http://www.courts.gov.bc.ca/jdb-txt/SC/15/12/2015BCSC1256.htm
Zhang v. Canada (Attorney General) (July 21, 2015 – 2015 BCSC 1256, Butler J.).
Précis: The Zhang decision is a somewhat unusual decision where rectification was denied. Mr. Zhang was a resident of Canada who carried on a successful business in China selling laser beam quality control equipment. When he filed his 2002 tax return he had a general discussion with his accountant about reducing tax on income earned in China. The accountant spoke of setting up a Chinese company as a subsidiary of a Canadian company to receive tax free dividends out of exempt surplus. Without informing his accountant, Mr. Zhang had already set up a Chinese company, LABest, on January 31, 2002. He owned all the LABest shares for which he paid $150,000 US (and, subsequently, another $30,000 US). He also set up a Canadian company, Beamtech, of which he also owned all of the shares. In August of 2003 his accountant became aware of the two corporations and advised that in order to limit income taxes on distributions from LABest it should be wholly owned by Beamtech. Mr. Zhang transferred the LABest shares to Beamtech at his cost of $217,263 by an agreement dated October 29, 2003, to be effective retroactively on September 24, 2003. In 2007 CRA assessed Mr. Zhang for a taxable capital gain of $221,950 on the transfer of the LABest shares since he had failed to file an election to transfer them at cost under subsection 85(1) of the Income Tax Act when the shares were transferred to Beamtech in 2003. While Mr. Zhang and his accountant had discussed the possibility of filing a subsection 85(1) rollover election Mr. Zhang had been reluctant to pay for the research ($2,000) and was concerned that the Chinese government had the right to set the transfer price in any event.
The Court in essence held that Mr. Zhang was the author of his own misfortune. He had failed to do sufficient “active” investigation of the rollover in 2003. The “mistake” was not within the ambit of a traditional order for rectification. It concerned a “different kind of tax avoidance” [para. [41]]. The petition was denied with costs to the Crown.
Decision: This decision was largely fact-based:
[5] At all material times, Mr. Zhang and his family were residents of Richmond, British Columbia. For some time prior to 2003, he carried on a business in the People’s Republic of China (“PRC”), which manufactured and distributed laser beam quality control equipment. On January 31, 2002, he established LABest under the laws of the PRC for the purpose of conducting that business. He invested capital of US $150,000 to start up LABest and later invested a further US $30,000. He was the sole owner of the company. Mr. Zhang had carried on the business in a personal capacity for some time prior to the incorporation of LABest, and the company was profitable from its inception.
[6] In April 2003, Mr. Zhang and his wife met with their accountant, Bob Zhang, to review their 2002 tax returns. Bob Zhang is not related to Mr. Zhang. To avoid confusion, I will refer to him as “Bob”, and in doing so I intend no disrespect. In the course of their discussions, Mr. Zhang asked if it was possible to distribute the income from his business in the PRC to British Columbia so that the earnings would be available to support his family. In response Bob said Mr. Zhang could set up a corporate structure whereby the income from the business would be earned in the PRC by a Chinese company which in turn would be owned by a British Columbia company. Using this structure, income earned and taxed in the PRC could be distributed to the British Columbia company as “exempt surplus dividends”. The dividends would not be subject to tax in Canada when received, and would only attract tax when distributed as dividends to the shareholders in Canada. This discussion was cursory and conceptual in nature. Bob made no notes of the discussion and did not charge Mr. Zhang for tax planning advice. The formal retainer was restricted to preparation of the 2002 tax returns.
[7] The discussions in April 2003 did not extend to the manner by which Mr. Zhang could transfer ownership of the Chinese company to the British Columbia company. Indeed, Bob was not advised of the existence of LABest. He assumed Mr. Zhang had yet to incorporate companies in the PRC and British Columbia. Sometime after that discussion, on August 1, 2003, Mr. Zhang incorporated Beamtech in British Columbia. Mr. Zhang subscribed for 100 shares in Beamtech and was the company’s sole shareholder and director.
[8] Bob became aware of the existence of LABest and Beamtech in August 2003 during a meeting with Mr. Zhang and his wife to follow up on the earlier discussion. At that time, they gave Bob a copy of the Chinese documentation establishing LABest and the British Columbia certificate of incorporation for Beamtech. At that point, Bob realized that Mr. Zhang had not set up a corporate structure which would allow the income from his Chinese company to be received tax-free in British Columbia. In order to “salvage” the structure, he advised Mr. Zhang to transfer ownership of LABest to Beamtech.
[9] There are material differences in the evidence of Bob and Mr. Zhang as to the nature of the discussion at their meeting in August 2003. Mr. Zhang says that Bob’s primary concern was the possibility that the transaction could trigger a capital gain. He said Bob was concerned that the transaction could trigger an immediate Canadian income tax liability unless a rollover procedure was followed if the fair market value of his shares exceeded the amount he had invested in LABest. Bob advised that the work to accomplish a rollover, pursuant to s. 85, was complicated and would cost $2,000. Bob also said he was not sure it would be possible to do that rollover. Mr. Zhang also says Bob told him that if the value of the proposed share transfer did not exceed US $150,000, the amount of his initial capital investment, then a rollover would not be necessary. Mr. Zhang says he instructed Bob not to do any research or work on a rollover until he found out what the value in the PRC would be for the transfer of his interest in LABest. He says he did not ask for or receive any detailed advice about the requirements for a rollover, or any tax planning in relation to the transfer of his interest in LABest to Beamtech.
[10] Bob’s recollection of the sequence of events as set out in his affidavit and cross-examination is different from Mr. Zhang’s. Bob says that when he saw that Mr. Zhang owned the shares of Beamtech and of LABest, he advised Mr. Zhang to transfer his interest in LABest to Beamtech. At the time, he was not sure this would be effective to save the structure. He says they had a discussion about what the transfer price might be. It was not possible to establish that because the Chinese government had to be involved and had the ability to determine the transfer value. The determination made by the government could not be questioned. Mr. Zhang recalls a brief discussion about the possibility of a rollover but it was not substantive. Bob recalls that Mr. Zhang was reluctant to pay the fee of $2,000 that would be required to explore that possibility. Bob’s evidence strongly suggests that the discussion was focused on putting in place a corporate structure which would enable income from LABest to be received tax-free in Canada, not on tax issues arising from the possibility of triggering a capital gain on the transfer of LABest to Beamtech.
[11] The transfer of Mr. Zhang’s interest in LABest to Beamtech, a foreign entity, required approval of the Chinese authorities. This includes approval of the price. Mr. Zhang was in China and took the necessary steps to effect the transfer and obtain that approval. He arranged for the transfer to be made by way of the Agreement. He drafted the Agreement while he was in the PRC. It is in Chinese and was signed on October 29, 2003. The Agreement provides that Mr. Zhang’s interest in LABest is transferred to Beamtech effective as of September 24, 2003. On November 14, 2003, the PRC officials approved the transfer of Mr. Zhang’s interest in LABest to the new foreign owner, Beamtech, at a price of US $150,000, the amount of the original capital investment in the company by Mr. Zhang.
[12] Prior to completing the transaction, Bob had a brief telephone discussion about the transfer with Mr. Zhang, while the latter was in the PRC. Mr. Zhang informed Bob that the Chinese government would approve a transfer value which was the same as the initial capital investment: US $150,000. Mr. Zhang told Bob that was the fair market value. They both understood there was nothing that could be done about that valuation. Bob says they had no discussion about the possibility of Beamtech issuing shares to Mr. Zhang as consideration for the transfer. There was no discussion about a possible s. 85 rollover. Mr. Zhang assured Bob that with that value there was no gain or loss on the transfer. Mr. Zhang understood from his brief discussions with Bob that there would be no tax issue on the transfer of his interest in LABest.
The Judge reviewed the case law on rectification (including Re Pallen Trust, 2015 BCCA 222 which was blogged recently on this site by Rebecca Jones of Lenczner Slaght LLP) and observed:
[35] I cannot accept Mr. Zhang’s version of the meeting with Bob in August 2003. Bob’s version of the discussions is much more likely to be accurate and accords with the inherent probabilities of the case. This is so primarily because of the circumstances leading up to the meeting. Prior to the August meeting, Mr. Zhang had asked about a single tax issue: how to receive the revenue from his business in the PRC in British Columbia in a tax-efficient way. Bob described the necessary corporate structure, which would allow income earned and taxed in the PRC to be distributed in British Columbia as exempt surplus dividends. There was no discussion about transferring any interest in a Chinese company in a way that would minimize capital gains tax. Bob was not advised of the existence of LABest. Bob was not asked to provide information about capital gains tax issues; the brief discussion focused solely on a tax-efficient corporate structure for distribution of income.
[36] When the parties met in August 2003, Bob was surprised by the steps Mr. Zhang had taken. He had set up a corporate structure which would not accomplish the intended object. The focus of their discussion must have been on salvaging the structure. As both men stated, Bob was skeptical this could be done. The discussion did not focus on the tax-efficient transfer of Mr. Zhang’s interest in LABest; it focused on correcting the corporate structure to enable revenue to be received tax-free in this country. Bob did raise the possibility that Mr. Zhang may have to pay capital gains tax if the interest in LABest could be transferred to Beamtech. Bob asked Mr. Zhang if he wanted to explore the possibility of doing a s. 85 rollover but Mr. Zhang declined. He did not want to spend the money to explore that possibility. Mr. Zhang’s concern was not the tax consequences of the transfer; his focus was on setting up the corporate structure to facilitate distribution of LABest’s revenue in Canada in a tax-efficient manner. In other words, his specific intent was to establish the appropriate corporate structure for that purpose.
[37] The events that took place following the August meeting serve to confirm this conclusion. In order to transfer his interest in LABest to Beamtech, Mr. Zhang had to get the approval of the Chinese government. That approval would establish the transfer price. Mr. Zhang made no enquiries of Bob as to how the transaction needed to be structured to obtain the approval of the Chinese government. He determined how that could be done in the PRC without concern about the tax treatment of the transaction by Canadian authorities. The idea to transfer his interest for cash was his, or derived from advice he received in the PRC, and he prepared or arranged for the preparation of the Agreement without concern for Canadian tax consequences.
[38] I infer from these steps that the object of the transaction was consistent with the original object: to set up a structure which would permit the transfer of his interest in LABest to a British Columbia company and would facilitate receipt of the LABest revenue in Canada in a tax-efficient way. In other words, when the Agreement was entered into, Mr. Zhang was focused on two things. First, the clearly defined object was to create the corporate structure whereby LABest would be a subsidiary of Beamtech. The second focus was on establishing the structure in a manner that was acceptable to the Chinese government. In order to do this, Mr. Zhang prepared the Agreement and completed the transaction. There is no evidence before the court that the Chinese authorities would have approved the transfer, had it been done by way of a share transaction for a different value than what was approved.
[39] In these circumstances, it is not possible to say that the parties to the Agreement had a clearly defined common intention to limit the capital gains tax that might be payable on the transfer of Mr. Zhang’s interest to Beamtech. To use the language of the Ontario Court of Appeal in Juliar, here, the true agreement between the parties was the acquisition of Mr. Zhang’s interest in LABest by Beamtech in a manner that would allow for the distribution of LABest’s income in British Columbia on a basis which attracted the minimum amount of income tax. It was not based on Beamtech acquiring the interest in LABest in a manner which would not attract immediate liability for capital gains tax. That was a secondary concern and one which Mr. Zhang asked Bob not to investigate. He did not seek assistance regarding the capital gains issue until long after the transaction concluded when the CRA took the position that he owed tax as a result of a capital gain.
As a result the petition was dismissed, with costs:
[39] In these circumstances, it is not possible to say that the parties to the Agreement had a clearly defined common intention to limit the capital gains tax that might be payable on the transfer of Mr. Zhang’s interest to Beamtech. To use the language of the Ontario Court of Appeal in Juliar, here, the true agreement between the parties was the acquisition of Mr. Zhang’s interest in LABest by Beamtech in a manner that would allow for the distribution of LABest’s income in British Columbia on a basis which attracted the minimum amount of income tax. It was not based on Beamtech acquiring the interest in LABest in a manner which would not attract immediate liability for capital gains tax. That was a secondary concern and one which Mr. Zhang asked Bob not to investigate. He did not seek assistance regarding the capital gains issue until long after the transaction concluded when the CRA took the position that he owed tax as a result of a capital gain.
[40] To test the conclusion I have arrived at, it is appropriate to consider whether there would be an injustice, unfairness or unconscionableness in “leaving a mistake in a disposition uncorrected”. The question is to be examined by looking, with an “intense focus” at the “mistake” “in the round” and examining “its degree of centrality to the transaction in question”: Kennedy & Ors v. Kennedy & Ors. When that is done, it is evident that there is no unfairness or injustice in refusing to grant rectification in this case. There are a number of reasons for this:
a) The “mistake”, being the unfavourable tax consequence, is not something that Mr. Zhang ever saw fit to actively investigate. He was not prepared to pay to obtain advice on structuring the transaction. It may be that he did not think it worthwhile to do so because the Chinese authorities would make their decision on the transaction without any consideration of what a Canadian tax consultant might recommend.
b) To the extent that the Agreement contained a mistake, it was not an active mistake as in Juliar. Here, Bob gave no advice that was incorrect. Bob was provided with little information by Mr. Zhang because the latter did not want to incur expenses. While Mr. Zhang thought that the fair market value of his interest in LABest was equal to his investment in the company, this was an uninformed view. He did not attempt to value his interest or his current revenue stream. He failed to take any reasonable steps to value his interest in LABest. None of the cases suggest that a failure to make any proper inquiry can be the basis for rectification.
c) When the “mistake” is considered in the context of all of the facts, it is evident that the transaction, which proceeded in accordance with the terms of the Agreement, actually accomplished the two things it was supposed to do: it created the structure which enabled the LABest revenue to be received tax-free in British Columbia; and the Chinese government approved the transaction.
[41] The final reason for rejecting Mr. Zhang’s position is that the rectification sought by the petitioners is aimed at a wholly distinct kind of tax avoidance which was not specifically contemplated at the time of formation of the Agreement. Mr. Zhang and Beamtech were focusing on the tax which might be payable on directing a stream of revenue from LABest to Beamtech in British Columbia. The Agreement successfully put in place the structure which allowed the parties to minimize tax on that revenue stream. The fact that the structure could have been set up in a different way to minimize tax on transfer of Mr. Zhang’s interest to Beamtech is “a different kind of tax avoidance” which was not specifically contemplated when Mr. Zhang and Beamtech entered into the Agreement. Rectification should not be granted when the parties are seeking to rewrite history after the fact.
Comment: While this decision refers to Re Pallen Trust it seems to run contrary to the spirit, if not the letter, of that decision of the British Columbia Court of Appeal. Subsection 85(1) rollovers are not a form of “tax avoidance”; they are devices that are at the core of how small and medium-sized Canadian businesses function and they have operated with the blessing of CRA (and its predecessors) for decades. Mr. Zhang was caught in an odd situation. He had formed LABest roughly 18 months previously and there is nothing in this decision that explains how it tripled in value in the interim. Moreover he was facing a situation where the Chinese government had an absolute control over the transfer price of the LABest shares. He was like a deer in the headlights. This seems to be the type of transaction rectification was designed to remedy; implicitly castigating Mr. Zhang for pursuing “a different kind of tax avoidance” seems to set back the jurisprudence in this area for no good reason.