The Canada Revenue Agency (“CRA”) gave each of Robert Mandel and his business partner, Ellen Pike, a very nasty surprise. It reassessed each of them and added $15,000,000 to each of their taxable incomes. The CRA did not like the tax planning they had done in anticipation of the 21st anniversary of their trusts. Not surprisingly, Mandel and Pike retained lawyers. Part of their story is explained in the recent decision of the Ontario Superior Court of Justice in Robert Mandel et al. v. 1909975 Ontario Inc. et al. 2020 ONSC 5343. The tax community may wonder why the taxpayers sought relief in the Ontario Superior Court of Justice (the “OSCJ”) rather than the Tax Court of Canada.
The judge who decided the application was not experienced in tax matters. Unfortunately, the judge’s decision does not clearly state the tax issues. Accordingly, it is necessary for us to go on a journey and to make some assumptions in order to figure out what was going on and what we can learn from it.
Introduction to 21st anniversary tax planning
We can begin our journey by reviewing some of the issues facing a taxpayer who used a trust to effect an estate freeze in 1990 and who had to do 21st anniversary tax planning in 2010 (before the expansion of the Tax On Split Income (“TOSI”) rules).
Mr. Mandel and Ms. Pike carried out their tax planning for the 21st anniversry of the settlement of their trusts before the TOSI rules were expanded. In 2020, tax planning for the 21st anniversary of the settlement of a trust would include consideration of the expanded TOSI rules in addition to consideration of the issues discussed below.
First, we will consider a hypothetical situation.
Suppose that in November 1990, Mr. A owned all of the shares of a corporation (“Profitco”) which carried on a successful business. At that time, Mr. A had three young children, Sandra, David and Michael. Mr. A effected a “Plain Jane” estate freeze in which he exchanged his existing shares of Profitco for freeze shares and “thin” or “skinny” voting shares (typically not entitled to dividends, non-participating and redeemable and therefore having no or nominal value). A discretionary trust subscribed for new common shares of Profitco. Mr. A’s three children were the discretionary beneficiaries of the family trust.
At all times, each of Mr. A and his three children were Canadian residents. They are not residents of any other jurisdiction. They were not US citizens or holders of green cards.
Mr. A and his tax advisor (“Tax Advisor”) had the following discussion early in 2010:
Mr. A: You asked me to speak to you about my trust. Is anything wrong?
Tax Advisor: You settled the trust in November 1990. Unless we take some steps, in November 2011, the trust will be deemed to have disposed of each of its assets for an amount equal to its fair market value. If shares of Profitco held by the trust have appreciated, the trust may face a significant tax bill.
Mr. A: What can I do?
Tax Advisor: The standard planning is to cause the trust to distribute all of its assets to one or more of the beneficiaries before the 21st anniversary of the settlement of the trust. Have you thought about how you might want to allocate the shares of Profitco among your three children?
Mr. A: David and Michael have shown no interest in the business. Sandra is showing signs of interest, but has not yet made up her mind. For the time being, I would like to distribute an equal number of shares to each of the three children. However, I am concerned that would not be fair to Sandra if she eventually takes over the business. She should not be doing all of the work while David and Michael, who do no work, receive two thirds of the growth in value of Profitco. What can I do about that?
Tax Advisor: We could set up a second estate freeze. The three children could receive freeze shares of Profitco, and the trust could acquire new common shares of Profitco.
Mr. A: Is there any downside in that approach?
Tax Advisor: The CRA requires that the holder of freeze shares be able to require Profitco to redeem the freeze shares at any time for an amount equal to the fair market value of the freeze shares at the time of the freeze. If one or more of your children exercises that right, Profitco might not survive.
Mr. A: That will not do. What can we do about this?
Tax Advisor: We could incorporate a new corporation which I will call Newco. We could ask your children to transfer the freeze shares of Profitco into Newco in exchange for non-voting common shares of Newco. You would control Newco by holding non-participating voting shares of Newco. We could re-enforce your control of Newco with a shareholders’ agreement which would be signed by your children and yourself. This would give you a great deal of protection. However, there is a risk that if one of your children becomes alienated, he or she could seek relief by seeking an oppression remedy in the courts.
Mr. A: Sandra has a husband, Barry. I do not feel comfortable with Barry. I would like to protect Sandra’s interest in Profitco from Barry. What should I do?
Tax Advisor: Let’s set up a meeting with a family law lawyer to discuss this.
Back to the Court’s decision
We do not know what advice was given to Mr. Mandel and Ms. Pike. However, their actions were consistent with the advice given by Tax Advisor to Mr. A in our hypothetical situation. Unlike Mr. A in our hypothetical situation, Mr. Mandel and Ms. Pike were prepared to allocate the shares equally among their children and did not require the second estate freeze. However, Mr. Mandel and Ms. Pike took steps to protect their children from marital difficulties. Unfortunately, in doing so, they got into serious trouble with the CRA.
Mr. Mandel and Ms. Pike each had a 25% interest in a corporation named Welded Tube of Canada through holding companies (the “Initial Holding Companies”). The shares of the holding companies were in turn held by family trusts. As the 21-year deemed disposition for the trusts was approaching both the Mandel and Pike families decided to transfer those interests to a series of new corporations (the “New Holding Companies”), one for each of Mr. Mandel’s and Ms. Pike’s children. In each case, the trust distributed the shares in the Initial Holding Company to the child who transferred them to their New Holding Company in exchange for 100 non-voting common shares of the New Holding Company. Mr. Mandel or Ms. Pike subscribed for Class A voting shares of each of the New Holding Companies for an aggregate subscription price of $10 per company. The respective parent then subscribed for 100,000 Class B convertible shares in each of the New Holding Companies for an aggregate subscription price of $100 per company.
The applications judge described the effects of the subscription for the 100,000 Class B voting shares as follows at paragraph 17 of the decision:
One of the effects of this restructuring was to give Mr. Mandel or Ms. Pike control of each of the Child Corporations. In addition, the reorganization was intended to ensure that, in the event of a marriage breakdown of any child, the former spouse of such child would not share in the assets formerly held by the Family trusts. This was achieved by giving Mr. Mandel or Ms. Pike 100,000 Class B Convertible Shares in the Child Corporation of each of their respective children and giving the child only 100 shares. In a marriage breakdown, the child’s former spouse could claim up to 50 of the 100 shares which would be overwhelmed by the 100,000 shares of Mr. Mandel or Ms. Pike.
Unfortunately, the decision does not clearly describe the facts or the basis of the CRA’s assessment. It is reasonable to assume that the Class A voting shares were thin or skinny voting shares. At one time, the CRA indicated that it might attach a value to thin voting shares. However, the CRA has backed off from that position. Yet, the Class A voting shares likely gave the parents de jure control of the New Holding Companies. The Class B convertible shares are somewhat mysterious. We do not know whether they are voting shares. We do know that the subscription price was only $100 per company but the Class B convertible shares could overwhelm 50 of the non-voting common shares which might potentially be held by an estranged spouse of one of the children. Perhaps, each of the 100,000 Class B convertible shares could be exchanged for a non-voting common share. If so, the aggregate fair market value of the 100,000 Class B convertible shares was substantially in excess of the subscription price of $100. This suggests that the CRA may have assessed Mr. Mandel and Ms. Pike pursuant to section 15 of the Income Tax Act. The application judge indicated that this appeared to be the case but provided no explanation. We are left making assumptions.
Throughout the decision, the court refers to Mr. Mandel and Ms. Pike acquiring controlling shares. It is not clear what the court meant by “controlling shares.” It is possible that the court regarded the Class B convertible shares as controlling shares.
The OSCJ addressed three issues in its reasons. The first was whether the court should assume jurisdiction. The court found that it should not because the real issue was a tax assessment that is within the ambit of the Tax Court of Canada. The requested relief involved an argument that the shares underlying the tax assessment (presumably the Class A voting shares and/or the Class B convertible shares) were not validly issued under provincial law because Mr. Mandel and Ms. Pike did not pay for them. While the Tax Court does not have jurisdiction to rectify corporate records, it can interpret provincial legislation when needed to resolve a tax dispute. In this case, the Tax Court could determine the impact of the alleged lack of payment for the shares and the impact of the provincial corporate law requirement that shares be paid before they are issued. The Tax Court was also identified as better equipped to make findings of fact in relation to whether there was payment, and why the applicants recorded matters the way they did. As a result, the OSCJ declined jurisdiction.
The decision of the Supreme Court of Canada (the “SCC”) in Canada v. Fairmont Hotels 2016 SCC 5 (“Fairmont”) clearly indicates that the Superior Courts of the provinces have jurisdiction to make rectifications which have tax consequences. In numerous situations, the Superior Courts of the provinces have done so. There have been a few situations where the Superior Courts have declined jurisdiction. In most of these cases, a hearing in the Tax Court of Canada was imminent when the court was considering the rectification application. This situation can be avoided if the taxpayer’s lawyers ask the CRA to hold the notice of objection in abeyance or ask the Department of Justice (the “DOJ”) to stay proceedings in Tax Court pending the resolution of a rectification application. Our experience has been that the CRA and the DOJ are often co-operative.
Despite declining jurisdiction, the OSCJ did address the second and third issues relating to the relief sought. The second issue was a request for a declaration that Mr. Mandel and Ms. Pike had never been controlling shareholders under section 97 of the Courts of Justice Act which allows for binding declarations of right, “whether or not any consequential relief is or could be claimed.” The court declined to make this declaration. Mr. Mandel and Ms. Pike argued that they had not paid for the shares and the issuance of the shares was void because subsection 23(3) of the Business Corporations Act of Ontario requires payment before shares can be issued. The court noted that the application of subsection 23(3) is not simple in this situation. In this case the evidence was conflicting, and the corporate records indicated Mr. Mandel and Ms. Pike had paid for the shares. For instance, they had both signed director’s resolutions saying that they had paid. They had both signed shareholders’ agreements indicating that they were shareholders. The court also noted that there was no need to intervene from a justice perspective because there was no dispute within the corporations or inability to conduct their affairs. Furthermore, Mr. Mandel and Ms. Pike could still raise the issue of lack of payment before the Tax Court.
The third issue was the issue of rectification. Mr. Mandel and Ms. Pike sought an order rectifying the corporate records under section 250 of the OBCA. They also argued that this was distinct from equitable rectification. The court rejected that distinction, noting that no authority was given for the proposition and that a remedy may be incorporated in a statue without changing its nature or the relevant principles for its application. The court then turned to the SCC’s judgement in Fairmont. The court noted that allowing parties to change the transaction into something different than originally intended would allow them to engage in impermissible retroactive tax planning. The court found that rectification was not available in this case because the corporate records did reflect what the parties intended and agreed at the time.
The four requirements for rectification from Fairmont are set out in paragraph 38 of the SCC reasons. They are that
- There was a prior agreement whose terms are definite and ascertainable,
- That agreement was still in effect at the time the instrument was executed,
- The instrument failed to accurately record the agreement, and
- That instrument, if rectified, would carry out the parties’ prior agreement.
The court did not address these requirements explicitly. However, the reasons do indicate that the applicants were not able to establish that the legal documents failed to accurately record their agreements. The court found that the original agreements were that Mr. Mandel and Ms. Pike would acquire the Class B convertible shares. That is what the documents reflected.
There have been successful rectification applications since the Fairmont decision; however, this was not one of them. In order to succeed, it is necessary for the applicant to be able to show that all four elements of the test are met. Rectification corrects the instrument, not the agreement itself.
This article was originally published in Wolter Kluwer Tax Topics. Republished with permission.
Brian Nichols and Kelsey Horning are lawyers at Goldman Sloan Nash & Haber LLP in Toronto. Brian Nichols practises law through Brian Nichols Professional Corporation.