An individual ("Pallen") or his spouse ("Tonn") settled the taxpayer, a family discretionary trust, and transferred his shares of "New Integrated" to a personal holding company ("Pallen Holdings") in exchange for shares under s. 85(1). Pallen Holdings then subscribed $100 for (discretionary dividend) Class D shares of New Integrated, and sold them to the taxpayer for the same amount, which was their fair market value. New Integrated then paid approximately $1.75M in dividends on the Class D shares to the taxpayer, as to which $1.74M was satisfied by issuing a promissory note. Over a year later, New Integrated paid $0.25M to partially repay the promissory note.
The plan was intended to result in s. 75(2) attributing the $1.75M in taxpayer dividend income to Pallen Holdings, which was a beneficiary of the taxpayer, so that such dividends would be received tax-free under s. 112(1). However, following Sommerer, CRA (which viewed the plan as a surplus strip) included the $1.75M of dividends in the taxpayer's income on the grounds that s. 75(2) did not apply to a fair market value sale.
Masahura J granted the taxpayer's application for rescission of the dividends (with the monies apparently to be returned to New Integrated (per para. 56).) It was appropriate to apply Pitt, which allows for rescission of a "voluntary disposition" (such as the dividends) where there is "a mistake of sufficient causative gravity was made that would make it unconscionable, unjust or unfair to leave the mistake uncorrected" (para. 34). The "causative mistake" in this case was a mistake of law regarding s. 75(2) - and this mistake clearly had sufficient gravity given that "the tax implications were basic to the Plan" (para. 50).
After acknowledging the cautionary note in Pitt that rescission should not provide relief for artificial tax avoidance (para. 48), Masuhara J stated (at para. 57):
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.
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