The Law of Unintended Tax Consequences

Torys Quarterly: Sharpen Your Focus

Increasing complexity in business structures, the speed at which transactions are conceived and closed, and rapidly changing tax laws, particularly surrounding base erosion and profit shifting (BEPS) can result in unintended material tax consequences.

Managing the tax remediation process through proactive strategies can achieve better outcomes than waiting for a Canada Revenue Agency (CRA) audit and losing control over the process. Early and appropriate disclosure may also stave off market criticism. Three recent developments in tax remediation impact the ability to rectify a completed transaction, the ability to correct a transaction without prosecution or penalty through voluntary disclosure, and the consequences of insufficient disclosure of tax consequences. The changes surrounding rectification and voluntary disclosure further restrict available tax remediation and increase the incentives to dispute potential non-compliance rather than use other methods. The Silver Wheaton case in the U.S. regarding public disclosure of material tax non-compliance demonstrates the importance of understanding the tax at risk and having a strategy of appropriately disclosing it.


One remediation strategy has been to resort to the Superior Courts for declaratory relief usually to “rectify” a contract or arrangement to correct an error or in some cases to substitute different steps or legal consequences that achieved the same commercial goals while avoiding unintended consequences. If a legal instrument fails to accurately reflect the true agreement between parties, the rectification remedy allows for a court to exercise its equitable jurisdiction to alter the instrument. In Canada (Attorney General) v. Fairmont Hotels Inc., and its partner decision for Quebec, Jean Coutu Group (PJC) Inc. v. Canada (Attorney General), the Supreme Court of Canada narrowed the availability of the remedy of rectification commenting that “[r]ectification is not equity’s version of a mulligan.” Instead, it is a remedy that allows for a correction of a contract that did not reflect the agreed upon intentions of the parties when it was formed.

Prior to these decisions, the availability of the rectification remedy was considered in some cases as very broad relying on a “common continuing intention” between the parties usually relating to a general intention not to pay more tax in a transaction. The Supreme Court held that evidence of a mere common intention was insufficient, because this did not coincide with the purpose of rectification, which is focused on the incorrect recording of an agreement. The party seeking rectification must be able to point to the putative error and articulate the way in which the instrument should be rectified in order to correctly record what the parties intended to do—“rectification aligns the instrument with what the parties agreed to do, and not what, with the benefit of hindsight, they should have agreed to do.”

The Supreme Court held that to meet the new test for rectification in cases of common mistake, the party must show on a balance of probabilities that:

  1. there was a prior agreement whose terms are definite and ascertainable;
  2. that the agreement was still in effect at the time the instrument was executed;
  3. that the instrument fails to accurately record the agreement; and
  4. that the instrument, if rectified, would carry out the parties’ prior agreement.

The Supreme Court also held that rectification is the same under the common law and civil law—a result that was not obvious and was contentious. In previous cases, the Crown had argued that rectification did not exist as a doctrine in civil law.

With these clarifications, rectification remains a potentially important tool in tax remediation. Many mistakes do involve an intention regarding the tax consequences of an agreement at the time when the contract was formed and a mistake in recording that intention. Future cases may benefit from amending agreements created at the time the error surfaces that specify the terms that the parties intended and which, had they been included, would have carried out that intention.

The Superior Courts have other inherent powers. The next frontier of equitable remedies for tax remediation is rescission. The B.C. Court of Appeal in Re Pallen Trust applied the remedy of rescission when tax planning went awry due to changing interpretations of the relevant tax provisions. It remains unclear how this doctrine will evolve, whether consistency between civil and common law systems will be achieved and how (if at all) it intersects with the “common intention” analysis in rectification.

Voluntary Disclosure

Another remediation strategy has been resorting to a voluntary disclosure under the CRA Voluntary Disclosure Program (VDP). The purpose of the VDP is to promote compliance with Canada’s tax laws by encouraging taxpayers to voluntarily come forward and correct previous omissions in their dealings with CRA. Taxpayers who make a valid disclosure have to pay the taxes or charges plus interest, but without penalty or prosecution that the taxpayer would otherwise have been subject to. Voluntary disclosure is available for income tax and GST/HST matters. Proposed changes to the VDP, released June 9, 2017 for a 60-day public comment period, will restrict its current availability. These proposed changes stem from the October 2016, House of Commons Standing Committee on Finance report to the Government that recommended that CRA undertake a comprehensive review of the VDP.1 CRA’s proposed changes will:

  1. exclude applications from corporations with gross revenue in excess of $250 million from VDP relief—such corporations should follow normal procedures to amend their tax filings;
  2. exclude applications relating to transfer pricing adjustments or a penalty for incorrect transfer pricing;
  3. exclude applications relating to an advance pricing arrangement (an agreement with a taxpayer that confirms the appropriate transfer pricing methodology);
  4. exclude applications that depend on an agreement being made at the discretion of the Canadian competent authority under a provision of a tax treaty;
  5. in the case of GST/HST, exclude applications where a registrant is attempting to increase the amount of input tax credits, other credit adjustments or rebates without any corresponding increase in tax liability in the application period; and
  6. require the payment of the estimated taxes owing as a condition of qualifying for the program.

The OCAC implied that sophisticated larger taxpayers should not have to resort to the voluntary disclosure program and that is borne out in the CRA proposals. Affected companies should consider making submissions about the proposals.

Mistakes do happen, even in large enterprises with sophisticated advisors and risk mitigation strategies.

It is not clear how CRA intends to address these exclusions. The reference to large taxpayers following normal procedures to amend tax returns seems to suggest that in such a process the Minister of Revenue’s discretion to “waive or cancel all or any portion of any penalty or interest otherwise payable under this Act” could be exercised in the normal audit process. Consequently, a taxpayer who is affected by the proposals may want to consider requesting administrative relief outside the context of a voluntary disclosure. It is not clear whether CRA could rely on the proposal as justification for an outright denial of relief of such requests for entire classes of taxpayers without being subject to judicial review framed in accordance with the Federal Court of Appeal’s guidance in Canada (National Revenue) v. JP Morgan Asset Management (Canada) Inc. for fettering the discretion of the Minister.

Mistakes do happen, even in large enterprises with sophisticated advisors and risk mitigation strategies. In the past, voluntary disclosure was an effective means of resolving potential disputes. If it is eliminated for large taxpayers and most international matters it will make tax remediation for large sophisticated businesses more challenging, and taxpayers will need to consider its limitations and the availability of other remediation strategies.

Managing Disclosure

Another case last year highlighted the importance of managing the disclosure of potential tax issues. The 2016 U.S. decision In re Silver Wheaton Corp. Securities Litigation is notable for its recognition that an audit conducted by CRA can constitute a material change that, if insufficiently disclosed, could lead to a class action claim of misrepresentation.

In 2009, CRA began its audit of Silver Wheaton (SW), which culminated in 2015 with a proposed transfer pricing adjustment for 2005-2010 of approximately C$715 million.

In 2015, SW issued a press release describing the proposed reassessment, which estimated that if this became a reality, SW would be subject to approximately US$150 million in federal and provincial tax. The press release also stated that SW believed it was in compliance with Canadian tax law and that it intended to vigorously defend its tax filing positions. Following publication of the press release, SW’s share price fell approximately 12%.

A class action was brought claiming that SW had failed to disclose its tax liability on the basis that SW was obligated to record any tax liability it was “more likely than not” to incur. The plaintiffs also alleged in the alternative that the defendants were required to disclose it as a “contingent” tax liability. These arguments were tied to GAAP and IFRS standards. While SW did disclose the existence of the audit and the potential for an adverse result, the plaintiffs argued that SW consistently downplayed its potential results.

SW brought a motion for dismissal of the class action based on the absence of a material misrepresentation or omission. As it was a motion to dismiss, the plaintiffs’ pleadings were assumed to be true.

SW argued that CRA’s reassessment was being disputed and that the Canadian tax courts would ultimately vindicate their tax position. The Court held that this argument was misplaced because the question relating to disclosure in the financial statements was whether it was “probable” that SW would eventually be required to pay unpaid income taxes and applicable penalties, relying on case law that held that the legal standard in the U.S. was the failure to disclose the “potential” that SW would be subject to an enhanced tax liability. The court commented that disclosure of the probability that CRA would assess upon audit should have been disclosed under IFRS.

These recent developments suggest that future tax remediation will be more difficult and more complex. But since unintended tax consequences generally do not get better being left alone, businesses faced with tax mistakes will require a tax remediation risk mitigation strategy rooted in a thorough understanding of the facts, law and administrative practice surrounding the suspected non-compliance, good identification of risks and benefits of particular remediation strategies and sound judgment.


1 These hearings were triggered by the favourable settlements made by CRA involving an Isle of Man promoted tax scheme. On December 5, 2016, the Offshore Compliance Advisory Committee (OCAC), an independent committee composed of tax experts, presented its Report on the VDP to the Minister of National Revenue, with recommendations on how to “improve” the VDP so that it could be made more effective and more fair. The OCAC recommended the continuation of the VDP but proposed to tighten the criteria for acceptance into the program.


The Authors

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