C.N.R. v. MNR, 88 DTC 6340, [1988] 2 CTC 111 (FCTD)

Strayer, J.:

Introduction

This is an appeal with respect to the 1978 taxation year of Northern Alberta Railways Company which was amalgamated with the plaintiff in 1980. The amount in question is $824,874 being a sum paid to Northern Alberta Railways in 1976 by Canadian Bechtel Limited (henceforth "Bechtel") on the occasion of the termination of a contract between those two companies. This amount was part of a larger sum paid by Bechtel to Northern Alberta Railways (henceforth, "NAR") in respect of that termination, the remainder having been turned over by NAR to Pe Ben Industries Company Limited (hereafter “Pe Ben”), a subcontractor to NAR in the provision of transportation services to Bechtel. The amount turned over to Pe Ben, $1,152,354.60 is the subject of an appeal in case T-1583-82 which was tried at the same time as the present case. Most of the evidence in the present case was by agreement applied in the Pe Ben case as well.

In both cases, the primary issue is as to whether the sums paid on termination of these contracts should be treated as income or capital. The Minister assessed such amounts as income in respect of both plaintiffs and it is those reassessments which are being appealed. While the plaintiff in each case primarily asserts that the sum it received was a non-taxable capital amount, in the alternative it alleges that such sum was an “eligible capital amount", or in the further alternative that it was the proceeds of disposition of property (namely, its contractual rights) and thus taxable only as a capital gain.

While I will write a separate judgment in respect to Pe Ben, I will in it refer back to the facts and law discussed in the following reasons.

Background Facts

Serious development of the tar sands north of Edmonton in the area of Fort McMurray got under way in the 1%0's. In 1971 the Syncrude project was proposed and planning proceeded for its construction. Bechtel was the general contractor for the construction of this plant and in 1973 NAR proposed to Bechtel an arrangement for intermodal transportation, by rail and by road, for moving supplies and building materials from Edmonton to Mildred Lake, the site of the Syncrude plant. NAR had a railway line branching off from its main line at Carbondale, just north of Edmonton, and ending at Waterways, a railway yard on the Clearwater River just outside Fort McMurray. From Fort McMurray there is a road running north to the Mildred Lake site. The distance from Edmonton to Fort McMurray is approximately 300 miles and from Fort McMurray to Mildred Lake is about 40 miles. At that time NAR was owned 50 per cent by the plaintiff in the present case, and 50 per cent by Canadian Pacific Railway, and both these parent companies were also interested in the development of an arrangement which would include carriage by them of supplies for the Syncrude project from elsewhere in Canada to Edmonton. NAR first considered establishing its own trucking arm to carry goods from Waterways to Mildred Lake but by early 1974 had decided to contract out the trucking aspect. On April 29, 1974 NAR invited tenders from four trucking companies and in May 1974 Pe Ben was selected as its subcontractor. By June 1974 rail shipments for Bechtel were arriving at the Waterways yard and Pe Ben started hauling onward by road. It was soon realized that the Waterways yard could not be used very long for this kind of operation, as it was immediately adjacent to residential areas in Fort McMurray and road access suitable for heavy trucking was limited. NAR looked for another site for a yard suitable for such an intermodal operation and by July 1974 had started construction of a yard at Lynton, not far from Fort McMurray and adjacent to its existing track. It leased the land for the yard from the government of Alberta and that government constructed a road connecting the yard with the nearest highway. This yard commenced operation in December 1974, after it had been cleared, drained and graded and the necessary tracks and unloading ramps had been built.

As yet no contract had been signed between NAR and Bechtel or between NAR and Pe Ben. In fact, the contract was not signed between NAR and Bechtel until November 17,1975 although it was made effective April 1, 1974. The evidence shows that while it had been made clear to Bechtel from the beginning that NAR would want a commitment for a certain tonnage to be shipped as a minimum throughout the life of the contract, by October 1974 the volumes of tonnage shipped under the intermodal arrangement had peaked and that thereafter it became increasingly apparent that it was unlikely Bechtel would meet the full commitment to ship at least 250,000 tons (the figure put in the written contract signed on November 17, 1975) during the life of the contract. What in fact happened was that Bechtel appears to have discovered that it was cheaper to have supplies and equipment carried directly from Edmonton by road rather than using the inter- modal means offered under the NAR contract. This arose in part because Bechtel found that many components for the Syncrude plant could be assembled more cheaply at a site in Edmonton before being transported to Mildred Lake, and once the components had been taken off railway cars for this purpose it was cheaper simply to load them on trucks and haul them directly to Mildred Lake. It appears that concern was expressed about this practice many times by Pe Ben to NAR, and by NAR both on its own behalf and on behalf of Pe Ben, to Bechtel. By December 1976, the situation had deteriorated to the point where Pe Ben's solicitor had written to NAR threatening suit under its contract with that company because of the shortfall in the tonnage being shipped, and NAR was in turn pressing Bechtel on this matter. As of December 17,1976 Bechtel had shipped only 85,025.29 tons of its total commitment of 250,000 tons. On that day Bechtel by letter to the General Manager of NAR terminated the agreement and paid (after some adjustments) the sum of $1,957,463.25 as what was described in its letter as “liquidated damages". Of this amount NAR paid $1,152,354.60 to Pe Ben and retained for itself $824,873.55. The various contractual terms under which these payments were made will be discussed below. The amount of $824,874 retained by NAR, although received in 1976, did not affect its income tax position until 1978 because of a carry forward of losses until this, its first profitable year during the period in question.

Relevant Legal Principles

There is much jurisprudence on the question of whether compensation paid on the occasion of the termination of some business arrangement is capital or income. To a large extent each case turns on its own facts. It appears to me that there are two aspects which a court must consider in examining such a situation retrospectively: was the purpose of the payment to replace capital or income; and, whether or not the purpose can be reliably determined, was the effect of the payment to replace capital or income? It appears to me to be a dual test because the purpose may not be discernible, or it may not be reliably discernible in the sense that parties to settlements should not, by misstating the real purpose, determine the tax consequences of the receipt of such compensation. It is therefore necessary to look at both purpose and effect.

With respect to purpose, the essential question is to determine what the compensation — whether paid pursuant to a contract, a court award of damages, or otherwise — is intended to replace. [1] In some cases the contract providing for compensation may be clear. [2] The measure employed for calculating compensation is not always determinative: potential lost income may be taken into account in calculating a capital sum to be paid. [3] Nor on the other hand does the fact that an amount is paid as damages for breach of a contract necessarily make it a capital sum and not income. [4] On the contrary it appears to me that whatever the source of the legal right to the compensation, be it the contract or the law of damages, the substantive issue is: what is this amount intended to replace? [5] .

With respect to the effect of the termination of the business arrangement and the role of compensation in respect thereto, I believe the two possibilities are well expressed in the judgment of Lord Russell in the Fleming case. [6]

. . . When 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 organisation 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.

It will be noted that to apply such criteria it is necessary to make value judgments as to the severity of the impact on the taxpayer of the termination of certain business activities in respect of which compensation has been paid.

Conclusions

Looking first at the purpose of the compensation paid to NAR one must seek enlightenment in the terms of the contract itself. The contract was to run until 90 days after start-up, or readiness for start-up, of the Syncrude plant, but in any event to terminate no later than April 30, 1979 (subsection 8.06(1)). During the life of the contract Bechtel undertook to ship a minimum of 250,000 tons of traffic via NAR to the Syncrude plant. This will be referred to hereafter as the “traffic commitment”. Paragraph 6.01(5)(a) provided as follows:

(5)(a) If the traffic commitment has not been met at the termination of this agreement for any reason other than that specified in section 8.06, sub-section (3), Bechtel shall pay to NAR, as liquidated damages and not as a penalty, $15.00 per ton on the difference between the number of tons of traffic credited and the traffic commitment.

The reasons specified in subsection 8.06(3), as referred to above, for failure to meet the traffic commitment is the cessation of construction of the plant. Subsection 8.06(3) provides:

(3) If all construction in connection with the plant is terminated or is suspended for a period in excess of 30 days by Syncrude, then either Bechtel or NAR may terminate this agreement. In the event of such termination: Bechtel shall have no liablity to NAR except that if the traffic commitment has not been met at that time, Bechtel shall be obligated to pay to NAR the fixed cost reasonably incurred by NAR and its contractors to establish the operation contemplated by this agreement and unrecovered employing accepted accounting practices at the termination date plus the out-of-pocket cost reasonably incurred by NAR and its contractors and directly attributable to the termination of the agreement. If NAR and its contractors are making use of any facilities affected under this sub-section, such use will be considered when establishing the unrecovered fixed cost and the out-of- pocket cost cannot be agreed upon, it shall be established by arbitration under the provisions of section 8.07.

Finally, for present purposes, there was provision for unilateral termination by Bechtel in subsection 8.06(4) as follows:

(4) Bechtel shall have the right at any time to terminate this agreement upon payment of the liquidated damages set out in section 6.01 of this agreement and shall be relieved of and have no further or other liability to any of the parties to this agreement save for the payment of any outstanding freight accounts which it might have incurred prior to termination.

By December 20, 1976 only 85,025 tons had been shipped. This was far short of the some 200,000 tons originally projected to have been shipped by this time and even farther short of the 250,000 tons that Bechtel promised to ship during the life of the contract. When Bechtel terminated the agreement by notice on December 17, 1976 effective December 20 it expressly relied on subsection 8.06(4) and it enclosed its cheque for $1,956,620.65 "representing the liquidated damages" calculated in accordance with the formula incorporated by reference in subsection 8.06(4).

It is somewhat unclear as to whether this payment is properly referred to as "damages". The contract certainly refers to it as such: paragraph 6.01(5)(a), which is part of a section dealing with the “traffic commitment", provides that when the contract is terminated “for any reason" (other than a specified reason which is not relevant here) then, if at that time the traffic commitment has not been met and less than 250,000 tons have been shipped, the sum of $15 per ton is to be paid to NAR for each ton of the shortfall "as liquidated damages not as a penalty". If that were the only contract provision applicable it would seem to provide for damages for breach of the contract in respect of the traffic commitment, and the term “liquidated damages" would be appropriate to describe an agreed sum per ton which the parties would have fixed in advance as adequately representing the damages NAR would suffer in case of a breach of this nature. Subsection 8.06(4), under which the payment was made, relates to termination of the agreement for a particular kind of reason, namely unilateral notice by Bechtel. While by subsection (4) this situation is brought by reference within the general provisions of paragraph 6.01(5)(a) as calling for “liquidated damages" of $15 per ton, it seems somewhat inappropriate to describe a payment made upon the exercise of a party's unqualified right to terminate at any time as "damages". This seems more akin to a payment of salary for the unexpired portion of a contract of employment in accordance with a contract of employment in accordance with a contract giving the unqualified option of termination to the employer exercisable at any time during the contract. Be that as it may, I do not believe that anything necessarily turns on whether these were "damages" or whether they were paid "on" termination of the contract or "for" termination of the contract, notwithstanding the arguments of counsel on this question. The more relevant question is, what was the purpose of this payment: to compensate for loss of capital or for loss of income? On this the contract is not clear either, although there are certainly indications that it was intended to replace income. The contract provides elsewhere, in subsection 8.06(3) as quoted above, that in a particular situation, namely termination of construction of the Syncrude plant, Bechtel would be obliged (if the traffic commitment had not yet been met) to pay to NAR the “fixed cost" incurred by NAR and its contractors "to establish the operation contemplated by this agreement and unrecovered". Such a payment would clearly be of a capital nature. This would suggest that, at the very least, payments made other than in such circumstances were to represent something else, or were to replace both income and capital.

Some extraneous evidence as to the meaning of the contract was tendered but I do not find any of it helpful or convincing. It was also argued that in fact Bechtel was guilty of fundamental breach of the contract and that the payment which it made, purportedly under subsection 8.06(4) was really for the settlement of a law suit. It was urged that, had Bechtel merely intended to make the shortfall payments required under the contract, it could have waited until the natural expiration of the contract on April 30, 1979 thus delaying its payment and having the use of the money in the meantime. I find all this to be very speculative. There is no convincing evidence that Bechtel felt liable for fundamental breach of the contract. As is well known, what constitutes fundamental breach and whether it nullifies an exemption clause is highly debatable. Further, whether the provisions for liquidated damages could be regarded as an exemption clause in this context is very doubtful. There was no direct evidence as to Bechtel's intent, other than its letter of December 17, 1976 making the payment and in that letter it invoked subsection 8.06(4). I think I must take that as the relevant contractual provision under which payment was made. I can only speculate as to why Bechtel decided to make the payment in December 1976 rather than waiting until April 1979, but it is quite possible that it though it best to terminate the contract so as to release NAR, and through it Pe Ben, from their contractual commitments, either as a matter of fairness or to bring an end to their growing complaints about tonnage shortfalls.

As the terms of the contract as invoked by the parties do not provide a clear indication as to the purpose of the compensation paid, I must look to the surrounding circumstances to see its effect. It was variously argued that the termination of the contract had the effect of terminating a separate business (i.e., the intermodal operation) or of sterilizing an asset of enduring value (the “asset” being either the intermodal arrangement with Pe Ben or the Lynton Yard itself). I am not satisfied that any of this has been proven. In my view this was not a separate business as contemplated by the jurisprudence. NAR was a common carrier by rail. It had a main line and several branch lines including the line from Carbondale to Waterways. On that line two trains ran every week each way, and as I understand it this continued before, during, and after the contract in question. While it maintained a separate account for the intermodal service, this surely cannot be determinative of tax liability. The tonnages involved, each if the contract had been fulfilled, would not have dominated shipments on this line: in the four years preceding the year in which shipments under the intermodal contract began, total tonnages over this line had been 180,000 in 1970, 139,000 in 1971, 111,000 in 1972, and 124,000 in 1973. The contract itself only contemplated the shipment of a total of 250,000 tons spread over about five years. Nor was there any dramatic impact on the losses of this branch line except in taxation year 1976 when the extraordinary payment was received from Bechtel upon termination of the contract. In 1973 the branch line loss was $1,347,043 whereas in 1974 and 1975, years in which the contract was in effect, the losses were even larger at $1,529,567 and $1,626,572.

I accept that this was at least at the time a unique arrangement for NAR because it involved a long-term contract with NAR's shipper, a trucking subcontract, and special rates, none of which were typical of its general freight carriage on this branch line. But this was not a discrete operation separate from its other railway activities. It is true that four employees were hired or reassigned especially to this intermodal operation, and that after its termination two of those employees were let go. This can hardly be seen as the destruction of NAR's whole “profit-making apparatus" or even "the serious dislocation of the normal commercial organization” of the NAR, to use the terms employed by Lord Russell in the Fleming [7] case. Considering the contractual arrangements themselves, their termination was hardly the destruction of an "enduring asset”. The contracts which NAR had with Bechtel and with Pe Ben were trading contracts of a relatively short duration. At most they would have run for five years and were terminable at any time.

Nor can I view the termination of the Bechtel contract as the "sterilization" of a capital asset dedicated to that contract. I accept the evidence presented by the plaintiff that the Lynton yard would not have been built had it not been for the imminence of the Bechtel contract (which, however, was not in fact signed until 11 months after the Lynton yard went into use). But witnesses for the plaintiff admitted that from the outset they had longer range expectations for the Lynton yard. Of its total construction cost of $706,145, only some $561,386 was wholly applicable to the Bechtel contract. (Exhibit D-34). The remaining expenditures were made to provide facilities for loading sulfur, trucked from tarsands plants for haulage from Lynton by rail. Apart from this type of business, it is obvious that NAR foresaw a great future for itself in providing transportation services for this and many more anticipated tarsands projects: in a letter of February 14, 1974 the General Manager of NAR described to the Chairman of the Operating Committee (made up of representatives of the two parent companies which then owned NAR) this potential, including the construction of seven additional tarsands plants by 1996. (Exhibit D-1). While he there predicted the ultimate need for an extension of the railway, he clearly contemplated that for some years to come much tarsands business would be handled through the Lynton yard, even after the first Syncrude project was completed. While of course developments of this magnitude have not occurred the Lynton yard has nevertheless remained a worthwhile asset. It had a few lean years after 1976, but by 1981 it was being used in a major way for shipping sulfur from a tarsands plant. These shipments have ranged from 243,000 tons in 1981 to 445,000 tons in 1985. Compared with the traffic commitment under the Bechtel contract of 250,000 tons spread over some five years, this use of the Lynton yard has proven to be much more significant. While not foreseen in this precise form, sulfur shipments generated from tarsands plants were clearly foreseeable in the planning of the Lynton yard in 1974. While the Bechtel contract was the immediate justification for building that yard, it was not, either in anticipation or experience, the only or most important use of the yard in the long run. As the general manager of NAR said in a letter of December 21, 1976 to his Operating Committee (Exhibit D-24), the day after the Bechtel contract was terminated:

I am sorry that the great hopes we had for this intermodal service were not realised, but our efforts were rewarded with some measure of success. This is that we have an excellent intermodal yard at Lynton which will with the passage of time and the further development of the oil sands prove, I am sure, to be a valuable asset . . .

It is also significant to note that had NAR wished to have any kind of trucking terminal in the Fort McMurray area associated with its railway yard, whether operated by it or not, and whether or not for the purposes of transloading goods between railway cars and trucks (its own trucks or trucks under contract to NAR) in connection with shipments to or from the tar sands projects, it would have had to build a new yard somewhere such as the one in Lynton. NAR recognized itself in 1974 that it could not have a “major trucking terminal” associated with its Waterways yard because that yard was bounded on one side by the Clearwater River and on the other side by a residential area of Fort McMurray. Further, the streets in Fort McMurray were not suitable for truck routes. (See Exhibit D-1). All in all, then, it is not possible to characterize the Lynton yard as a capital investment solely dedicated to the Bechtel contract and sterilized by the termination of that contract.

It was also contended by the plaintiff that it had made substantial investments for relaying of railway tracks on the Carbondale-Waterways line just for the purposes of this contract, such capital investment also having been wasted by the termination of the contract and thus compensated for by the payment made by Bechtel. The evidence did not convince me of this. It appeared that while the relaying, replacing old track with heavier trackage, may have been accelerated on this line because of the Bechtel contract, it did not begin nor end with that contract. Mr. Tinston, Regional Controller for the plaintiff, confirmed in his evidence that the relaying of track was not just for the purposes of the contract as heavier traffic generally was anticipated because of the tar sands development. As noted earlier, heavier traffic has in fact ensued since the termination of the contract.

Indications in the contract itself that the compensation was for lost profits is reinforced by evidence of the effect of termination and the relationship of the compensation thereto. No enduring asset in the sense of a distinct business or long-term contract was destroyed, nor was any tangible asset rendered useless by the termination of the contract. The compensation paid was not in fact used to reduce the capital costs of the yard or of relaying, according to Mr. Tinston. In fact, of the total cost of the yard of $706,145, some $495,000 was paid through subsidies of the Canadian Transport Commission in compensating NAR for losses including depreciation on this yard. Quite apart from the fact that no asset was destroyed, it would be difficult to relate to any such asset the “compensation” paid as prescribed by the contract. According to that contract, if Bechtel had never shipped a ton of freight according to its traffic commitment but instead elected to pay the "liquidated damages", NAR would have been entitled to $1,250,000. This is in

excess of the total cost of the yard of $706,000 but would not have paid for the relaying of track undertaken during the term of the contract. If it has any rational base it would appear to be a rough estimation of "return on investment" just as NAR's general manager so described the purpose of a "suitable reimbursement clause” involving a traffic commitment of 250,000 tons, in a letter he wrote prior to the drafting of the contract (Exhibit D-4).

Thus I conclude, as was said in the Fleming [8] case, that this compensation provision in the contract was in purpose and effect to enable NAR to "absorb the shock as one of the normal incidents to be looked for" and that the compensation received was "no more than a surrogatum for the future profits surrendered". Therefore that payment should be treated as income.

It follows from this conclusion that the sum could not have been a capital gain. [9] Nor can it be treated as an “eligible capital amount". For reasons which I will elaborate in the Pe Ben decision, the money when paid by Bechtel was for the purpose of gaining or producing income — to pay an operating expense or an amount in lieu thereof — and the plaintiff's relationship to it must be tested by that measure. As such it would have been a deductible expense if actually paid by the plaintiff instead and this excludes it from characterisation as an “eligible capital amount" by the criteria as they then were in subsections 14(1) and (5) of the Income Tax Act." [10] Also as the money when received by the plaintiff was, as I have found, on income account it could not come within section 14 in any event. [11]

The appeal is therefore dismissed.

Appeal dismissed.