T. Eaton Co. v. R., 99 DTC 5178, [1999] 2 CTC 380 (FCA)

Robertson J.A.:

The appellant taxpayer, a well-known Canadian retail merchant, entered into a long-term lease for retail space in the Oshawa Shopping Centre. The year was 1955. Under the terms of that lease, the landlord agreed to a “par- ticipation clause” entitling the taxpayer to 20% of the shopping centre’s annual net profits over the duration of the lease term and any renewal period. No participation income was received until 1981. From 1981 to 1989, the taxpayer received and reported nearly $3.9 million as income under the participation clause. In 1989, the landlord offered to “buy-out” the participation clause for $9.25 million. The offer was accepted, and the taxpayer reported this amount as proceeds of the disposition of capital property, with an acquisition cost of nil. The Minister of National Revenue reassessed the appellant on the ground that the entire amount constituted income from a business and, therefore, the taxpayer was not entitled to claim a capital gain equal to two-thirds of the $9.25 million for the 1989 taxation year.

The Tax Court Judge agreed with the Minister’s characterization of the transaction having particular regard to two decisions. The first is London & Thames Haven Oil Wharves Ltd. v. Attwooll (Inspector of Taxes)', [1] decided by the English Court of Appeal. The second is Canadian National Railway v. R.2, [2] a decision of the trial division of this Court. One of the issues to be decided in this case is whether those decisions are determinative of the outcome of this appeal. In my respectful view, they are not. There is no single bright-line rule for determining whether proceeds will be deemed to have been received on capital as opposed to income account.

For the reasons which follow, I conclude that the proceeds arising from the cancellation of the participation clause are a capital receipt. The fact that the clause is an integral component of what is clearly a capital asset, and that cancellation of that clause impacts significantly on the value of a leasehold estate in land are, in my respectful opinion, overriding considerations. Specifically, they displace the general rule that compensation which serves as a substitute for the surrender of future profits is on revenue account. The Minister’s contention that the participation clause is akin to either an ordinary trade contract or a tenant inducement payment cannot withstand close scrutiny.

The taxpayer advances two arguments in support of its position. The first is ingenious, but clearly untenable. It is based on two premises, the second of which is fatally flawed. The first premise is that the cancellation of the participation clause constitutes a “disposition” of property within the meaning of section 54(c) of the Income Tax Act. That term is defined to include any transaction by which “any debt owing to a taxpayer or any other right of a taxpayer to receive an amount is settled or cancelled”. Subsection 248(1) goes on to define “property” as including “a right of any kind whatever”. In light of these provisions, I have no objection to the first premise [3] .

The second premise proffered by the taxpayer is that all property is either capital property or inventory. Correlatively, inventory is said to include property held for sale as an adventure in the nature of trade. In support of this premise, the taxpayer invokes the following passage from the Supreme Court’s decision in Friesen v. 7?. [4] :

[t]he second problem with the interpretation proposed by the respondent is that it is inconsistent with the basic division in the Income Tax Act between business income and capital gain. As discussed above, subdivision b of Division B of the Act deals with business and property income and subdivision c of Division B deals with capital gains. The Act defines two types of property, one of which applies to each of these sources of revenue. Capital property (as defined in s. 54(b)) creates a capital gain or loss upon disposition. Inventory is property the cost or value of which is relevant to the computation of business income. The Act thus creates a simple system which recognizes only two broad categories of property. The characterization of an item of property as inventory or capital property is based primarily on the type of income that the property will produce. [emphasis added. I

Relying on the above passage, the taxpayer postulates that a particular piece of property becomes either inventory or capital property in the hands of a taxpayer at the time of its original purchase or acquisition. Moreover, it is submitted that if property does not qualify as inventory, which is said to include an adventure in the nature of trade, it is by necessity a capital item. Finally, the taxpayer submits that this Court should decide the issue by resorting to the various factors to be examined when deciding whether property has been held as an investment or an adventure in the nature of trade. Having regard to those factors, it is argued that the property in question was not held for resale and, therefore, its disposition was on capital account. As stated at the outset, the problem with this line of reasoning is that the second premise is fatally flawed.

In my respectful view, the Tax Court Judge did not err in concluding that Friesen is inapplicable to the facts in issue. I agree that that case dealt with a “timing” issue with respect to the recognition of gains and losses from an adventure in the nature of trade. Nothing that was decided in Friesen, in my opinion, detracts from the following understanding of the legal framework imposed by the Income Tax Act.

It is trite law that a capital gain or loss is a gain or loss arising from a disposition of property. According to section 54(b) of the Act, the disposition of property which gives rise to a capital loss or gain is deemed to be capital property. That provision reads as follows:

54(b) “Capital property”. - “capital property” of a taxpayer means

(i) any depreciable property of the taxpayer, and

(ii) any property (other than depreciable property), any gain or loss from the disposition of which would, if the property were disposed of, be a capital gain or a capital loss, as the case may be, of the taxpayer;”

Read in isolation, section 54(b) does not tell us which kinds of property constitute capital property. Section 39, however, specifies those which do not qualify for capital gains treatment. Excluded property is not capital property. For our purposes, the relevant provisions are paragraphs 39(1 )(a)(i) and (b)(i) which read as follows:

39(1)(a)a taxpayer's capital gain for a taxation year from the disposition of any

property is his gain for the year determined under this subdivision (to the extent of the amount thereof that would not, if section 3 were read without reference to the expression “other than a taxable capital gain from the disposition of a property” in paragraph (a) thereof and without reference to paragraph (b) thereof, be included in computing his income for the year or any other taxation year) ir rom the disposition of any property of the taxpayer other than e. . eligible capital property!

(b) a taxpayer's capital loss for a taxation year from the disposition of any property is his loss for the year determined under this subdivision (to the extent of the amount thereof that would not, if section 3 were read in the manner described in paragraph (a) and without reference to the expression “or his allowable business investment loss for the year” in paragraph 3(d), be deductible in computing his income for the year or any other taxation year) from the disposition of any property of the taxpayer other than [e.g., depreciable property] [emphasis added]

The above provisions have the effect of excluding from capital gains treatment proceeds realized from a disposition of property which gives rise to ordinary income, for example, income from business. Those sections also refer expressly to certain kinds of property which are to be excluded from the concept of capital property. What the legislation does not tell us is how one goes about distinguishing between dispositions of property which are not expressly referred to and otherwise excluded from the category of capital property. Thus, the characterization of a gain or loss as being on capital or income account is determined by reference to common law principles or rules. I should add that not every receipt must fall within either the capital or income category. For example, a “windfall” is not regarded as income or capital. [5]

Despite the development of various common law rules for assessing whether a gain or loss should be on capital or income account, litigation persists because of the tax advantage accruing to dispositions of capital property. For ease of reference, the case law can be conveniently grouped into a number of discrete categories. The category with the largest number of cases concerns adventures in the nature of trade. Today, the outcome of such cases is determined largely by isolating key factual considerations and then applying legal judgment. Other categories include foreign exchange transactions, cases involving the forgiveness of debts not regulated by section 80 of the Act, and the receipt of “subsidies” not caught by paragraph 12(1)(x).

Two other closely-related categories are of particular relevance to this appeal. One involves the receipt of damage awards or settlement payments intended as compensation for the loss of, or damage to, a capital asset, together with any consequential loss of profits, caused by the negligence of a third party. The second involves compensation for breach or early termination of a contract, which may include an amount for lost profits. The present case is slightly different in that it involves the mutual cancellation of a contractual right, as opposed to the termination of the entire contract.

One of the questions I must address is whether there is any rule of law which precludes the taxpayer from claiming a capital gain on the $9.25 million which it received for the cancellation of the participation clause. In my respectful view, none of the cases relied on by the Tax Court Judge or the Minister imposes such a result. As a starting point, I will return to the two cases on which much of the argument focused.

The first case invoked by the Minister and Tax Court Judge is London & Thames Haven. The following passage from Lord Diplock’s judgment is invariably cited in cases similar to this one [6] :

[w]here, pursuant to a legal right, a trader receives from another person compensation for the trader’s failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising on any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as the sum of money would have been treated if it had been received instead of the compensation.

The above passage reflects the view that compensation for a failure to receive monies should be taxed in the manner in which the monies would have been taxed if received (the “surrogatum rule”). In essence, the “surro- gatum” rule seeks to characterize ambiguous receipts by reference to income holes. Thus, for example, it is generally accepted that compensation flowing from the breach of a trade contract should be taxed as if it had been received in the ordinary course of business; that is to say, as business income. On the other hand, if compensation is paid for the loss of a capital item, such compensation should be taxed on capital account. As a general proposition, the surrogatum rule makes good sense. The issue of how it is to be applied in the present case is addressed below.

An interesting aspect of London & Thames Haven is that the proposition outlined above was not dispositive with respect to that appeal. The taxpayer was the owner of a wharf damaged through the negligence of a third party. Compensation was paid for the cost of repairs, as well as for profits lost during the time that the wharf was unavailable for use. Only the compensation relating to lost profits was in issue, since the parties agreed that compensation relating to the repairs was on capital account. The trial judge had held that the compensation relating to lost profits should be accorded the same tax treatment as compensation for the repairs. In reaching that conclusion, he relied on a series of English cases which stood for the proposition that compensation paid for an income-producing asset which had been permanently destroyed was on capital account, even if part of the compensation related to lost profits. The trial judge reasoned that no distinction should be drawn between partially damaged property and that which is completely destroyed, notwithstanding that part of the compensation is attributable to lost profits.

On appeal, the English Court of Appeal in London & Thames Haven retained the distinction between compensation paid for property which is completely destroyed and that which undergoes “partial injury”, so far as lost profits are concerned. Thus, if an income-producing asset is partially damaged, then compensation for lost profits is treated as a trading receipt. However, if the asset is completely destroyed, then the entire compensation payment qualifies as a capital receipt since an asset’s profitability is one element to be considered in assessing the asset’s capital value. This latter point supports my view that the compensation in question is on capital account. Finally, the Court of Appeal went on to clarify that the entire business of the taxpayer did not have to be lost before compensation for lost profits would be regarded as having been received on capital account. It was deemed sufficient if the losses related to part of a taxpayer’s business, such as occurs with the loss of an income-producing asset.

In summary, London & Thames Haven stands for the proposition that compensation paid for the destruction of a capital asset will be on capital account even if some of the compensation relates to lost profits [7] . If compensation flows from the partial destruction of that capital asset, then any amount received in regard to lost profits is taxable as a trading receipt, while compensation relating solely to the damaged property is a capital receipt. At the end of the day, however, none of this is dispositive of the present appeal.

Both the Minister and Tax Court Judge relied heavily on Canadian National, supra. In my respectful opinion, that decision cannot be read without reference to Pe Ben Industries Co. v. R.®, [8] a case decided on similar facts and contemporaneously with Canadian National. Both cases were decided by Justice Strayer (as he then was). I shall deal with each case in turn.

In Canadian National, the taxpayer had received $1.9 million as compensation for the early termination of a transportation contract. The taxpayer reported the amount as capital, but the Minister assessed it as income. Justice Strayer agreed with the Minister’s assessment, placing particular re- liance on Lord Russell’s judgment in Inland Revenue Commissioners vy. Fleming & Co. (Machinery) Ltd.?: [9]

[w]hen the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient’s profit-making apparatus, involving the serious dislocation of the normal commercial organization and resulting perhaps in the cutting down of the staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilisation of a capital asset and is therefore a capital and not a revenue receipt.... On the other hand when the benefit surrendered on cancellation does not represent the loss of an enduring asset in circumstances such as those above mentioned — where for example the structure of the recipient’s business is so fashioned as to absorb the shock as one of the normal incidents to be looked for and where it appears that the compensation received is no more than a surrogatum for the future profits surrendered the compensation received is in use to be treated as a revenue receipt and not a capital receipt.

In Fleming, the issue was whether the compensation received for the cancellation of an ordinary trade contract was on income account. The above passage suggests that where the cancellation of a trade contract materially affects a taxpayer’s business operations, compensation paid for the loss of that contract may be deemed to be on capital account. In short, Fleming represents an exception to the general rule regarding trade contracts (the “Fleming exception”). Justice Strayer reasoned that when the transportation contract in question was mutually terminated, no enduring asset in terms of a distinct business or long-term contract had been destroyed or rendered useless, nor did the contract’s cancellation have a crippling effect on the taxpayer’s business. Thus, the taxpayer in Canadian National could not rely on the Fleming exception.

In summary, Canadian National accepts that compensation for lost profits received with respect to a breach or termination of an ordinary trade contract constitutes business income. It does not challenge the principle that compensation received in respect of the loss of a trade contract which is of fundamental significance to the taxpayer’s business may be deemed a capital receipt. This latter principle was decisive in Pe Ben Industries.

In Pe Ben Industries, Justice Strayer held that the compensation received for the breach of a trade contract resulted in the destruction of a distinct part of the taxpayer’s business. The critical factual distinction be- tween Pe Ben Industries and Canadian National is that, in the former case, the taxpayer’s intermodal carrier business consisted of one substantial contract which had been prematurely terminated. However, the transportation contract in Canadian National was simply an ordinary trade contract and its termination was not of critical significance to the taxpayer’s business operations. In summary, it is clear that in appropriate circumstances compensation paid for the cancellation or breach of a trade contract may be a capital receipt. Admittedly, the general rule is that such compensation is on income account.

As Justice Strayer so aptly noted in Canadian National, there is considerable jurisprudence on the question of whether compensation paid pursuant to the termination of a trade contract is capital or income and, to a large extent, each case turns on its own facts. I acknowledge that it would be much simpler to adopt an inflexible rule deeming any compensation received for breach or termination of any trade contract, or even a right thereunder, as business income. But that is not the path chosen by the common law. Nor am I prepared to jettison the existing jurisprudence solely to promote certainty in the law at the expense of flexibility and rationality. This is an appropriate time to turn to the taxpayer’s alternative submission and the Minister’s arguments.

The taxpayer’s alternative submission, as I understand it, is that the participation clause is an integral component of the lease and, therefore, should receive the same tax treatment as the disposition of a leasehold estate in land. For the purposes of this appeal, I am prepared to accept the taxpayer’s characterization of the receipt in question as a capital receipt. However, the Minister advances serious arguments which warrant consideration. Mr. Gill’s comprehensive and cogent Factum can be distilled into two principal submissions on behalf of the Minister. The first is that the compensation received for the cancellation of the participation clause is akin to a tenant inducement payment and, therefore, the proceeds should receive the tax treatment accorded such payments by the Supreme Court in a trilogy of recent cases. [10] The second submission is that the participation clause is akin to an ordinary trade contract and, therefore, any compensation received is on income account. Correlatively, the Minister argues that the exception outlined in Fleming and Pe Ben Industries is inapplicable. I turn first to the tenant inducement analogy.

According to recent Supreme Court jurisprudence, tenant inducement payments must be treated as income by the tenant and as an expense by the landlord in the year in which they were received or paid, respectively. This rule is not absolute. If well-accepted business principles dictate otherwise, then the payments may be treated differently for tax purposes. I accept that the participation clause in question had the effect of inducing the taxpayer to enter into the long-term lease. What I cannot accept is that tenant inducement payments have any application to cases involving the cancellation of a contractual right.

To answer the question before us by invoking the analogy of a tenant inducement payment is to side-step the issue of how tax law deals with cases involving compensation paid for the surrender of a right to future profits. The tenant inducement payment analogy attempts to force us to accept that the participation clause is akin to a trade contract, independent of the lease in which it is found. That argument is addressed more fully below. In my view, the recent trilogy of Supreme Court cases dealing with the tax treatment of tenant inducement payments is not determinative of the issue at hand. Lest there be any doubt, the following represents my understanding of what was decided by the Supreme Court.

In Ikea, supra, the Supreme Court held that the receipt of a tenant inducement payment was on income account because it was an integral element of the taxpayer’s day-to-day operations, and was not linked to a capital purpose. Whether the inducement payment represented a reduction in rent or a payment in consideration of the tenant’s assumption of its various obligations under the lease did not alter the fact that it was an income receipt. The Supreme Court rejected the argument that the payment was a capital receipt simply because it related to the acquisition of a capital asset (the lease). For the purpose of deciding this appeal, I recognize that the compensation received for the buy-out of the participation clause is not a capital receipt simply because that clause is contained within a lease, itself a capital asset. I turn now to the Minister’s second submission.

The Minister’s second submission is that the participation clause is similar to an ordinary trade contract. The Minister adopts the Tax Court Judge’s finding that the participation clause was simply a contractual provision con- tained in the lease and that its cancellation did not have a significant impact on the taxpayer’s business. According to the Tax Court Judge [11]

[w]hat then was the effect of the payment in issue? The appellant argued that the participation clause was part of its leasehold interest; that it should therefore be regarded as capital property and that the disposition should therefore be seen as a disposition of capital property. I disagree. It is wrong, and in any event quite beside the point, to regard the participation clause as part of the estate in land which is conferred on a tenant by a lease. The participation clause is simply a contractual provision contained in a lease. The nature of the document in which the clause happens to have been inserted does not imbue it with any sort of magical status. The cancellation of the participation clause did not affect the appellant’s right under the lease to remain in possession of the Oshawa store. Indeed it was admitted that the cancellation did not have any effect on the operation of the appellant’s retail merchandising business. It is clear that the cancellation of the clause did not affect either the structure of the appellant’s business as a whole or the structure of any component of it. For that reason the case is readily distinguishable from cases such as Glenboig Union Fireclay Co. Ltd. v. C.LR., 12 T.C. 427 Van Den Berghs v. Clark, 19 T.C. 390 and H.A. Roberts Limited v. M.N.R., [1969] C.T.C. 369. [emphasis added]

The Minister asserts that the landlord’s failure to pay under the participation clause would not have entitled the tenant taxpayer to withhold the payment of rent, and that this is evidence that the clause is a contractual arrangement independent of the lease. In effect, the Minister is invoking the common law principle that covenants or obligations in a lease are “independent” of one another, such that a breach does not give rise to the remedial option of termination or forfeiture by either the landlord or the tenant, in order to buttress the argument that the participation clause is akin to a trade or collateral contract. In my respectful opinion, this common law principle is of no assistance to the Minister’s position.

In my view, the landlord’s obligation under the participation clause is as much a part of the lease as the landlord’s obligation to insure against perils or the taxpayer’s obligation to pay rent. Thus, for example, the landlord’s failure to insure the leasehold property does not entitle the tenant to withhold rent. But we would not conclude from this that the obligation to insure is not an integral part of the lease. It is true that, at common law, covenants in a lease are independent of one another, but this does not change the fact that the participation clause was an integral aspect of the lease in question. There is a difference between the concept of the independence of covenants in a lease and the fact that such covenants are an integral part of the obligations assumed by the parties. The independent nature of covenants is only relevant to the remedial options available to the parties under landlord and tenant law when one party has breached his or her obligations. It does not mean that such covenants are severable from the lease itself.

In short, the Minister’s argument that the participation clause is a contractual arrangement independent of the lease is misconceived. Had the taxpayer been in breach of the lease, and the landlord elected to bring the leasing arrangement to an end, the benefits to have been derived under the participation clause would have been forfeited as well. I need not cite legal authorities for these propositions. Common sense dictates that any landlord who agrees to a participation clause is not going to make that clause independent of the leasing contract. If the lease is terminated or the lease term expires, the right to participate in future profits ends as well. This explains why a participation clause is inserted in the lease and not drafted as a collateral contract.

Admittedly, the cancellation of the participation clause is not equivalent to the cancellation of the lease, whereupon the tenant’s leasehold estate is reconveyed to the landlord, as occurred in Westfair Foods Ltd. v. /?. [12] . Both the Minister and Tax Court Judge are correct in maintaining that the participation clause is not part of the leasehold estate conveyed to the taxpayer by the landlord. But that concession does not mean that the participation clause is the equivalent of a “collateral” or “trade” contract, as argued by the Minister and effectively accepted by the Tax Court Judge.

The Minister goes on to maintain that the receipt in issue simply reflects the present-day valuation of a future stream of income receivable by the taxpayer. Accordingly, the Minister submits that a payment made in return for a surrender of the right to future profits must be on revenue account. Essentially, the Minister considers that a participation clause is the equivalent of an ordinary trade contract and, as such, the surrogatum rule applies. Consequently, the $9.25 million received as compensation for the cancellation of the clause should be taxed in the same manner as the proceeds received over the 1981 to 1989 taxation years. The Minister’s argument that the buy-out had no effect on the taxpayer’s normal commercial operations is intended to preclude the taxpayer from benefitting from the Fleming exception outlined earlier. That exception is applicable only if it can be established that the effect of the cancellation had a fundamental impact on the taxpayer’s business.

In this case, the buy-out of the participation clause had no effect upon the taxpayer’s normal business operations. Nor did it affect the taxpayer’s right to remain in possession under the lease. Its termination did not, for example, “cripple” the taxpayer’s profit-making business at the Oshawa Shopping Centre. Thus, I readily concede that the Fleming exception has no application to the present case. But this concession does not end the matter, because I am also of the view that the trade contract analogy is inappropriate.

In my respectful view, the participation clause is not only an integral component of the lease in question, but it also profoundly affects the value of a capital asset, namely, a leasehold estate in land. As stated in London & Thames Haven, an asset’s profitability is an element to be considered in assessing its capital value. In this regard, the participation clause is intimately linked to a capital asset and its value. What the Minister fails to appreciate is that a tenant’s lease is not simply a liability, as was asserted in oral argument. A leasehold interest in land also represents a capital asset, the value of which depends on both the terms of the lease and market conditions. For example, a tenant whose rent obligation is one-half the market rate has a valuable asset which can be sold by way of assignment, subject to any restriction protecting the interests of the landlord. Similarly, a lease which contains a participation clause is of even greater value, particularly if the shopping centre becomes profitable, as in the present case. Otherwise, the landlord would not have been willing to buy-out the clause for $9.25 million.

In my respectful opinion, the buy-out of the participation clause had the obvious effect of diminishing the value of the taxpayer’s capital asset by $9.25 million. That is what the clause was worth to both the landlord and the taxpayer. I see no reason why this Court should not accept that compensation paid for the diminution in value of a leasehold estate is on capital account. The cancellation of the participation clause had as much effect on the value of the leasehold interest as would a fire, which partially destroys the premises. Since compensation for such a loss would be on capital account, the same should hold true for a voluntary loss arising from the can- cellation of a contractual right which forms an integral component of a capital asset.

At the end of the day, there are two sets of prescription lenses that can be used to determine whether compensation for the loss of future profits arising from the cancellation of a participation clause is on income or capital account. Using the Minister’s prescription, the buy-out of the participation clause replaces an income source and is, therefore, an income receipt. According to the taxpayer’s prescription, the buy-out diminishes the value of a capital asset for which compensation must be characterized as a capital receipt. Were it not for the fact that the participation clause in question is an integral component of the lease, the Minister’s prescription would have been the only acceptable one.

I would allow the appeal with costs here and in the court below, set aside the judgment of the Tax Court of Canada dated June 24, 1996 and remit the matter back to the Minister for reassessment on the basis that the $9.25 million was on capital account.

Appeal allowed.