Court File and Parties
Court File No.: 17-74016 Date: 2019/02/07 Court of Ontario, Superior Court of Justice
Re: Technocomm Solutions Inc., Applicant And: Attorney General of Canada, Respondent
Before: Mr. Justice Calum MacLeod
Counsel: Rod A Vanier, for the Applicant Dan Daniels & Tanis Halpape, for the Respondent
Heard: January 16, 2019
Reasons for Decision
[1] The applicant is a Canadian business corporation and seeks a court order to rectify its records. It contends that it erroneously recorded certain payments to its sole shareholder as loans without declaring an offsetting capital dividend and consequently the shareholder was assessed for a substantial tax liability. If granted, the order would permit retroactive declaration of a dividend and would offset or neutralize payments made to the shareholder in 2007 and 2008.
[2] The Attorney General opposes the relief which he characterizes as retroactive tax planning. He argues that the facts do not meet the test for rectification as outlined in the leading decision from the Supreme Court of Canada. The income tax appeal is before the Tax Court of Canada but it has apparently been put in abeyance pending the decision of this court.
[3] For the reasons which follow rectification is not an appropriate remedy on the facts of this case. Even if rectification is available in these circumstances, this is not a case in which the court should exercise its equitable discretion.
The Facts & the Context
[4] Antoine Karam was a founder of C-Com Satellite Systems Inc., a successful business which eventually went public. At the time of the public offering, Mr. Karam’s shares in C-Com, originally acquired for nominal $1.00 value, were worth more than $2 million.
[5] On the advice of the lawyer handling the IPO, Mr. Karam incorporated a new company, 3692248 Canada Inc.[^1] The new numbered company subsequently became the applicant, TechnoComm Solutions Inc. The plan was to transfer his shares in C-Comm to TechnoComm under a rollover agreement pursuant to s. 85 (1) of the Income Tax Act.[^2]
[6] Mr. Karam signed the rollover agreement on May 4th, 2000. That was an agreement signed by himself in his personal capacity and himself as President of the new corporation. Under the terms of the agreement, Mr. Karam’s C-Com shares were acquired by TechnoComm in exchange for 10,000,000 “Special Shares” in the latter.
[7] Ordinarily, of course, a sale of his C-Com shares would have triggered a capital gain for Mr. Karam of over $2 million at the time of the disposition. The rollover provisions of the Act permit an owner of a corporation to avoid this result by rolling the shares into the corporation at his original cost. Subject to a number of complex rules and calculations, where that is done and the taxpayer and the corporation file the appropriate joint election, the capital gain is deferred and the ultimate tax liability is transferred to the corporation.
[8] The Act also permits a hybrid approach in which the taxpayer may elect to realize a portion of the capital gain and the corporation will then acquire the shares at a higher adjusted cost. In this case Mr. Karam elected to realize a capital gain of $500,000.00. It was his intention to set off that gain against his lifetime capital gains exemption. By this means, a capital gain of $500,000.00 would be triggered but would be tax free in his hands. The balance of the capital gain would be rolled into TechnoComm. Under the terms of the rollover agreement, TechnoComm’s adjusted cost base for the C-Comm shares it acquired should then have been $500,001.00. That is Mr. Karam’s original adjusted cost base plus the amount of the capital gain realized by him on disposition of his shares.
[9] In furtherance of this agreement Mr. Karam and TechnoComm filed a joint election in form T2057 which was intended to reflect the numbers in the rollover agreement. As I will come to momentarily there may be an error in the form but it is clear from the evidence before me what was intended. Mr. Karam intended to realize the amount of capital gain that would be offset by his personal lifetime exemption and then to defer realization of any additional gains by rolling the shares into the new corporation. This is the principal objective of the rollover agreement.
[10] The agreement also deals with the manner in which TechnoComm is to acquire the shares by issuing 10,000,000 “Special Shares” to Mr. Karam in full satisfaction of the purchase price of $2,127,795.00. In addition, the $500,000.00 on which he elected to declare a capital gain was to be added to the capital account for the Special Shares. Paragraph 3.4 and 3.5 of the agreement require TechnoComm to add this amount to the “stated capital” for the new shares and also the “paid up capital” for those shares in the corporation’s records.
[11] “Stated capital” is a corporate law concept which in this case is regulated by s. 26 of the Canada Business Corporations Act. Paid up capital (“PUC”) by contrast is a concept which must be computed for various purposes under the Income Tax Act. While “stated capital” and PUC are generally identical, they are different concepts and they may diverge under certain circumstances. Stated capital is essentially the amount the shareholders have contributed to the corporation by investing in shares of a particular class. PUC is the amount of capital which the Income Tax Act permits the corporation to return to the holders of the shares on a tax free basis.[^3] This can be done by declaring a dividend on those shares which does not exceed the amount of the PUC. Any dividend in excess of the PUC amount would be a taxable dividend. The rollover agreement establishes that the PUC of the shares would be the amount set out in “Schedule 1” to the agreement.
[12] For purposes of this application, the main importance of PUC is that the paid up capital of a class of shares represents an amount that can be paid out to the holders of those shares as a tax free capital dividend in certain circumstances. The theory presumably is that PUC represents an investment by the shareholder of funds that have already been taxed. The capital may therefore be returned without triggering a tax liability.
[13] Although the rollover agreement contemplates fixing an amount for PUC and thus setting the stage for the tax free dividend which is the objective of the rectification order, it is important to note that the agreement does not oblige the corporation to declare such a dividend. Dividends, of course, can only be declared by a corporation that is in a surplus position and are at the discretion of the board of directors.[^4] There are many reasons why a corporation might decide not to reduce its capital and many reasons why dividends may not be declared at a particular point in time. The rollover agreement certainly demonstrates an intention to create $500,000.00 of paid up capital but it does not deal directly with when or if a dividend will be paid.
Adjournment Request
[14] The possibility of there being an error in the T2057 was raised by the Attorney General in its factum and addressed by the applicant in a supplementary affidavit sworn on January 15th, 2019. The issue seems to be that the form contains an error in the PUC for the Special Shares. Mr. Karam has sought accounting and legal advice and agrees he will have to seek an amendment to the form. If the PUC was not properly stated in the joint election then CRA may not allow the tax free dividend even if rectification is granted.
[15] I am not asked to rectify the Form T2057. The procedure for amending the form is to request the Minister to allow the filing of an amended form and I am advised that such a request has been made. Mr. Vanier asked for an adjournment so that the court would have the benefit of that decision by the minister.
[16] I refused the adjournment for a number of reasons. Firstly, I can accept the applicant’s evidence that the election form is incorrect and he has taken steps to correct it. The issue before the court is whether the books and records of the corporation should be rectified and not whether the T2057 was properly completed.
[17] Secondly, this application has been pending since 2017 and I am advised the assessment appeal before the Tax Court of Canada is being held in abeyance. There is little prospect that the Minister will allow the amendment of the form in light of the Attorney General’s position on this application. If the applicant disagrees with the Minister’s decision the remedy would be way of judicial review to the Federal Court. To grant the adjournment raises the prospect of gridlock in three separate courts. By contrast, if this court determines that the applicant’s intention was clear that finding may inform the decision of the Minister.
[18] Finally, there is no prejudice to the applicant in proceeding. This application has been scheduled for many months. Mr. Vanier’s arguments are fully prepared. Although I accept that the argument at p. 6 of the respondent’s factum took him by surprise, I will give no weight to the Attorney General’s argument of mootness. For the purposes of the application, I am prepared to presume that the form can be amended and to consider the question of rectification on its merits. As noted, I am not asked to rectify the T2057 form.
The Issue before the Court
[19] What I am asked to rectify is the corporate records, specifically its financial statements and minute book.
[20] Apparently Mr. Karam drew funds out of the corporation over several tax years. These amounts were recorded in the books of the corporation and on its year-end financial statements as loans to the shareholder. Loans to shareholders that are not repaid within a specific period of time are treated as personal income under the Income Tax Act. As a result when there was a CRA audit, Mr. Karam was assessed a personal income tax debt as well as interest penalty. The applicant contends that it had intended for these funds to be paid out tax free and now wishes the court to repair the problem by rectifying the records.
[21] The proposed special resolution of the directors submitted on behalf of the applicant would retroactively reduce the PUC for the Special Shares to $1.00 and credit the difference to the shareholder loan account as of April 30, 2001. Then the resolution proposes to categorize payments made to Mr. Karam in 2007 and 2008 as repayment of the shareholder loan by way of a non-taxable dividend rather than as loans to the shareholder. It is anticipated that such a rectification order would reduce the amount owing under the tax audit.
[22] The applicant is seeking to have the court correct what it says is an accounting error and to allow the reduction of capital to be paid out on a tax free basis. The applicant argues that this was an obvious purpose of the rollover agreement and the corporate records should be rectified to reflect that intent. The Attorney General argues that this is after the fact retroactive tax planning and cannot be achieved by rectification.
The Legal Framework for Rectification
[23] Rectification is an equitable remedy designed to correct errors in the terms recorded in written legal instruments. The availability of the remedy has been restricted by the Supreme Court of Canada in the Fairmont Hotels case.[^5] In that case, Fairmont had entered into various agreements with the intention of ensuring tax neutrality in connection with complex financing arrangements.
[24] In 2007 Fairmont was asked to terminate certain reciprocal loan arrangements “on an urgent basis” to permit the sale of certain hotels. Fairmont then had the boards of its subsidiary hotels execute resolutions permitting Fairmont to redeem its shares in the subsidiaries. The redemption later resulted in tax liability following a CRA audit, Fairmont sought judicial rectification to convert the share redemptions into intercompany loans. Rectification was granted by the Superior Court of Justice and upheld in the Court of Appeal. At both levels of court in Ontario it was accepted that a general intent to effect a tax neutral transaction was sufficient to support a demand for rectification. Both courts were prepared to repair the erroneous redemption of shares by Fairmont on a nunc pro tunc basis.
[25] When the case reached the Supreme Court of Canada, the two dissenting judges agreed that rectification cannot be used for retroactive tax planning. They would however have been more generous in permitting rectification to carry out a general intention of tax neutrality even though the precise mechanism had not been agreed in advance. For that reason they would have dismissed the appeal and accepted the law as previously enunciated by the Ontario courts.
[26] For the majority, however, the law in Ontario had gone too far in using rectification to correct errors in judgment or in drafting of contracts.[^6] Courts, it was said, “rectify instruments which do not correctly record agreements.” Courts “do not rectify agreements” which have led to an “undesirable or otherwise unexpected outcome”.[^7] Put another way, 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”. “Alternatively”, said the court, “rectification aligns the instrument with what the parties had agreed to do, and not what, with the benefit of hindsight, they should have agreed to do”.[^8] Rectification was denied to Fairmont. In order to grant rectification, the court would require proof of the precise terms which should have been included in the instrument and proof that it was always the intent of the parties to include those terms.
[27] There are certainly cases in which the courts have granted rectification of corporate records.[^9] Share registers, minute books and other corporate records are not always kept up to date and can contain errors. In an appropriate case, the directors’ resolutions and shareholder ledgers can be corrected by rectification.[^10]
Analysis
[28] Mr. Vanier argues that the rollover agreement is an agreement which demonstrates the intent of Mr. Karam and the applicant to minimize personal income tax. He argues that one of the clear purposes of a rollover agreement is to permit capitalization of the new corporation and to permit funds to be drawn out tax free. Since Mr. Karam paid tax on $500,000.00 in capital gains, it is an unfair windfall to CRA if he is taxed again on the same funds.
[29] The applicant seeks a judicial finding that it was always the intention of the corporation to pay funds to Mr. Karam free of tax. As discussed above, this intention does not appear in the rollover agreement at least not directly. The agreement creates the preconditions for a tax free dividend, it does not require the corporation to declare a dividend and it does not speak to the timing of such a dividend.[^11]
[30] This runs directly into the issue identified in Fairmont. I agree with the Attorney General that the rollover agreement does not prove a specific intent to issue a non-taxable dividend in any of the years in question. The agreement simply contains an intention to create the preconditions for such a dividend by contributing $500,000.00 to the PUC for the Special Shares received by Mr. Karam. As I have said, it does not require the declaration of such a dividend and it does not speak to timing. Rectification does not speak to aspirations, plans or motives but only to repairing incorrect implementation of specific terms of an antecedent agreement.[^12]
[31] It is quite clear from the rollover agreement that Mr. Karam and the corporation intended to add $500,000.00 to the PUC of the new shares. While the agreement was intended to capitalize TechnoComm in a manner that would permit a tax-free dividend at an appropriate time, it is another thing entirely to argue that the agreement required such a dividend to be declared at any particular time. On that point the agreement is silent.
[32] Dividends can only be declared when a corporation is in a surplus position. That is generally speaking they are paid out of corporate profits on which the corporation has paid tax. Dividends also require a resolution of the directors. As the sole director, Mr. Karam could have declared a dividend on the Special Shares by an appropriate special resolution but he did not do so. In fact on the evidence before me there was no director’s resolution either declaring a dividend or authorizing a loan to the shareholder or authorizing any other kind of payment. For that matter, there does not appear to be a director’s resolution approving the financial statements pursuant to s. 155 or a shareholders resolution dispensing with an audit pursuant to s. 163 of the CBCA.
[33] What appears to have happened is that Mr. Karam drew funds out of the corporation without obtaining legal or accounting advice. When this occurred, the bookkeeper noted such draws as loans to shareholder and the informal unaudited year-end financial statements were prepared accordingly. This is not a case of inaccurately implementing terms of an agreement. It is a failure to exercise diligence or maintain appropriate records.
[34] This is a common problem in closely held corporations. Sole shareholders, directors and officers of corporations frequently forget that they act in at least these three separate capacities and they frequently omit to maintain legally necessary records in the minute book for the corporation. The omission to properly record transactions or approvals is frequently addressed by having the directors and shareholders approve the proper resolutions after the fact and in some cases to restate financial statements and refile tax returns.
[35] In this case the corporation has not attempted to repair the problem in this manner. There has been no attempt to cure the defect by correcting the corporate records. So not only is the agreement silent about when and if there should be a tax free return of capital, there is nothing in the corporate records indicating any intention to do so.
[36] This is precisely the problem identified in the Fairmont case. According to the Supreme Court a vague agreement to minimize tax is not sufficient to support rectification. What is necessary is proof that a specific mechanism was intended but that mechanism was not properly recorded in the records. The rollover agreement does not support an intention to declare tax free dividends in any of the years in question nor is there anything in the corporation’s records to indicate that anyone turned their mind to that question at the time. This may be contrasted with a recent decision in British Columbia. In that case the directors had a definite and ascertainable agreement to drain the capital dividend account. They had then passed a resolution based on advice from the accountants but the calculations were in error. The Supreme Court of British Columbia allowed rectification.[^13] The corporation had a specific intention to return the capital and empty the capital dividend account. The error was a calculation error and was amenable to rectification.
[37] The applicant corporation does not require an order of the court to correct its books and records. It may pass a director’s resolution, special resolution or shareholders resolution to amend its records, bring them up to date or to restate its financial statements. Of course the Minister or the CRA may refuse to recognize those changes as legitimate for much the same reason that the Attorney General opposes this application. The question of bona fides could then be argued in the Tax Court which is the proper forum.
[38] Rectification is not the remedy for failure to keep proper books and records nor is it a substitute for the failure to obtain timely legal and accounting advice. As stated in Fairmont, it is insufficient to have a general intention to minimize taxes. Rectification addresses errors in implementing an agreement. It is not a substitute for due diligence nor does it address failure to make appropriate decisions and elections at the appropriate time.[^14]
[39] For these reasons, the application is dismissed. I may be spoken to if the Attorney General seeks costs.
Mr. Justice C. MacLeod
Date: February 7, 2019
Court File No.: 17-74016 Date: 2019/02/07
Ontario Superior Court of Justice
Re: Technocomm Solutions Inc., Applicant And: Attorney General of Canada, Respondent
Before: Mr. Justice Calum MacLeod
Counsel: Rod A Vanier, for the Applicant Dan Daniels & Tanis Halpape, for the Respondent
Reasons for decision
Mr. Justice Calum MacLeod
Released: February 7, 2019
[^1]: Incorporated under the Canada Business Corporations Act, RSC 1985, c. C-44 as amended (“the CBCA”) [^2]: Income Tax Act, RSC 1985, c. 1 (5th Supp) as amended (“the Income Tax Act” or “the Act”) [^3]: See Krishna v. Income Tax Law, 2nd Edition, Irwin Law Inc, 2012 @ page 420 [^4]: CBCA s. 42 [^5]: Canada (Attorney General) v. Fairmont Hotels Inc., 2016 SCC 56; [2016] 2 SCR 720 [^6]: In so doing the Supreme Court also overturned Juliar v. Canada (AG), (1999) 1999 15097 (ON SC), 46 OR (3d) 104 (SCJ Commercial List); aff’d (2000) 2000 16883 (ON CA), 50 OR (3d) 728 (Ont. CA) [^7]: Supra, @ para 39 [^8]: Supra, @ para 19 [^9]: See QL Hotel Service Ltd. v. Ontario (Minister of Finance), (2008) 2008 15226 (ON SC), 90 OR (3d) 760 (SCJ); aff’d on other grounds at 2009 ONCA 715 although this case must be read with caution because it relies upon the Juliar decision. [^10]: Re: Razzaq Holdings Ltd., 2000 BCSC 1829 and Orman v. Marnat Inc., 2012 ONSC 549. [^11]: Assuming the T2057 can be corrected, if the dividend was not declared, it may still be declared in the future as long as the PUC has not been reduced for any other reason. [^12]: Fairmont, supra, @ para 31 - 32 [^13]: 5551928 Manitoba Ltd (Re), 2018 BCSC 1482 [^14]: See Performance Industries Ltd. v. Sylvan Lake Golf & Tennis Club Ltd., 2002 SCC 19, [2002] 1 SCR 678 @ para. 31