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The Globe and Mail

How an honest mistake beat a $6-million tax bill

Some mistakes can be costly. Consider the story of Andrew Espey from Jackson, Minn. According to KEYC-TV, Mr. Espey was fined $2,000 (U.S.) and sentenced to 90 days in jail for improperly shingling his house (he affixed the new shingles without first removing the old ones). I just hope that same building inspector doesn't show up at my place to examine the poor job I did of hanging our new screen door.

While a home improvement faux pas can be bad enough, other mistakes – particularly tax mistakes – can cost even more. How about $6-million more? Today I want to share the story of siblings who found that they owed the taxman that much. The good news? The tax bill was the result of a mistake made by these siblings, and the court was sympathetic to them. This could be good news for other taxpayers.

The story

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Ashok and Saroj Arora are siblings who owned and operated a business by the name of Stone's Jewellery Ltd. In 1996, Stone's entered into an agreement to purchase a parcel of land in Springbank, Alta., for $500,000. The closing date was delayed until 2004 at which time the property was worth about $4-million. The Aroras were advised at the time of closing to register the property in their personal names rather than in the name of Stone's in order to protect the property from potential creditors of the business. The advice they received was that this transaction would be tax-free.

Then, in 2006, the Aroras transferred the property to a wholly owned corporation on the advice of their advisers. The property was worth about $6-million at the time of this transfer, and the transfer was to be treated as a tax-free transfer (by taking advantage of section 85 of our Income Tax Act which allows certain transfers to a corporation to be made tax-free).

Here's the problem: The Canada Revenue Agency argued that there were two taxable transfers here: the one in 2004 when the Aroras took possession of the property personally (CRA called this a taxable transfer by Stone's to the Aroras), and again in 2006 when the property was transferred to the new corporation (CRA argued that section 85 was not applicable to the transfer since this was "land inventory," or land held for resale). CRA also argued there was a taxable shareholder benefit that arose when the land was placed in the names of the Aroras. The total tax bill owing by Stone's and the Aroras was about $6-million. This issue ended up in court (Stone's Jewellery Ltd. v. Arora, 2009 ABQB 656) and the Court of Queen's Bench of Alberta rendered a decision that may help other taxpayers.

The decision

In their application, the taxpayers argued that they were entitled to relief based on three different principles. One of these was the principle, or doctrine, of mistake. The court summarized the doctrine of common law mistake by saying that a mistake must be fundamental, going to the identity of the contract, where the contracting party obtained something other than what was intended. This should be distinguished from a situation where the contracting party did receive what was intended but it turned out to be less valuable than expected. In this latter case, the mistake is not considered to be fundamental. In a case where a mistake is fundamental, the contract can be rendered by the court to be void from the very beginning.

It shouldn't be surprising that CRA opposed the taxpayers' application, arguing that (1) other legal remedies were available and (2) the parties should not be allowed to undertake retroactive tax planning.

The court dealt with the 2006 transfer first. Although the court acknowledged that it didn't have the power to order that the transfer take place under section 85 of the Income Tax Act, it did say that all of the parties held the mistaken belief that the transaction could be done on a tax-free basis – a fundamental mistake that went to the root of the contract. The court said the transfer was therefore void from the beginning.

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As for the 2004 transfer, the court said that there was a common mistaken belief by the parties, based on the advice of their advisers, that there would be no negative tax consequences to registering the property in their personal names. This too was a fundamental mistake that went to the essence of the agreement, and the transaction was rendered void from the outset.

This is, of course, good news for taxpayers who may be in a similar situation where an honest and fundamental mistake results in taxes owing.

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About the Author
Author and founder of WaterStreet Family Offices

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author and founder of WaterStreet Family Offices. More

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