30 October 2003 External T.I. 2003-0031775 - DAMAGES

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: Whether a payment in respect of "damages" is deductible in computing income from the business of the taxpayer.

Position: Question of fact.

Reasons: In light of 65302 BC Ltd. v. HMQ, a review of each specific situation would determine whether the amount is deductible in computing income from a business.

A. Seidel
XXXXXXXXXX (613) 957-2058
2003-003177
October 30, 2003

Dear XXXXXXXXXX:

Re: Deductibility of Payment for Damages

We are writing in response to your letters dated July 17 and September 27, 2003, wherein you requested our comments regarding the deductibility of the payment for "damages" made in settlement of a legal proceeding commenced against you by a plaintiff (the "Plaintiff").

You describe the following sequence of events. You are a physician licensed to practice medicine in XXXXXXXXXX and carried on a medical practice as a walk-in clinic. On XXXXXXXXXX the Plaintiff sought medical treatment at said clinic for a sore throat. The Plaintiff claimed that she was sexually assaulted during the course of the medical examination. The claim was settled before the matter went to court and the Plaintiff received a payment for "damages" in XXXXXXXXXX. You retired from practicing medicine on XXXXXXXXXX. You query whether the amount paid to the Plaintiff will be deductible in computing the income earned from the medical practice.

The particular circumstances in your letter, on which you have asked for our views, relate to a factual situation involving specific taxpayers and completed transactions. As explained in Information Circular 70-6R5, it is not this Directorate's practice to comment on transactions involving specific taxpayers other than in the form of an advance income tax ruling. However, we would point out that advance income tax rulings are not provided in respect of transactions that are substantially completed. Completed transactions are reviewed by the local tax services office.

Although we cannot provide any specific comments with respect to the situation described in your letter, the following general comments may be of assistance.

As stated in paragraph 2 of Interpretation Bulletin IT-467R2 ("IT-467R2"), a payment in settlement of a damages claim to avoid or terminate litigation will be considered "damages", even where there was no admission of any wrongdoing.

Paragraph 5 of IT-467R2 outlines the tests that must be met for a payment for damages to be deductible as a current expense in computing income from a business or property. The tests that must be met include that:

(a) the outlay must have been made for the purpose of gaining or producing income from the business or property,

(b) the outlay must not be on account of capital,

(c) the outlay must not be made for the purpose of gaining or producing exempt income,

(d) the outlay must not be a personal expense, and

(e) the outlay must be reasonable in the circumstances.

Paragraph 18(1)(a) of the Income Tax Act (the "Act") provides that, in computing a taxpayer's income from a business or property, no deduction shall be made in respect of an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property. This is confirmed by the following comment by Iacobucci, J. in 65302 British Columbia Ltd. v. Her Majesty the Queen, 99 DTC 5799 (SCC) (hereinafter referred to as "65302 BC"): "if the taxpayer cannot establish that the fine was in fact incurred for the purpose of gaining or producing income, then the penalty cannot be deducted". Iacobucci, J. goes on to say that "[I]t is conceivable that a breach could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income".

Notwithstanding that a physician may provide medical care in accordance with the ethical standards of the medical profession and in accordance with the fiduciary duty arising from a doctor-patient relationship, situations may arise where an "injured" party may choose to initiate legal proceedings in objection to the medical care they received. As a physician, like any business, there are certain risks associated with the carrying on of a medical practice. As stated in 65302 BC and paragraph 6 of IT-467R2, where a physician can establish that an amount paid as damages was incurred for the purpose of gaining or producing income from a medical practice, such amount would generally be deductible in computing income from the medical practice. However, there are also situations where legal proceedings are initiated for actions that cannot be considered to be part of the normal course of carrying on a business for the purpose of gaining or producing income. It is difficult to envision a situation where a physician accused of sexually assaulting a patient could establish that such an act could be associated with the provision of medical care or incurred for the purpose of gaining or producing income from a medical practice. It is our view that this is the type of situation alluded to in the 65302 BC case, where the breach giving rise to the "damages" is so egregious or repulsive that it cannot be justified as being incurred for the purpose of producing income. Accordingly, any amount paid by the physician, as "damages", would not be deductible in computing the income of the medical practice by virtue of paragraph 18(1)(a) of the Act.

Generally, an expenditure is considered to be on account of capital where the expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade. Dixon J. commented in the case of Sun Newspapers Ltd. et al. v. The Federal Commissioner of Taxation, (1938) 61 C.L.R. 337 at page 359 as follows:

"The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

In other words, as I understand it, generally speaking, (a) on the one hand, an expenditure for the acquisition or creation of a business entity, structure or organization, for the earning of profit, or for an addition to such an entity, structure or organization, is an expenditure on account of capital, and (b) on the other hand, an expenditure in the process of operation of a profit-making entity, structure or organization is an expenditure on revenue account."

A physician accused and subsequently found guilty of sexual exploitation or sexual assault of a patient could be suspended or permanently prevented from practicing medicine. There is also the possibility that public awareness of such accusations would adversely affect the medical practice if other patients decide to find another physician. A payment for damages as a "once and for all" payment to secure a release from legal proceedings related to such a statement of claim commenced against a physician may enable the physician to continue his/her medical practice. Such a payment would therefore be for the enduring benefit of the medical practice and would be a payment on account of capital. Accordingly, the payment would not be deductible in computing income from the medical practice in the year paid by virtue of paragraph 18(1)(b) of the Act.

Where a patient commences a civil proceeding for sexual assault/sexual exploitation against an individual directly, as opposed to the physician's medical practice, it is the individual that would be liable for the payment of any damages awarded to the patient. Such a payment for damages would be considered to be a personal expense of the individual and not an expense related to the carrying on of a medical practice. Paragraph 18(1)(h) of the Act provides that no deduction is permitted in respect of a personal or living expense of the taxpayer. Accordingly, the physician would not be entitled to a deduction, in computing income from the medical practice or in computing income for income tax purposes, for any amount personally paid for damages.

Yours truly,

John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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