Citation: 2006TCC449
Date: 20060804
Docket: 2002-4913(IT)G
BETWEEN:
BOURGAULT INDUSTRIES LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Woods J.
[1] In the mid-1990s, Bourgault Industries Ltd. instigated two patent infringement actions in the Federal Court of Canada against its main competitor, Flexi-Coil Ltd. After the Federal Court determined liability against Flexi-Coil in one of the actions, both lawsuits were settled for a lump sum amount of $6,000,000.
[2] The question that arises in this appeal is whether the settlement payment is income or capital in Bourgault's hands. If the payment is capital, the parties agree that the amount should be treated as a capital gain.
[3] The appeal relates to the 2000 taxation year of Bourgault which ends on October 31, 2000.
I. Facts
A. General
[4] The appellant, which is based in St. Brieux, Saskatchewan, manufactures and distributes large farm implements such as cultivators and seeders. Most of the appellant's business is conducted in western Canada but it also has some customers in the United States and Australia.
[5] The appellant prides itself in manufacturing products using state of the art technology developed by its own research and development.
[6] Generally, the technology developed by the appellant is protected through patents. The president of the appellant, Mr. Gerard Bourgault, testified that the corporation has been granted over 70 patents and it has an additional 40 pending.
[7] The infringement actions against Flexi-Coil involve technology for a sprayer and a packer. These are implements that are drawn behind a tractor and are used by a farmer after seeding. The appellant marketed products using this technology under the names "Wing Packer" and "Auto Fold Sprayer."
[8] Patents for the Wing Packer and Auto Fold Sprayer technologies were issued to the appellant or predecessor corporations on December 18, 1990 and August 18, 1992, respectively.
[9] Although patents are granted for a term of 20 years, the useful life of these particular patents was between five and ten years. The Auto Fold Sprayer was no longer being sold in 1996. The Wing Packer began to be replaced by a better product in 1998 and sales in that year were less than half of what they had been in the previous several years.
B. The infringement actions
[10] Flexi-Coil also manufactures and sells farm equipment in western Canada and is the main competitor of the appellant. Flexi-Coil is the larger company, being approximately twice the size of the appellant. Its chief place of business is in Saskatoon, Saskatchewan.
[11] Flexi-Coil started selling products similar to the Wing Packer and the Auto Fold Sprayer almost as soon as the appellant did, even before the technology was patented.
[12] After sending cease and desist orders to no avail, the appellant commenced two patent infringement actions against Flexi-Coil in the Federal Court of Canada.
[13] The essence of the claims, which were filed on February 9, 1994 with respect to the Wing Packer patent and on November 14, 1995 with respect to the Auto Fold Sprayer patent, were that Flexi-Coil made and sold farm implements in infringement of these two patents.
[14] A number of remedies for the alleged infringements were sought by the appellant, including injunctions and "damages or alternatively an accounting of profits from the Defendant as the Plaintiff may elect."
[15] The Wing Packer action was the only one that proceeded beyond the discovery stage. In the course of that litigation, the appellant submitted a brief to the Federal Court that outlined its alternative claims for damages, which were described as lost profits and royalties, or for an accounting of the profits that Flexi-Coil made.
[16] The following are excerpts from the brief:
4.0 Damages
4. The plaintiff is entitled to such damages as will provide fair and reasonable compensation for any loss suffered by the plaintiff as a result of the infringing acts of the defendant. Accordingly, the plaintiff will be entitled to profits lost on sales it would have made but for the infringement. In the event of sales which the plaintiff could not have made, the plaintiff is entitled to a royalty.
(Emphasis added)
5.0 Accounting of Profits
15. An accounting of profits is an equitable remedy which may be awarded at the discretion of the Court. The remedy is based on the premise that the defendant, by reason of its wrongful conduct, has improperly received profits which belonged to the plaintiff. The objective of the award is to restore the actual profits to their rightful owner. The profits will be the gross revenue less proper expenses earned through the infringing sales together with any investment interest earned on such profits. The award includes profits realized by a defendant through subsidiaries or related companies.
(Emphasis added)
[17] The Wing Packer trial was heard by Campbell J. of the Federal Court and judgment was issued on February 27, 1998. In reasons reported at (1998) 80 C.P.R. (3d) 1, the judge determined that Flexi-Coil had in fact infringed the Wing Packer patent and in his final paragraph ordered:
... in addition to damages or alternatively an accounting of the profits, I grant to Bourgault the requested declaration, injunction, delivery up, post-judgment interest, and costs of this action.
[18] The decision was confirmed on appeal (86 C.P.R. (3d) 221) and leave to appeal to the Supreme Court of Canada was denied.
[19] The order of the trial judge did not deal with the quantum of either damages or an accounting of profits as this was to be dealt with in a separate hearing. Subsequent to the decision, though, the appellant did elect an accounting of Flexi-Coil's profits.
[20] Before the Federal Court heard arguments on the quantum, a settlement was reached on both actions. The settlement negotiations took place through a mediation process overseen by a judge of the Federal Court shortly after Flexi-Coil had exhausted its rights of appeal in the Wing Packer action.
[21] The minutes of settlement, signed on October 5, 2000, dealt with a number of matters in relation to the two patents, including an agreement by Flexi-Coil to pay $6,000,000 to the appellant on or before December 4, 2000.
[22] The appellant also agreed to grant licences to Flexi-Coil for future use of the patented technology. The licences were valueless, though, because the technologies were obsolete by the time of the settlement. During the argument before me, the parties agreed that the entire $6,000,000 is attributable to the infringement and no part of it is attributable to the licences.
[23] At the Federal Court's mediation conference, the appellant filed a memorandum for each of the actions that outlined the relief that it sought.
[24] In the memorandum for the Wing Packer action, the appellant described the relief sought as being an accounting of Flexi-Coil's profits. At paragraph 6 of the memorandum:
Since the decision of Mr. Justice Campbell, the plaintiff has elected an accounting of the defendant's profits. Accordingly, the issues that remain to be determined in this proceeding are:
i) what is the defendant's total profit on its sales of the infringing packers; and
ii) what profit is the plaintiff entitled to in respect of sales of cultivators and air seeders by the defendant as part of one pass seeding systems.
[25] The memorandum for the Auto Fold Sprayer action claimed either damages or an accounting of Flexi-Coil's profits and computed both as being equal to the profits that Flexi-Coil wrongly made. At paragraph 17 of this memorandum:
For the purpose of the dispute resolution conference, calculations have been made to estimate defendant's profits and plaintiffs damages based on the number of unit sales produced by the defendant. ...
[26] The $6,000,000 amount that was ultimately agreed to is much less than what the appellant was claiming. Mr. Bourgault testified that the appellant agreed to a substantial reduction largely because Flexi-Coil was in financial difficulty at the time. He stated that the agreed upon figure bore no relation to either profits lost by the appellant or to profits wrongfully earned by Flexi-Coil.
C. Reporting of the settlement
[27] For financial statement purposes, the appellant included the $6,000,000 amount as general sales revenue. This was done, according to a note to the financial statements, to keep the amount confidential in compliance with a court order.
[28] For income tax purposes, the appellant reported the $6,000,000 as a capital gain. The gain was included in the 2000 taxation year, which was the year in which the settlement was reached, and a reserve was claimed for four-fifths of the total because the lump sum was not received until the next taxation year. The respondent does not challenge this treatment if the lump sum amount is determined to be a capital receipt.
D. Additional facts
[29] According to the testimony provided by Mr. Bourgault in the course of the Wing Packer litigation, four competitors of the appellant, including Flexi-Coil, commenced selling products similar to the Wing Packer shortly after it was introduced by the appellant. Another company started competing later.
[30] At the hearing of this appeal, Mr. Bourgault testified that the other competitors were small and that they had in total no more than 20 percent of the market. He also testified that he thought that there were no other competitors for the Auto Fold Sprayer.
[31] This evidence was central to the appellant's argument which was that the actions of Flexi-Coil essentially destroyed the entire value of the patents. Although it would have been helpful to have independent corroboration of Mr. Bourgault's self-interested testimony regarding the market share of the competitors, the respondent did not really challenge this testimony and I accept it.
II. Issue
[32] The issue to be decided is whether the receipt by the appellant of the $6,000,000 settlement payment is in the nature of income or capital.
III. Analysis
[33] In determining whether a settlement payment is income or capital to a recipient, the principle that is generally applied is referred to as the surrogatum principle. It provides that the settlement will have the same character as the interest that is settled: The Queen v. Tsiaprailis, [2005] 2 C.T.C. 1 (S.C.C.).
[34] The surrogatum principle was recently described by Sharlow J.A. in Transocean Offshore Ltd. v. The Queen, 2005 D.T.C. 5201 (F.C.A.), at para. 50:
... the answer to that question requires the application of a judge-made rule, sometimes called the "surrogatum principle", by which the tax treatment of a payment of damages or a settlement payment is considered to be the same as the tax treatment of whatever the payment is intended to replace. Thus, an amount paid as a settlement or as damages is income if it is paid as compensation for lost future rent ... It is a capital receipt if it is compensation for a diminution of capital of the recipient ...
[35] The respondent submits that in this case the settled interest is profits - either the appellant's profits that were lost through the wrongful conduct of Flexi-Coil, or Flexi-Coil's profits that had to be divulged if the appellant elected an accounting of profits. In either case, the respondent says, the receipt has the character of income in accordance with the decision of the Exchequer Court of Canada in Donald Hart Ltd. v. M.N.R., [1959] C.T.C. 268.
[36] The appellant, on the other hand, suggests that the conduct of Flexi-Coil deprived the appellant of the entire benefit of the patents and that the settled interest has the nature of capital. According to the appellant, it was forced to compete with Flexi-Coil as if it had no patent protection at all.
[37] The appellant suggests that its position is supported by various decisions dealing with consensual settlements in intellectual property transactions. Some of the authorities that counsel referred to are: Westfair Foods Limited v. The Queen, 91 D.T.C. 5625 (F.C.A.); Canadian Industries Ltd. v. M.N.R., 80 D.T.C. 6163 (F.C.A.); The Queen v. Canadian General Electric Company Limited, 87 D.T.C. 5070 (F.C.A.); Steinberg Inc. v. M.N.R., 92 D.T.C. 1478 (T.C.C.); and BP Canada Energy Resources Company v. The Queen, 2002 D.T.C. 2110 (T.C.C.).
[38] Although the reasoning in these decisions is useful, ultimately the finding in each case is very much dependent on the particular facts.
[39] The essential question in this case is whether the $6,000,000 payment was intended to compensate the appellant for a diminution in the value of its patents. For the reasons that follow, I have concluded that the true nature of the payment is not as compensation for the patents but for profits.
[40] One of the difficulties that I have with the appellant's argument is that it is not clear that the conduct of Flexi-Coil diminished the value of the patents at all. Counsel for the respondent submits that an act of infringement cannot damage a patent because a patent is a statutory right that can only be taken away by Parliament. It seems to me that there is merit in this argument.
[41] The right of an inventor to apply for a patent is conferred by the Patent Act. The statute grants to the patent holder the exclusive right to use the patented technology for a period of years and gives the right to damages or an accounting of profits for an infringement of the patent. No conduct by an infringer can take these rights away. On the contrary, the conduct of the infringer engages these rights.
[42] Moreover, an infringement generally has the result of eroding a portion of the patent holder's profits from exploiting the patented technology. And in this case it is clear from the briefs and memoranda filed in connection with the infringement actions that the appellant was claiming compensation for either its own lost profits or an accounting of the profits earned by Flexi-Coil.
[43] It is true that the damages suffered by a patent holder may in a particular circumstance go beyond lost profits. In this case, Mr. Bourgault testified that Flexi-Coil's conduct also damaged the appellant's relationship with its customers and therefore its goodwill.
[44] If the appellant's goodwill is damaged by Flexi-Coil's conduct, it could make a claim against Flexi-Coil for the damages suffered. But there is no evidence that it did this. It is not reasonable in the circumstances of this case to attribute the settlement to anything other than the profits that were claimed.
[45] I would also note that, at the time the settlement was reached, the appellant's entitlement with respect to the Wing Packer action had become crystallized. That entitlement was limited to an accounting of Flexi-Coil's profits. To the extent that the $6,000,000 is attributable to this action and not to the Auto Fold Sprayer action, the settled interest is clearly the profits that were wrongly earned by Flexi-Coil.
[46] Counsel for the appellant submits that there is contradictory evidence before me as to the nature of the payment and that it is not necessarily compensation for profits. Counsel referred to the fact that the amount ultimately agreed to was arrived at by horse-trading and bore no relationship to an actual computation of profits.
[47] Because the minutes of settlement signed on October 5, 2000 did not set out what the $6,000,000 was intended to compensate for, all a court can do is to determine the settled interest based on all the surrounding facts and circumstances. In this case, the most important evidence is the appellant's brief and memoranda filed in connection with the infringement litigation, excerpts from which are set out above. These documents suggest that the claims were for profits.
[48] Moreover, the fact that the parties came to a compromise and settled for an amount that bears no relationship to profits does not change the nature of the settled interest.
[49] Counsel for the appellant further suggests that, if the arrangement had been consensual, a payment by Flexi-Coil would have been in the nature of capital.
[50] I disagree. If Flexi-Coil's use of the patented technology had been consensual, the arrangement would have been in the nature of a licence and the appellant would be entitled to royalties. Generally a lump sum in lieu of royalties is income.
[51] For these reasons, I conclude that the $6,000,000 amount paid by Flexi-Coil to the appellant has the character of income. The appeal will be dismissed and the respondent is entitled to costs.
Signed at Ottawa, Canada, this 4th day of August, 2006.
Woods J.
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