The term rectification comes from the word “rectify,” which has its roots in Medieval Latin and means “make right.” Rectification is used by parties to a contract to modify the contract if there has been an obvious mistake that was not intended or the meeting of the minds was improperly documented. The courts have used the general principle that rectification is for the purpose of restoring a transaction to its original purpose.
Rectification is also being used in income tax situations to “correct” a mistake that has occurred. There has been a significant amount of jurisprudence in the area over the last several years, which has fined-tuned the legal principles involved from a tax perspective.
In order to be successful in rectifying a past transaction, the taxpayer must be able to prove in court that the objectives of the transaction were not satisfied because of the structure of the transaction.
Let’s look at an example. One objective of a transaction could be to minimize the immediate income tax consequences. If the transaction were structured in such a way as to frustrate tax minimization, then the taxpayer could potentially go to court and request a rectification order to change the transaction.
A shareholder transferred his operating company shares into a holding company, taking back a promissory note equal to $800,000 and common shares for the remainder of the value. One of the objectives was to set up a holding company, and another was to minimize any immediate income tax consequences. However, the $800,000 promissory note triggered an anti-avoidance measure, creating a deemed dividend. Rectification was granted in such a situation, and the promissory note was re-characterized into preferred shares.
The courts will need to see clear evidence as to the original intentions of the parties at the time of the transaction. Evidence that the parties would have done the transaction differently had they known about the income tax consequences will be considered irrelevant by the courts. Consider the following example:
The transfer of a piece of land between related parties was completed on a tax deferred basis. However, subsequent to the transfer it became apparent that the transfer was subject to provincial land transfer tax. The rectification order in this situation was denied.
Rectification is available to avoid a tax disadvantage, which the parties had originally transacted to avoid; however, it is not available to avoid an unintended tax disadvantage, which the parties had not anticipated at the time of the transaction. Rectification is not intended as a cure for all that goes wrong in a transaction. That said, proper planning should involve clearly documenting the objectives of every transaction to ensure evidence could be produced in the future should the need arise.
E.O. & E.
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Copywrite ISSN 0382-7038
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.