Re Pallen Trust – BCSCt: Rectification granted where attribution-based trust tax plan based on mistake of law

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Re:  Pallen Trust[1] (February 27, 2014) was a decision of the Supreme Court of British Columbia on a rectification application.  The applicant Pallen Trust (the “Trust) had been created in 2007 as part of a tax plan based on what subsequently turned out to be an incorrect understanding of the operation of the attribution rule under subsection 75(2) of the Income Tax Act:[2]

[6]             The plan is dated December 14, 2007 and addressed to Mr. Hagan (the “Plan”).  The Plan involved various steps, including:

(a)            the creation of two new corporations, D.W. Pallen Holdings Ltd. (“Pallen Holdings”) and DWP Holdings Ltd., both of which would be owned by Mr. Pallen.

(b)            the creation of Tonn Holdings Ltd. to be owned and held by Tammy Tonn, Mr. Pallen’s common law spouse.

(c)            the creation of a discretionary trust that would be called the Pallen Trust.  Mr. Pallen and Ms. Tonn would be the trustees.  The beneficiaries would be Pallen Holdings and Tonn Holdings.  The trust deed would permit the trustees to add other persons as beneficiaries.

(d)            DWP Holdings would then be amalgamated with Integrated into one company under the name Integrated Pest Supplies Ltd. (“New Integrated”).

(e)            Upon amalgamation, Mr. Pallen would be issued 100 Class A voting common shares of New Integrated, which shares were entitled to dividends at the direction of New Integrated’s sole director, Mr. Pallen.

(f)              The shares of New Integrated would then be sold to Pallen Holdings Ltd. in exchange for 99 shares of Pallen Holdings.  This sale would be tax deferred under section 85(1) of the ITA.

(g)            Pallen Holdings would pay $100 to New Integrated to subscribe for 100 Class D shares.  The amount paid would be fair market value.  The Class D shares would be entitled to dividends at the discretion of Mr. Pallen as New Integrated’s director.

(h)            Pallen Holdings would sell its 100 Class D shares to the Trust for $100.  The Trust would pay for those shares with $100 borrowed from Pallen Holdings.

(i)              New Integrated would declare a dividend of $10,000 on its Class D shares and pay the amount in cash to the Trust.

(j)              The Trust would then use $101 of the dividend to repay the loan from Pallen Holdings, with interest, invested $5,000 in a term deposit and loan the remaining $4,899 to Pallen Holdings, who in turn would re-lend it to New Integrated.

[7]             The Plan was predicated on an understanding that s. 75(2) would apply no matter how property was transferred to the trust, whether it was merely contributed for free or sold to the trust at fair market value.  The Trust would not be taxable on the dividends it received on the Class D shares.

[8]             Mr. Pallen deposed that he “retained Hagan to advise Tammy and me on the creation and implantation [sic] of the Plan to allow [Integrated] to protect its assets from potential creditors, while at the same time minimizing or eliminating any income tax payable as a result of implementing the Plan.”

[9]             He deposed that “I understood that [the Plan] would result in the Dividends being paid to the Trust without any tax being payable on the Dividends.  That was a critical part of the Plan; I would not have carried out the Plan if the Trust had had to pay tax at the highest rate on the Dividends.”

In 2008 the Trust received dividends in excess of $2 million which it did not include in its income.  In 2011 the Tax Court decided in the Sommerer case that subsection 75(2) did not apply where there was a transfer at fair market value.  This ultimately led to CRA assessing the trust to include those dividends:

[20]         In 2011, the Tax Court of Canada handed down Sommerer v. Her Majesty the Queen, 2011 TCC 212, aff’d 2012 FCA 207.  It held that s. 75(2) does not apply when property is sold to a trust at fair market value.

[21]         The implication for the Trust was that s. 75(2) would not apply to deem the Trust’s dividends to have been paid to New Integrated.  This meant that the Trust would be taxed at the highest possible rate on the dividends.

[24]         As a result of the Sommerer decision Mr. Eugenio [Aggressive Tax Planning Auditor] wrote that s. 75(2) did not apply to the Class D shares because Pallen Holdings sold the Class D shares to the Trust at fair market value.  Accordingly, the dividends would be included as taxable income for the Trust.  This amount was determined to be $2,187,500 for 2008.  CRA’s proposed reassessment would lead to a tax liability for the Trust of $552,678 plus interest at prime plus 4% compounded daily, from April 1, 2009 to the date of payment.

[25]         As a result, this application to rescind was filed.

The court first set out its understanding of the relevant test for rectification and the positions of the parties:

[33]         The court in Pitt [3] stated at para. 122:

…I can see no reason why a mistake of law which is basic to the transaction (but is not a mistake as to the transaction’s legal character or nature) should not also be included, even though such cases would probably be rare.  If the Gibbon v Mitchell test is further widened in that way it is questionable whether it adds anything significant to the Ogilvie v Littleboy test.  I would provisionally conclude that the true requirement is simply for there to be a causative mistake of sufficient gravity; and, as additional guidance to judges in finding and evaluating the facts of any particular case, that the test will normally be satisfied only when there is a mistake either as to the legal character or nature of a transaction, or as to some matter of fact or law which is basic to the transaction.  [emphasis added]

[34]         In summary, the test as set out in Pitt is that a court may rescind a voluntary disposition where it is found that it a mistake of sufficient causative gravity was made that would make it unconscionable, unjust or unfair to leave the mistake uncorrected.

[35]         The parties in the case at bar take different positions on the applicability of Pitt to this case.  The Crown argues that the current applicable law on rescission of a voluntary disposition for mistake is the law from Gibbon, and that the alleged mistake in this case must be assessed to determine whether it was a mistake as to the transaction’s effect (for which rescission could be granted) or the transaction’s consequences (in which case there could be no rescission).  The Crown argues that, on the basis of this law, rescission should not be granted in this case as any alleged misunderstanding by those who participated in the design and implementation of the plan was merely as to consequences or the advantages to be gained by entering the transactions and not to the effect of the transactions themselves.

[36]         The Crown submits that the parties entered into the transactions in accordance with the plan proposed by MNP and that the creation of the Trust and related parties, and the payment of the dividends, are the legal effects of the transactions themselves.  The taxability of the dividend in the Trust’s income is only a consequence of the Plan.  It is further argued that a taxpayer should not be permitted to go back and forth in arranging their affairs when a taxpayer is faced with a bill that they do not want to pay.

[43]         The analysis in Pitt is persuasive.  In my view, the approach set out in Pitt for determining whether a mistake was made that can give rise to rescission warrants adoption and is applicable to this case.

The court concluded that the general understanding in the tax community prior to the Sommerer decision was that subsection 75(2) applied to fair market value transactions:

[52]         However, the uncontroverted evidence is that prior to the Sommerer decision, the general understanding of tax professionals in Canada was contrary to the position that if the condition of s. 75(2) were met, then the fact that property was sold to the trust at fair market value rather than merely donated to the trust was irrelevant to its operation did not apply to the dividends paid to the Trust.  This general understanding was also in line with that of CRA.  The various interpretation bulletins issued by CRA, which I recognize are non-binding and certainly are not law, and the cross-examination of Mr. Eugenio on his affidavit demonstrates that this was so:

Q         From at least 1994 to November of 2010, the CRA’s consistent position and the general understanding of the tax community as a whole was that 75(2) continues to apply, assuming its other conditions are met, even if the property is transferred to the trust under a sale at fair market value; is that a fair statement?

A          Yes, it is.

As a result the court concluded that a grant of rectification was in order:

[57]         In my view, the circumstances warrant the relief sought by the petitioners.  The tax implications were basic to the transaction, there was clearly a causative mistake, the gravity of the mistake was significant and there is no prejudice to a third party affected by the Plan.  The monies remain within the entities and remain subject to taxation.  A key determinant in this case is the common general understanding as to the operation of s. 75(2) by income tax professionals and CRA as well as my finding that CRA would not have sought to reassess the Trust prior to Sommerer.  This aspect of the case in my view is what takes the case into the zone of unfairness.  While there was an aspect of risk in the Plan, given the common understanding as to the operation of s. 75(2), I do not see the assumption of risk in this case as a sufficient factor to refuse the relief sought.  Had the understanding been less certain, the assumption of risk taking would have negatively affected the question of fairness.


[58]         The dividend declarations are rescinded.

[1] 2014 BCSC 305.

[2] R.S.C. 1985, c. 1 (5th Supp.).

[3] Pitt v. Commissioners for Her Majesty’s Revenue and Customs, [2013] UKSC 26.