More rectification cases

Blaine Cameron at KPMG, Hamilton, was kind enough to point me in the direction of two recent rectification decisions.

In Orman v. Marnat Inc., 2012 ONSC 549, the Ontario Superior Court refused to rectify transactions entered into by the taxpayers over a eight-year period in connection with a Ponzi scheme of which they were victims because they “intended that the documents express the meaning that the payments from [the rogue] were income. There is no error in the expression of that intent in the corporate and tax documents, and, therefore, the equitable remedy of rectification is not available.”

The Court, however, agreed to issue a declaration to the effect that “income” received from the Ponzi scheme was in fact a return of capital. The Crown had argued that “in a Ponzi scheme, the investors do not receive a return of capital but rather investors receive funds from the contribution of new investors into the Ponzi scheme, which is a source of income for tax purposes”, which is interesting in light of Johnson v R, 2011 TCC 540. The Court was careful to emphasize its agnosticism on the effect of the declarations for tax purposes as follows:

[61] [I]n the case at bar, it would be wrong of me to declare how for tax purposes the monies received by D.S.D. Holdings and Marnat as investment income but now know in truth to be something other than genuine investment income should be treated for tax purposes. At this juncture, the determination of the legal effect of the nature of the payments received by D.S.D. Holdings and Marnat is for the Minister of National Revenue and the Minister of Finance subject to judicial review in the Federal Court with respect to the Income Tax Act or this court with respect to corporate tax under the Corporate Tax Act.

[62] Therefore, I do not have to agree or disagree with Simmonds v. R, [1997] 2 CTC 2293 (TCC), where the Tax Court held that money from a Ponzi scheme is a source of income for tax purposes or with Johnson v. R 2011 TCC 540, where the opposite decision was reached.

[…]

[65] For the above reasons, without prejudice to how as a matter of law the monies received by D.S.D. Holdings and Marnat from Downing & Associations and used by those corporations to provide bonuses and interest income to Messrs. Orman and Freed is treated for tax purposes, I declare the monies are not income but rather a return of principal or capital to D.S.D. Holdings and Marnat.

I’m not sure I understand the Court’s reasoning. The declaration seems to address an issue that is squarely within the jurisdiction of the Tax Court unless one accepts the idea that the declaration is without tax effect, in which case one might ask how it assists the taxpayers. With respect, I think the court has confused a question of pure fact (did the taxpayer receive certain payments in particular amounts from the rogue?) or a question of law that is not tax-related (eg is this person a director of X Corp, as in Danso-Coffey?) with a question of mixed tax law and fact (were the Ponzi payments “income” for the purposes of the Income Tax Act?).

In any case, the CRA is apparently not appealing this decision.

In McPeake v. Canada (Attorney General), 2012 BCSC 132, the taxpayer was before the Court asking for rectification a second time because apparently the first time around didn’t take:

[10] In 2003, the CCRA issued reassessments of both the trust and Mr. McPeake for the years 1997 to 2001. The reassessments were based on the ITA, s. 75(2)(a)(i). As I understand the evidence and counsels’ submissions, the Auditor concluded that Mr. McPeake’s contribution of property to the trust, combined with his inclusion as beneficiary and the possible reversion of trust property to Mr. McPeake, rendered the trust’s income effectively his own.

[11] The Trustees considered an action for rectification. They consulted with previous counsel for CCRA within the Department of Justice. That counsel, who retired in the summer of 2009, did not oppose rectification. The petitioners applied for rectification on notice to CCRA.

[12] The unopposed petition was heard by Josephson J. in May 2009. Mr. Justice Josephson made an order for rectification of the trust deed as requested with respect to the items found to be in conflict with ITA, s. 75(2)(a)(i).

[13] In November 2009, CCRA informed the petitioners that two other errors existed in the trust deed to support the reassessments, in spite of the deed’s recent rectification. In April 2010, the Minister of National Revenue confirmed the reassessments.

[14] The two other grounds cited by CCRA fall not within s. 75(2)(a)(i) but within s. 75(2)(a)(ii) and s. 75(2)(b). CCRA’s position centres on the aspects of the deed that possibly conflict with these provisions, namely that the trust decisions require unanimous consent, which implies that Mr. McPeake as a Trustee holds control over disposal of the trust property, and that Mr. McPeake could become sole Trustee, in which role he could determine beneficiaries of the trust after the trust’s creation and distribute property to them.

The Court’s description of the “retroactive” nature of rectification is interesting:

Rectification is restorative, not “retroactive”: “[Rectification] is to restore the parties to their original bargain, not to rectify a belatedly recognized error of judgment by one party or the other” (Performance Industries, para. 31). Since rectification restores a truth to an instrument’s expression, it acts, in time, from the point of instrument formation forward.

In any case, the Court was not troubled by the fact that the trust was re-applying for rectification. It concluded that

As in Juliar, the desired tax consequences of the trust were not incidental to the trust’s formation but arguably the reason for its formation. This finding of a specific intention and the timing of its formation are sufficient to allow for rectification in this case.