A drafting mistake in an agreement can result in significant and unintended tax consequences. In the recent case of Baytex Energy Ltd. v. Canada (Attorney General) (Baytex), the Court of Queen's Bench of Alberta (Court) considered whether the equitable remedy of rectification was available to address mistakes in certain written agreements that, if unchanged, could have resulted in tax payable on additional income of over C$528-million. Baytex Energy Ltd. (BEL), Baytex Energy Corp. (BEC) and Baytex Energy Partnership (collectively the Applicants) obtained a rectification order from the Court to ensure that the written agreements fully and properly reflected the clear intention of the Applicants.
The Applicants were originally subject to a complicated royalty regime under the Income Tax Act (Canada) (ITA) that ended on December 31, 2006 (Pre-2007 Royalty Regime). Very generally, under the Pre-2007 Royalty Regime, an oil and gas producer was required to include the Crown's share of production from an oil and gas well in the producer's income for tax purposes (referred to by the court as "phantom income" because the producer never earned such income and was denied any deduction for royalties or freehold mineral taxes paid to the Crown). However, the phantom income could be transferred from the producer to another party that was entitled to receive the net cash flow from production.
BEL entered into a written net profits interest agreement (NPI Agreement) with Baytex Energy Trust (the Trust, being the predecessor to BEC) to address the Pre-2007 Royalty Regime. In simplified terms, the NPI Agreement provided that:
- BEL would pay to the Trust an amount equal to 99 per cent of BEL's net cash flow and income from its oil and gas operations;
- the Trust would reimburse BEL 99 per cent of all non-deductible Crown royalties; and
- these amounts could be set-off.
These transactions were completed each month, thereby allowing the Trust to distribute cash received from BEL to its unitholders as a monthly distribution. BEL explained the arrangement, and the intention behind it, in an information circular.
The Applicants' Intention & Mistakes in Documents
At the time the NPI Agreement was entered into and while the Pre-2007 Royalty Regime applied, BEL intended to transfer 99 per cent of its net cash flow and income from oil and gas operations to the Trust for monthly distributions by the Trust. The Trust, in turn, intended to reimburse BEL 99 per cent of all non-deductible Crown royalties. Moreover, it was intended that BEL would also transfer 99 per cent of the phantom income to the Trust, which was to be set-off against the non-deductible Crown royalties by offsetting journal entries. In addition, BEL and the Trust were aware that the Pre-2007 Royalty Regime was going to be completely phased out at the end of 2006 and also intended to cease the offsetting transfers of the phantom income and reimbursements effective January 1, 2007, as there was no business reason to engage in such transactions after that date.
However, the NPI Agreement failed to fully document the Applicants' specific intention because it did not expressly provide that: (i) BEL would transfer 99 per cent of the phantom income to the Trust while the Pre-2007 Royalty Regime was in effect, and (ii) the monthly transfers of the phantom income and related reimbursements (and the routine administrative practice of making offsetting journal entries) would end with the cessation of the Pre-2007 Royalty Regime.
Indeed, BEL and the Trust mistakenly continued the practice of making offsetting journal entries well after the end of the Pre-2007 Royalty Regime. Once this was discovered in 2008, the parties amended the NPI Agreement to be consistent with their practice (2008 Amendments) after being informed by their tax advisers that the offsetting entries would have no adverse tax consequences following the elimination of the Pre-2007 Royalty Regime. The Canada Revenue Agency (CRA) took a different view, concluding that the Trust earned C$528-million of income.
Rectification generally allows parties to fix a written contract where the parties agreed on its terms but by mistake wrote them down incorrectly; i.e., the contract must be shown to not accord with the parties' true intention driving its formation. Accordingly, Justice J.A. Strekaf held that the Applicants had to overcome three "hurdles":
- the existence and content of a prior oral agreement;
- that the written document does not correspond with the prior oral agreement; and
- the precise form in which the written instrument can be made to express the prior intention.
In considering the first hurdle, Justice Strekaf held that there was "uncontroverted evidence" (including from BEL's information circular and BEC's chief financial officer) of a prior oral agreement that reflected the Applicants' clear intention to transfer 99 per cent of the net cash flow and income (including 99 per cent of the phantom income) to the Trust (with an offsetting adjustment) prior to January 1, 2007, and to stop the transfer of the phantom income after that date. Simply stated, the Applicants were able to prove that their original and specific intention was to navigate the Pre-2007 Royalty Regime to avoid any adverse tax consequences and to cease the practice of offsetting journal entries post-2006.
In respect of the second hurdle, the Court accepted that none of the following was in accordance with the Applicants' intention:
- the NPI Agreement;
- the continuation of the administrative practice of making offsetting journal entries for the transfers of the phantom income and reimbursements after the Pre-2007 Royalty Regime ended; and
- the 2008 Amendments, which confirmed that practice based on the professional advisers' erroneous advice that the entries would have no adverse tax consequences.
Justice Strekaf rejected the CRA's submission that the 2008 Amendments recorded the Applicants' intention perfectly because the Applicants "consciously agreed" that they would document their administrative practice of making offsetting journal entries. Justice Strekaf stated: "This situation is analogous to a land transaction in which the parties think that the legal description in their executed agreement might be incorrect and ask a surveyor to provide them with the correct legal description. If the surveyor then provides them with an incorrect legal description and they amend the agreement accordingly, should they be precluded from seeking rectification if it becomes apparent that the surveyor was wrong?"
The third hurdle was not in dispute in this case. The Court concluded that the requirements for rectification had been satisfied.
Justice Strekaf also requested that the parties address whether rescission might be available to cancel the 2008 Amendments. Rescission voids a contract. The Court decided that while the 2008 Amendments were intended to clarify the NPI Agreement and avoid adverse tax consequences, they had the opposite effect. This was deemed to be a fundamental mistake that went to the root of the contract and therefore rescission was also an available remedy.
There are at least two takeaways or reminders from the Baytex case.
First, in deciding whether to grant a rectification request, a court will closely examine the evidence of the intention of the parties. In Baytex, Justice Strekaf accepted the "uncontroverted evidence" of the Applicants' original and specific intention to navigate the complex Pre-2007 Royalty Regime, allowing the Trust to make monthly distributions to its unitholders.
Second, where parties have intended specific tax consequences, but failed to properly record the terms of their agreement, rectification can be available regardless that the specific result sought affects tax obligations. In other words, rectification of an agreement is properly used to prevent unexpected and accidental windfalls to taxation authorities. At the same time, courts have warned that "the intent of avoiding tax is not the same thing as the assumption that a tax liability would not be incurred" (see Graymar Equipment (2008) Inc. v. Canada (Attorney General)). Generally, rectification cannot apply where the parties had no intention to avoid the tax consequences at issue and cannot be used to engage in retroactive tax planning. This could occur where there was no intention to avoid a tax at the time the agreement was entered into, and the parties seek rectification to, using the benefit of hindsight, ameliorate their tax situation and either avoid adverse tax consequences or take advantage of beneficial tax planning opportunities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.