may result in the judge requesting notice be served prior to rendering his or her decision.  Having to serve the Crown after the initial application is likely to raise suspicion from the Crown.

It is important to know that the Department of Justice has a rectification committee which discusses and decides whether to oppose an application.  The CRA and the Department of Justice have established a procedure to be followed when applying to the Court for a rectification order; notably, that a letter be sent to the Director of the Tax Services Office advising rectification will be sough, that the CRA should be named as a party in the Motion and that the Department of Justice be served with the Notice of Motion.

Once served, the rectification committee will review and discuss the merit of the application and inform the party(ies) whether it intends to oppose the application.

Conclusion

In tax matters, an application for a rectification order remains a valuable tool for taxpayers and should be considered when adverse tax consequences are erroneously triggered by an error or errors in implementing a transaction.

An application for a rectification should be considered by tax advisors, including accountants, lawyers and any other tax advisors.  Indeed, rectification may be the key to correct an oversight in their tax planning memorandum or an error in the drafting of an instrument.  Rectification may translate into a lifeline for their mistake, thus avoiding a liability; something well worth considering.

Ultimately, the original intent is the key determining factor in the decision whether to grant a rectification order.

In our next newsletter, we will address rectification in estate matters.

Tierney Stauffer LLP would be glad to assist and advise you.  If you have any questions, please do not hesitate to contact us.

Sébastien Desmarais
LL.B., LL.L., J.D.
Lawyer, Tierney Stauffer LLP
This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship.

Voluntary Disclosure Program – It’s worth considering under the right circumstances

The Voluntary Disclosure Program (VDP) is an initiative from the Canada Revenue Agency (CRA)  designed to encourage  taxpayers to be more compliant with their income tax filings and to correct omissions or errors which may be considered “negligent” from previous income tax returns.  
The VDP offers taxpayers an opportunity to correct inaccurate or incomplete information or to correct previous erroneous information without penalties or prosecution.
One of the major incentives of proceeding by way of a voluntary disclosure is the assurance of knowing that IF his/her disclosure is accepted by the CRA, the taxpayer is assured of not facing tax evasion charges.

Criteria for a VD to be Valid

For a voluntary disclosure to be valid, it must meet certain specific criteria.  If the taxpayer fails to meet any of these criteria, the voluntary disclosure will be considered potentially invalid resulting in penalties and prosecution.
The CRA is unequivocal that a valid voluntary disclosure must be

(1) voluntary,
(2) complete,
(3) involve a monetary penalty, and
(4) involve information that is one year or more overdue.

Timing

Timing is crucial when filing a voluntary disclosure.  The CRA and the jurisprudence are clear: a disclosure may not qualify as a voluntary disclosure if it is found to have been made with the knowledge of an audit, investigation or other enforcement action that has been initiated by the CRA or other authorities or an administration with which the CRA has information exchange agreements.
It is crucial that the taxpayer be unaware of any audit, investigation or enforcement procedure when filing a voluntary disclosure. This means that if there is any direct contact by the CRA (such as a telephone call from a CRA agent or receiving a letter or a requirement to file from the Agency), the voluntary disclosure will be denied on the basis that it is not voluntary.
Furthermore, if a third party closely associated with the taxpayer receives a communication from the Agency or if any enforcement action against that third party is initiated and such action is sufficiently related to the taxpayer in the eyes of the CRA, the taxpayer’s voluntary disclosure may be denied on the basis it is not voluntary.

Completeness

The CRA is unequivocal that the taxpayer must provide full and accurate facts and documentation for all taxation years where there was previously inaccurate, incomplete or unreported information.  In most instances, the agent reviewing the voluntary disclosure will most likely request additional specific documents or information corroborating the initial application.
Should the taxpayer fail to provide the information requested, or should the facts in the initial application not withstand the scrutiny of the CRA, the voluntary disclosure will likely be denied.
As is always the case in tax matters, the onus of proof lies with the taxpayer. It is the responsibility of the taxpayer to prove that the information submitted provides a complete and accurate account of the facts involved.
However, it is worth noting that minor errors or omissions shall not disqualify the disclosure. Further, the CRA clearly states that each submission will be reviewed on its own merits.

Monetary Penalty

Another criterion is the obligation that the voluntary disclosure must involve the application, or potential application, of a monetary penalty.  There are different reasons as to why a penalty would be levied (such as a late filing penalty, a failure to remit penalty, an installment penalty or a discretionary penalty) but in order for a voluntary disclosure to be valid, it must involve a monetary penalty applying to one reporting period.

One Year Past Due

The last criterion for a valid disclosure is that it must include information that is (1) at least one year past due, or (2) the disclosure is to correct a previously filed return.

10 Year Limitation

CRA will only grant penalty relief for a period of 10 years.  (§220(3.1) of the Income Tax Act was amended in 2004 to only provide relief for a period of 10 years prior to the application for relief of interest and penalties).
This is quite unfortunate as a taxpayer that would like to rectify past filings must take into consideration this 10 year limit.  Indeed, should a taxpayer opt to file a disclosure concerning taxation years dating back more than 10 years from the application, they run the risk of being liable for penalties.
CRA does not advertise such a limitation period and this further emphasises the importance of seeking professional assistance prior to proceeding with a voluntary disclosure.

Conclusion

The VDP is worthy of consideration by any taxpayer that wishes to rectify a previous filing and avoid any penalties or prosecution.
However, the criteria of a valid voluntary disclosure are precise and one should always seek professional assistance given the significant risks that an invalid application may invoke.
Should you be interested in proceeding by way of a voluntary disclosure, Tierney Stauffer LLP would be glad to assist and advise you.  If you have any questions, please do not hesitate to contact us.

Sébastien Desmarais
LL.B., LL.L., J.D.
Lawyer, Tierney Stauffer LLP
This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship.

Net Worth Assessment – Avoid it at all costs

A net worth audit is one of the most powerful techniques available to the Canada Revenue Agency (CRA) to unilaterally deem a taxpayer to have a certain amount of unreported income. The net worth audit is a method which, on its premise, assumes the taxpayer has hidden or failed to disclose annual income, and as a result CRA is not able to rely on the accuracy of the amount of taxpayer income from tax returns filed. Subsequently, CRA will use the results of a net worth audit to deem a taxpayer to have unreported income, resulting in allegations of tax evasion or civil fraud against the taxpayer.

In recent years tax professionals have noticed an increase in CRA’s use of net worth audits against taxpayers. The CRA appears to be targeting their net worth audits to cash-based businesses, owner-manager businesses and illegal businesses (such as drug dealers).

The following will attempt to answer two primary questions, first, what is a net worth audit and second, what is the burden on a taxpayer faced with a net worth audit.

What is a Net Worth Audit?

A net worth audit is a two-step audit by the CRA. First, the Agency will look at the taxpayer’s assets and liabilities at the beginning and end of the tax year and determine the increase and/or decrease in the taxpayer’s net worth. Second, the CRA will review the taxpayer’s expenditures for that same tax year and compare them with standards of expenditures according to Statistics Canada.

The net worth method relies on the concept that when a taxpayer accumulates wealth during a tax year, he shall either invest it or spend it. For an auditor conducting a net worth audit, they will consider an increase in the taxpayer’s net worth throughout the year as taxable income. From that starting point, the auditor will add all non-deductible expenditures to the taxpayer’s net worth and then compare the taxpayer’s net worth at the beginning of the taxation year and the taxpayer’s net worth at the end of the taxation year. Any increase in the taxpayer’s net worth will be considered income for tax purposes.

Interestingly, at the audit stage, the CRA has essentially free reign in their assessment and interpretation of the taxpayer’s net worth. Indeed, CRA may assume facts or use general statistics from Statistic Canada in their assessment; in most instances, to the taxpayer’s detriment.

Burden is on the Taxpayer

It is important to understand that because the Canadian tax system is a self-assessing system, the onus is on the taxpayer to rebut all of the Minister’s assumptions and findings.

The Courts have consistently taken the view that once CRA issues a reassessment based on a net worth audit, the taxpayer must rebut all of CRA’s assumptions and findings by either:

Challenging whether the net worth assessment is needed or is the most appropriate method of computing the taxpayer’s income; or

Challenging every specific aspect of the net worth assessment calculations.

In the context of a net worth audit, the taxpayer’s onus of proof is a considerable one. Indeed, in most net worth audits, the auditor will have requested all available taxpayer records including, but not limited to, a list of all inventories, physical assets, debts to creditors, bank records, securities, and any other statements of assets.

From the documentation provided, the auditor may have interpreted some book entries and assume facts that may not be accurate, however, the onus is on the taxpayer to provide proof to clarify, explain and rebut all of the auditor’s assumptions and interpretation of facts.

When combating a net worth audit, the devil is in the details. Every item, interpretation and assumption of the auditor must be analyzed in great detail and dissected for correctness.

Indeed, with every error found, the trustworthiness of this inherently untrustworthy method is called further into question.

If the matter is to proceed before the Tax Court of Canada, pointing out the auditor’s errors in their interpretation shall contribute to discrediting the auditor’s findings and tilt the judge’s opinion in favor of the taxpayer. However, the taxpayer will also need to provide evidence explaining and clarifying the increase in his net worth over the year.

A valid explanation, such as the receipt of an inheritance, will undoubtly favor the taxpayer in his pursuit of rebutting the auditor’s finding. However, if the taxpayer lacks any evidentiary documentation attesting his point then the matter becomes one of credibility; something a taxpayer should always avoid.

Conclusion

Maintaining well-organized documents and financial records is truly the sole solution for succeeding over a net worth audit. Indeed, documenting all receipts of significant funds received during the taxation year, especially any foreign funds, is the very best way to beat a net worth audit.

My former colleague Arthur Drache once wrote: “good paper almost always will prevail, but in a contest of your unsupported word against CRA, you’ll almost always lose.” This remains the gold standard in a net worth audit.

 If you are the subject of a net worth audit, we highly recommend you consult with your accountant and lawyer. Tierney Stauffer LLP would be glad to assist and advise you. If you have any questions, please do not hesitate to contact us.

Sébastien Desmarais
LL.B., LL.L., J.D.
Lawyer, Tierney Stauffer LLP
This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship.