In Re Pallen Trust (2015 BCCA 22), the British Columbia Court of Appeal upheld an order for rescission, which effectively nullified a CRA reassessment.
The equitable remedy of rescission unwinds, abrogates, or cancels a transaction, with the goal of returning the parties to their pre-contract positions. In 2013, the leading case on rescission - the UK Supreme Court in Pitt v Holt (2013 UKSK 26) said that rescission is available for mistakes about the tax consequence of a transaction, but only if the error was a “causative mistake of sufficient gravity” that went to either “the legal character or nature of a transaction or…to some matter of fact or law which is basic to the transaction”. The UKSC further said that the gravity of the mistake must be assessed objectively with a close examination of the facts.
Re Pallen Trust involved ITA subsection 75(2). Under that anti-avoidance measure, a taxpayer is prohibited from using a trust to shield a transferor of income-producing property from tax if the trust’s terms allow the transferor to direct that the property revert to him or her or to any other person. If subsection 75(2) applies, the transferor - not the trust – must pay the tax.
David Pallen reorganized his family’s pest control business in 2007, creating the trust and several new corporations including Pallen Holdings and New Integrated. To establish the trust, Pallen Holdings sold to it shares of New Integrated and relied on the position that subsection 75(2) applied: thus, Pallen Holdings and not the trust would pay the tax on any dividends paid by New Integrated. At the time, both the taxpayer and the CRA understood that subsection 75(2) applied regardless of how the transfer of the property into the trust occurred.
In 2012, the FCA judgment in Sommerer (2012 FCA 207) adopted a more restricted reading of subsection 75(2), holding that the section did not apply when the property in question was sold to a trust. Consequently, the CRA reassessed the Pallen Trust: the CRA asserted that post-Sommerer subsection 75(2) no longer applied because Pallen Holdings sold the shares to the trust and thus the dividends paid to the trust by New Integrated were now taxable in the hands of the trust - not Pallen Holdings. As a result, $552,000 in tax was attributed to the trust.
Following the reassessment, the trust sought a rescission order to retroactively invalidate the dividend payments previously made to it. The order was granted by the trial court, which found that before Sommerer the evidence was “uncontroverted” that subsection 75(2) applied to the dividends and that the CRA would not have charged the trust with tax related thereto. The CRA appealed to the BCCA.
The BCCA applied the test from Pitt v Holt to determine whether the lower court had properly granted the rescission order. The BCCA agreed with the CRA’s argument that mistakes about the tax consequences of a transaction do not necessarily justify rescission. However, the BCCA emphasized that rescission for tax mistakes must be justified by a “fact-focused” analysis, and held that “the facts of this case are unusual and…do not involve “aggressive” tax planning gone wrong”.
The courts are warning that retroactive tax planning is not to be encouraged, but since Pitt v Holt, they appear more willing to allow rescission to realize a taxpayer’s original intention. It remains to be seen how the courts will distinguish a true original intention from a retrospective regret that things had been done otherwise, but the recent SCC decision on Fairmont Hotels will undoubtedly impact the mix. To date no leave to appeal has been granted for Re Pallen Trust.
Robert G. Kreklewetz and Kathryn Walker
Millar Kreklewetz LLP, Toronto
A version of this article appeared in the January 2017 issue of Canadian Tax Highlights.