Common law or civil law, erroneous contracts can be corrected
Two related cases recently decided by the Supreme Court of Canada (“CSC”)  confirm that contractual errors with tax consequences can be corrected in Quebec civil law, as is the case everywhere in Canada. While civil law in Quebec is governed by the Civil Code of Quebec (“CCQ”), All other Canadian provinces are common law jurisdictions. The cases are important because they confirm that the Superior Court of Quebec has jurisdiction to examine these types of requests. The cases also provided guidance as to the proof required to establish the underlying error.
The SCC’s appeal arose out of the Quebec Court of Appeal (“QCA») Decisions relating to business transactions which have resulted in unforeseen tax consequences due to errors made by advisers.
AES Environmental Services Inc. has agreed to sell 25% of its shares in Center Techologique AES Inc. to a third party. To ensure that the deal was tax neutral, the parties used the adjusted cost base (“ACB“) Formula described in article 86 of the Income Tax Act (“ITA“). The parties mistakenly believed that the ACB was $ 1,217,028. The actual ACB was only $ 96,001. The transaction resulted in the assessment of an unexpected taxable capital gain of $ 840,770.
In the second case, Mr. Riopel and his wife, Ms. Archambault, sought to merge two companies. Mr. Riopel was the sole shareholder of one of the merging companies and had a 60% stake in the second company. Ms. Archambault’s shares were to be transferred to her husband before the merger in order to defer tax. However, due to a series of errors on the part of the parties’ advisers, the shares were not transferred as planned and a deemed dividend of $ 335,000 was therefore imposed on Ms. Archambault.
Superior Court of Quebec and Court of Appeal of Quebec
In both cases, the taxpayers had the primary intention to defer the tax consequences of the transactions. After being reassessed, the taxpayers presented claims to the Superior Court of Quebec. The court handed down conflicting judgments, varying the contracts in one case and refusing to do so in the other. The QCA made it possible to correct the contracts in both cases. The Quebec Revenue Agency (“ARQ”) Appealed to the SCC.
Problems at the CSC
The SCC described the two main issues on appeal as follows:
- Does Quebec Code of Civil Procedure allow the Superior Court of Quebec to examine this type of file and rectify or modify the contracts accordingly?
- What is the scope of the power of the courts to correct errors in contracts under the CCQ?
The question before the SCC was whether, under the law of obligations as applicable in Quebec, modifications would be allowed to correct erroneous documents so that taxpayers could be assessed on the basis of the corrections.
The ARQ, supported by the Attorney General of Canada (“AG”) As an intervenor, predictably argued that the Court lacked jurisdiction and that, although the CCQ allows for the correction of clerical errors, taxpayer errors were more than simple clerical errors . The taxpayers argued to the contrary and further emphasized that they were not seeking to import the equitable doctrine of rectification into Quebec law. Rather, they argued that the CCQ and the civil law of obligations were compatible with retroactive modification of erroneous documents and that such modification would bind the tax authorities.
In addition to arguing that rectification does not exist in civil law, the PG argued that the QCA went too far and gave the Superior Court too wide powers to interpret contracts. In addition, the AG asked the SCC to limit the common law doctrine of rectification, including asking that the SCC revise the decision by Juliar v. Canada (Attorney General) (“Juliar“), a leading rectification authority, on the grounds that the doctrine of rectification was too broadly applied in tax matters.
The SCC ruled in favor of the taxpayers and dismissed the ARQ’s appeals. The SCC ruled that the Superior Court had jurisdiction to review cases where the documents do not reflect the true intentions of the parties. In the view of the SCC, the Superior Court had jurisdiction under substantive legal principles which was not excluded by provincial rules of civil procedure.
According to the SCC, contract law is governed by the law of obligations, under which a contract is an agreement of wills for the purpose of carrying out legal transactions, based on the principle of consensualism. The common intention of the parties does not equate to how the will of the parties is expressed, whether orally or in writing – in other words, no material support is required for a contract to exist. Moreover, once a will agreement is reached, the contract simply establishes the applicable rules for carrying out the underlying operations or plans. The SCC confirmed that the parties are free between themselves to modify or cancel the contracts and the underlying documents and can freely recognize and correct common errors, subject to the rights of any third party.
The CSC indicated that the requirement of legal formalities complicates the legal environment of contracts and brings into play evidentiary requirements impacting third parties whose interests may be affected by the contract. However, in the cases before the SCC, evidence was produced without objection, so the requirements of the law of evidence were not engaged.
Applying the principles to the facts, the SCC concluded that Riopel the agreement of wills between the parties was not properly implemented due to errors made by the advisers. Likewise, inAES, the parties’ agreement was vitiated by an incorrect calculation of the ACB, an error which would have served, in the law of obligations, as the basis for the cancellation of the contract. Rather than canceling, the parties agreed to modify the documents that registered and implemented their agreement, so as to restore the documentary integrity of their previous agreement. The SCC held that the courts could act on the fundamental principles of the contract. Despite the weight given to “authentic instruments”, a court can rectify such documents when they contain inaccurate statements, in order to bring the acts into conformity with the intentions of the parties. “Private writing” can also express the common intentions of the parties. However, when the writing turns out to be wrong, it can be corrected.
The SCC examined the relevance of affected third parties under the civil law of obligations and concluded that the tax authorities are not entitled to benefit from a fundamental contractual error after it has been corrected by mutual consent. In our opinion, this was a correct and predictable result.
However, the SCC emphasized that article 1425 of the CCQ cannot be invoked if the common intention of the parties is not sufficiently determinable. The SCC clearly indicated “if a writing contains an error, in particular an error which can, as here, be imputed to the professional adviser of the taxpayer, the court must, once the error has been proven in accordance with the rules of proof in civil matters, find the ‘error and ensure that it is corrected.
The SCC was also careful to point out that the tax consequences of its judgment went beyond the scope of the case before it. The SCC thus affirmed that the process of contesting notices of assessment is limited to courts having legal jurisdiction, which jurisdiction cannot be circumvented. Consequently, the SCC did not purport to rule on the actual tax consequences for either party, but simply on the legal acts which led to the notices of assessment.
The CSC declined to comment on the Juliar decision by simply stating that “the two appeals heard by this Court are governed by Quebec civil law and are not appropriate cases for reconsidering the remedy for common law rectification”.
Overall, these decisions are welcome. Juliar made the remedy of rectification in tax matters available in common law jurisdictions and it would be unfair if the same type of relief were not available to taxpayers engaged in transactions governed by the CCQ.
With these rulings, the CSC has come to the sensible conclusion that mistakes do happen and that tax agencies should not be making a big deal out of them. However, the SCC also made an important caveat that taxpayers should not view these rulings and the possibility of correcting errors as an invitation to engage in bold tax planning initiatives assuming the concept of rectification will always come to the rescue. In the view of the SCC, a general intention to reduce the tax payable would not in itself constitute the object of an obligation, nor even the object of a contract under the CCQ. Consequently, in such a situation, article 1425 of the CCQ cannot be invoked to justify seeking to give effect to the common intentions of the parties. Thus, the scope of the Quebec contractual correction does not seem as broad as the common law doctrine of “fiscal rectification”, which has in some cases allowed taxpayers to substantially restructure their arrangements.