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Citation: 2003TCC264
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Date: 20030414
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Docket: 2001-1245(IT)G
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BETWEEN:
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656203 ONTARIO INC.,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Lamarre, J.T.C.C.
[1] This is an appeal against an
assessment made by the Minister of National Revenue
("Minister") under the Income Tax Act
("Act") for the appellant's 1997 taxation
year.
[2] In computing its income for that
year, the appellant reported an amount of $3,698,935 ($3,248,935
as proceeds of disposition and $450,000 for a business
interruption loss) received in 1997 from the Simcoe & Erie
General Insurance Company, Gan Canada Insurance Company and New
Rotterdam Insurance Company ("Insurers"). This amount
was awarded to the appellant by a judgment of Madam Justice Bell
of the Ontario Court (General Division) in an action brought by
the appellant against the Insurers in respect of the loss of its
lumber mill in a fire that occurred in January 1991. The
appellant, however, failed to report a further amount of
$1,500,000 that it received from the Insurers in the same year,
1997, in settlement of all actions brought against them by the
appellant. (See the 1997 tax return, Exhibit R-1, Tab 1, and the
appellant's financial statements as at April 30, 1997,
Exhibit R-1, Tab 4.)
[3] In reassessing the appellant for
the 1997 taxation year, the Minister accepted the inclusion of
the amount awarded by Bell J. as reported by the appellant in its
tax return. However, as stated in paragraph 14 of the Reply to
the Notice of Appeal, the Minister treated as proceeds of
disposition of property the extra amount of $1,500,000 received
by the appellant and included 75 per cent of this amount in the
appellant's income pursuant to paragraph 38(a) and
subsection 14(1) of the Act. The Minister allocated
these proceeds of disposition between tangible and intangible
property as follows:
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Property
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Proceeds of disposition
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Inclusion
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Buildings
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$ 517,011
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$ 387,758
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Lost Income
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$ 982,989
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$ 737,242
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Total
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$ 1,500,000
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$ 1,125,000
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[4] In its Notice of Appeal, the
appellant takes issue with the inclusion in income not only of 75
per cent of the $1,500,000 but also of a substantial portion of
the amount awarded to it by Bell J. Counsel for the appellant
argued at the hearing that only the amount of $450,000 was
correctly so included, as having been received for a business
interruption loss. In counsel's view, the balance of the
amount paid by the Insurers in 1997 does not constitute income
from any relevant source and should not have been reported as a
taxable capital gain (as it was originally in the appellant's
1997 tax return). Rather, he argued, the amount at issue was paid
"on account of the value of the properties destroyed or for
damages suffered, by the Appellant. Alternatively, the receipts
constitute a non-taxable windfall". (See paragraph
(E)1 of the Notice of Appeal.)
Facts
[5] The salient facts giving rise to
the reassessment centre around the acquisition by the appellant
of the Harcourt sawmill ("sawmill") in Barry's Bay,
Ontario, and the subsequent destruction by fire of a large
portion of the said sawmill.
[6] The appellant was incorporated
under the laws of the province of Ontario and is owned by Mr.
Frank P. Yantha, who testified at the hearing, and
Mr. Don Foley.
[7] In her Reasons for Judgment
(Exhibit A-1, Tab 6, at pages 5-7), Bell J. set out the facts
leading up to the purchase of the sawmill by the appellant (which
were not disputed before me by the parties). I will reproduce
hereinafter a summary of those facts. The sawmill was part of a
group of sawmills owned and operated by G.W. Martin Limited
before it closed in 1989, at which time it had been taken over by
a receiver. Mr. Yantha and Mr. Foley allegedly met each other
that same year and incorporated the appellant company with the
goal of acquiring and operating the sawmill. The appellant first
offered to buy the sawmill from the receiver in 1989 at a price
of $1,190,000. That offer included the Crown timber rights
previously enjoyed by G.W. Martin Limited. Nothing came of the
offer because the receiver obtained a better one from another
company, Commonwealth Papers Products ("Commonwealth").
However, the Commonwealth transaction did not close either, so a
second offer was put in by Mr. Yantha to purchase the sawmill for
$725,000. This second offer did not include the Crown timber
rights or certain buildings and equipment, which had been
included in the first offer. The receiver finally accepted this
offer and the transaction closed on October 5, 1990.
[8] In its Notice of Appeal filed with
this Court, the appellant said that what it paid for the sawmill
was substantially less than its fair market value at the time.
Indeed, Mr. Yantha and Mr. Foley had received from S. Rayner
& Associates Ltd. a replacement cost appraisal for the
sawmill as at October 4, 1990, which put its optimum value at
$11,507,185 and its minimum value at $1,850,000 (Exhibit
A-3).
[9] According to the appraisal report,
as at October 4, 1990, the subject property was at its minimum
value.
[10] Once the appellant had entered into the
agreement to purchase the sawmill, Mr. Yantha communicated with
the Insurers and apparently told them that he wanted enough
insurance to cover the mortgages. The Insurers suggested that the
property would in that case be underinsured having regard to the
appraisal value determined by S. Rayner & Associates Ltd.
Also, Mr. Yantha was aware that G.W. Martin Limited had obtained
a "value in use" appraisal in January 1987 of between
$5,950,000 and $6,710,000. The Insurers and Mr. Yantha finally
agreed to a figure of $4,500,000 for insurance coverage. (See
Reasons for Judgment of Bell J., Exhibit A-1, Tab 6, pages
11 and 12 of her reasons.) The $4.5 million coverage was
subsequently increased to $5,750,000 on January 7, 1991. (See
Exhibit A-1, Tab 5.)
[11] On the first day of operation of the
sawmill, on January 7, 1991, a fire occurred which destroyed the
mill. The Insurers refused to pay the insurance proceeds, which
resulted in an action being brought against the Insurers by the
appellant in the Ontario Court (General Division) ("First
Action"), which action was heard by Bell J.
[12] In its Statement of Claim in this First
Action (which is found in Exhibit A-1, Tab 6, pages
82-85 in black marker), the appellant claimed the
replacement cost value of the building and contents and an amount
for business interruption, for a total of $5,750,000 detailed as
follows:
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Item Involved
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Replacement Cost
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Cash Value
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Claimed under Policy
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Building
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$1,119,709
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$ 932,839
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$1,119,709
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Contents
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$3,592,271
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$ 2,271,612
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$3,592,271
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Business Interruption
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N/A
__________
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$ 1,117,247
___________
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$1,117,247
__________
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Total
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$4,701,980
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$ 4,321,698
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$5,750,000
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The appellant also claimed damages in the amount of
$500,000.
[13] The First Action resulted in a decision
by Bell J. in favour of the appellant (Reasons for Judgment
signed on September 5, 1995; Supplementary Reasons for Judgment
signed on October 25, 1995; Judgment signed on February 13,
1996). The appellant was awarded the cash value of the building
and contents, that is, $711,384 for the building and $2,271,612
for the contents for a total of $2,982,986, as well as $450,000
for the business interruption loss, plus pre-judgment
interest at 6.5 per cent per annum from July 16, 1991 to the date
of judgment. Bell J. also ordered that upon compliance with the
terms of the replacement cost endorsement in the insurance
policies (meaning upon the destroyed property being replaced at
the appellant's own expense), the appellant would be entitled
to receive from the Insurers a further sum of $2,017,004 (being
the excess of the replacement cost over the cash value of the
building and contents up to the limit of the insurance policy).
(See Judgment of Bell J. and her Reasons for Judgment, Exhibit
A-1, Tab 6 at page 77.) The Insurers appealed that judgment to
the Ontario Court of Appeal and the appeal was apparently
scheduled to be heard on December 16 and 17, 1996.
[14] On July 17, 1996, the appellant
launched a second action ("Second Action") in the
Ontario Court (General Division) against the Insurers. This was
an action for damages suffered by the appellant from the failure
by the Insurers to pay the insurance proceeds when due, or within
a reasonable time thereafter. (See letter from appellant's
counsel at the time, Mr. Paull N. Leamen, dated April 2,
1997, Exhibit A-1, Tab 11.) The claims were for $10,000,000
for reconstruction costs and lost revenue and for $1,000,000 in
punitive damages (Exhibit A-1, Tab 12). It is to be
understood from Mr. Leamen's letter that the damages were
being sought by the appellant for loss of personnel,
deterioriation (and subsequent demolition) of outbuildings and
loss of market share.
[15] The Insurers failed to deliver a
Statement of Defence in the Second Action, which led to a default
judgment by Mercier J. of the Ontario Court (General Division) on
November 29, 1996, awarding damages to the appellant. This
judgment ordered the Insurers to pay the appellant:
(a) damages in the amount of $483,188.30 plus goods and
services tax ("GST"); (b) $450,000 per year for lost
income from 1992 to 1997 inclusive, plus pre-judgment
interest at the rate of 5 per cent per year (Exhibit A-1,
Tab 13).
[16] Following the default judgment in the
Second Action, the Insurers presented a motion to set aside that
judgment. The Insurers principally argued in their motion that
the claims in the First Action had been, in effect, repeated in
the Second Action notwithstanding the fact that the allegations
made already had been or ought to have been put forward in the
First Action. The Insurers also maintained in their motion that
if they were successful on the appeal from the judgment rendered
by Bell J. in the First Action, the entire foundation of the
appellant's Second Action would disappear. In the
Insurers' view, the appellant's Second Action related to
the denial of coverage by them under the insurance policies in
issue in the First Action. (See Affidavit of David Sherriff-Scott
attached to the Notice of Motion, Exhibit A-1, Tab 10,
paragraphs 4 to 7.)
[17] On December 5, 1996, the default
judgment dated November 29, 1996, was set aside by an order of
Cunningham J. of the Ontario Court (General Division) (Exhibit
A-2). At the same time, the Insurers seriously engaged in
settlement discussions with the appellant. In his letter sent to
the appellant on April 2, 1997 (Exhibit A-1, Tab 11), Mr.
Leamen summarized the progress of the negotiations as
follows:
. . . Although the insurers had previously been prepared to
pay the actual cash value indemnity provisions awarded by the
Trial Judge [Bell J.], no agreement could be reached with respect
to the approximately $2,000,000.00 of replacement cost coverage
that was available to the Plaintiff in the event that the sawmill
was actually reconstructed at a cost in excess of that actual
cash value.
For the first time, during the week of December 9, 1996, the
insurers waived the policy requirement that the sawmill be
rebuilt before payment of the replacement cost coverage. This
steadily increased their offer to pay up to the sum of
$1,500,000.00 which was made and accepted on December 13, 1996.
In exchange for the insurers' agreement to pay this $1.5
million the Plaintiff was obliged to release its claim with
respect to action number 101303/96. [Second Action]
As a result, the settlement was made on the following
basis:
a) For the actual cash value portion of the
Judgment, payment of the sum of $3,698,935.04 as of December 15,
1996 plus per diem interest of $759.77 thereafter to the date of
payment, this figure includes an award of $450,000.00 for
business interruption coverage for the calendar year 1991, and a
credit of $750,000.00 for the two purchase money mortgages
assigned to the Defendant insurers which have subsequently been
discharged by them from the title to the Harcourt sawmill;
b) Legal costs in the amount of $500,000.00;
c) For release of damage claim, the sum of
$1,500,000.00;
[18] At the trial before me, Mr.
Yantha testified that he knew in December 1996 that they were not
going to rebuild the destroyed sawmill. He said that on the day
of settlement with the Insurers, he and Mr. Foley told their
lawyer that they would not accept anything less than $1.5 million
for damages, on top of the award already granted by Bell J. He
characterized the $1.5 million as punitive damages as it was not
paid for the replacement cost of a new sawmill. He also said that
their accountant had advised them that punitive damages were not
taxable. There is no document, however, to show how the Insurers
and the appellant actually characterized the payment of $1.5
million provided for in the settlement agreement.
[19] Indeed, the Insurers finally
signed, on December 20, 1996 a Full and Final Release
whereby they accepted to pay to the appellant an amount of
$5,208,052 plus $500,000 for costs and the discharge of the
mortgages (Exhibit A-1, Tab 1). In consideration of that
payment, they released and forever discharged "[the
appellant], Don Foley and Frank Yantha from any and all actions,
causes of actions, claims and demands, for damages, loss or
injury, howsoever arising, which heretofore may have been or may
hereafter be sustained by it in consequence of or relating to a
fire at the Harcourt Sawmill and the subsequent demolition of the
sawmill on the 7th day of January, 1991, insurance policy numbers
RSL3091 and RSL3092 and action numbers 56202/91 [the First
Action] and 101,303/96 [the Second Action] including the Order
for Costs made by Justice Cunningham on December 5, 1996,
including all damage, loss, and injury not now known or
anticipated or which may arise in the future and all effects and
consequences thereof" (Exhibit A-1, Tab 1).
[20] No allocation was made, in the
Full and Final Release, of the amount of $5,208,052. However, in
paragraph 16 of the Notice of Appeal, there is the following:
16. In the result, the insurers and the Appellant
reached a settlement and Releases were executed. The settlement,
in substance, was as follows:
A.
Judgment Action 56202/91 [First
Action]:
(i) actual cash value
indemnity of $3,698,935.04 as of December 15, 1996, plus
interest of $759.77 thereafter to the date of payment;
(ii) the figure includes an
award of $450,000 for business interruption coverage for the
calender [sic] year 1991;
(iii) and a credit of $750,000 for two
purchase money mortgages assigned to the insurers.
B. Action 101303/96 [Second
Action]: release of the damage claim upon payment of the sum of
$1,500,000;
C. Legal costs for both actions
in the sum of $500,000.
[21] In paragraph 10 of the Reply to the
Notice of Appeal, the respondent admits that allocation except
for the amount of $3,698,935 referred to in the above-cited
paragraph 16(A)(i) of the Notice of Appeal, which amount,
the respondent submits, is comprised of the amount of $3,432,996
awarded by Bell J. (which is the total of $711,384 awarded
for the building, $2,271,612 for the contents and $450,000 for
the loss from business interruption) and accrued interest.
[22] The appellant received in its 1997
taxation year the amounts to which it was entitled pursuant to
the settlement. The appellant reported an amount of $3,698,935 in
its taxable income for 1997 ($450,000 as business income and the
balance as the proceeds of disposition of capital property
resulting in a taxable capital gain) but did not include the
amount of $1,500,000 allegedly received as non-taxable damages in
settlement of the Second Action and shown in its financial
statements as an extraordinary item of revenue.
Issues
[23] The issues to be determined in the
present appeal are defined as follows in section (D) of the
Notice of Appeal:
1. What
portion, if any, of the sum of $3,698,935.04 paid by the insurers
pursuant to the judgment in Action No. 56202/91 [First Action]
constitutes capital gain and as such may be included as income
pursuant to section 3 of the Income Tax Act?
2. What
portion, if any, of the settlement payment of $1,500,000 in
Action No. 101303/96 [Second Action] constitutes business income
and, as such, may be included as income pursuant to section 3 of
the Income Tax Act?
[24] In paragraph 17 of the Amended Reply
to the Notice of Appeal, the respondent states the issues as
follows:
a) whether the
amounts received by the Appellant in settlement of its actions
have been correctly treated as proceeds of disposition of capital
property, resulting in:
i) a taxable capital
gain pursuant to paragraph 38(a), 39(1)(a) and 40(1)(a) of the
Act;
and,
ii) business income to be
included pursuant to subsection 14(1) of the Act or,
alternatively, pursuant to section 9 of the Act.
Appellant's Submissions
[25] Counsel for the appellant broke down
the payment received by the appellant in 1997 into two
components:
(1) all payments received
pursuant to the judgment of Bell J. were payments made pursuant
to the insurance policy and he argued, that being so, the
proceeds received under this insurance policy, other than the
business interruption loss amount of $450,000, do not constitute
a capital gain, but rather are a windfall, the $450,000 is to be
treated as business income;
(2) the payment of $1,500,000 was in
settlement of the Second Action and constituted punitive damages,
and therefore is not subject to tax; alternatively, if it does
not constitute punitive damages, it constitutes a non-taxable
windfall and not business income.
Respondent's Submissions
[26] With respect to the payments received
pursuant to the judgment of Bell J., counsel for the
respondent agreed that they are amounts received as proceeds
under the insurance policy. He was however of the view that, with
the exception of the $450,000, which the appellant accepted as
being income, those amounts constitute proceeds of disposition of
capital property, giving rise to a taxable capital gain.
[27] With respect to the $1.5 million,
counsel for the respondent first submitted that this amount was
paid to the appellant in compliance with the judgment of Bell J.
as the replacement cost of the property destroyed and therefore
should be characterized as proceeds of disposition of the
destroyed property, thus giving rise to a capital gain. The
respondent further argued that if this Court were to conclude
that it was not made under the insurance policies, the payment at
issue would nonetheless not be a windfall. It would constitute,
in his view, compensation for lost future income, as the
appellant's business had been materially crippled. The
appellant would therefore be deemed to have disposed of an
intangible property and the amount to be included in income would
consequently fall under subsection 14(1) of the Act and be
taxed at the same rate as a capital gain (that is, in 1997, on 75
per cent of the amount received). In any event, the payments do
not constitute a non-taxable windfall in the form of punitive
damages.
Analysis
I. Tax treatment of the amount of
$3,698,935 awarded by Bell J.
[28] The amount of $3,698,935 is comprised
of an amount of $450,000 awarded for the business interruption
loss and an amount of $2,982,986 awarded for the cash value of
the building and its contents, plus interest.
[29] The appellant conceded that the
$450,000 received for the business interruption loss should be
included in income as business income.
[30] The appellant however took issue with
the inclusion in income of the balance of the amount awarded by
Bell J. Although counsel for the appellant conceded that all
payments made pursuant to the judgment of Bell J. were payments
pursuant to the insurance policy, he stated that the proceeds of
disposition from the insurance policy do not give rise to a
capital gain here. This argument was based on the fact that the
fair market value of the sawmill was higher than the amount
received by the appellant in satisfaction of its claims. It has
been seen previously that the appellant purchased the sawmill at
a price substantially under fair market value. Indeed, the
purchase price was $725,000 whereas an appraisal report valued
the property at $1,850,000 minimum at the time of acquisition.
Furthermore, the Insurers agreed to insure the improved property
for $5,750,000.
[31] Counsel for the appellant considered
this valuation to be instrumental in the determination of a gain.
He defined a gain as "an increase in the wealth of value,
generated by economic circumstances" (see transcript at page
131). In paragraph 14 of his written submissions, counsel
for the appellant states that "[t]he case represents an
acquisition of an asset below fair market value where the
difference between fair market value and the consideration
represents windfall, and there is no 'gain', since there
is no real increase in wealth".
[32] This argument cannot stand in law. The
Act is so structured that, except where otherwise
mentioned, it is not the valuation of the property which
determines the existence of a potential capital gain, but rather
the disposition of the property for proceeds of disposition that
exceed the adjusted cost base. The calculation of a capital gain
or loss is found in subparagraph 40(1)(a)(i) of the
Act, which reads as follows:
SECTION 40: [Calculation of gain, loss or
reserve].
440(1)3
(1) General rules. Except as otherwise expressly
provided in this Part
(a) a taxpayer's gain for a taxation year from the
disposition of any property is the amount, if any, by which
(i) if the property was disposed of in the year, the amount,
if any, by which the taxpayer's proceeds of disposition
exceed the total of the adjusted cost base to the taxpayer of the
property immediately before the disposition and any outlays and
expenses to the extent that they were made or incurred by the
taxpayer for the purpose of making the disposition, or . . .
[33] A disposition was defined as follows in
section 54, as applicable for the taxation year at issue:
"disposition" - "disposition" of
any property, except as expressly otherwise provided,
includes
(a) any transaction or event entitling a taxpayer to
proceeds of disposition of property.
[34] An amount payable under a policy of
insurance in respect of the loss or destruction of property
constitutes "proceeds of disposition" pursuant to the
definition of that term in section 54.
"proceeds of disposition" - "proceeds of
disposition" of property includes,
. . .
(c) compensation for property destroyed, and any amount
payable under a policy of insurance in respect of loss or
destruction of property.
[35] Adjusted cost base is also
defined in section 54, as follows:
"adjusted cost base" - "adjusted cost
base" to a taxpayer of any property at any time means,
except as otherwise provided,
(a) where the property is depreciable property of the
taxpayer, the capital cost to the taxpayer of the property as of
that time, and
(b) in any other case, the cost to the taxpayer of the
property adjusted, as of that time, in accordance with section
53,
. . .
(d) in no case shall the adjusted cost base to a
taxpayer of any property at any time be less than nil.
[36] Except for specific transactions
with respect to which the Act stipulates otherwise, fair
market value does not play any role in the calculation of a
capital gain or loss. As noted by counsel for the respondent,
there is no "automatic bump-up" of the adjusted cost
base of property purchased at a bargain price in relation to its
fair market value. Fair market value only comes into play where,
for example, a taxpayer acquires property by way of gift, bequest
or inheritance. In such a case, the taxpayer is deemed to have
acquired the property at its fair market value in accordance with
paragraph 69(1)(c) of the Act.
[37] In the present case, the
appellant did not acquire the sawmill for nothing by way of gift,
bequest or inheritance. The appellant, after negotiations with
the receiver, was able to purchase the property at a certain
price. There is, therefore, no deeming provision applicable here
to boost the acquisition price to the property's fair market
value at the time of acquisition. Consequently, the gain must be
calculated in accordance with the general rule stated in
paragraph 40(1)(a) of the Act, referred to
above.
[38] In the present matter, the
appellant's tax return was assessed as filed and the capital
gain was calculated based on the various proceeds of disposition
and adjusted cost base figures given by the appellant. None of
those figures was readjusted and the appellant did not challenge
them at the hearing.
[39] Consequently, the assessment will
stand with respect to the amount awarded by Bell J.
II. The $1.5 million
agreed upon between the Insurers and the appellant in
settlement of all
actions.
[40] The question with respect to this
issue is: "What did the payment made by the Insurers purport
to compensate?"
[41] Counsel for the respondent first
submitted that this amount was paid to the appellant in
compliance with the judgment of Bell J., as the replacement cost
of the property destroyed, and therefore should be characterized
as proceeds of disposition of that destroyed property, thus
giving rise to a capital gain. Indeed on page three of her
judgment, Bell J. stated that "upon compliance with the
terms of the replacement cost endorsement in [the] insurance
policies [. . .], the [appellant] will then be entitled to
receive from the [Insurers] a further sum of $2,017,004.00"
(Exhibit A-1, Tab 6).
[42] In counsel's view, this is
what was compensated by the Insurers in making the $1.5 million
payment.
[43] Counsel for the respondent relied
on the letter (Exhibit A-1, Tab 11) signed by Mr. Leamen
(appellant's counsel at the time) wherein the latter
indicates that, during the week of December 9, 1996, the Insurers
waived the insurance policy requirement that the sawmill be
rebuilt before payment of the replacement cost coverage. This was
apparently followed by a steady increase - to $1.5 million - in
the amount the Insurers were offering to pay.
[44] Mr. Leamen however went on to say
that "[i]n exchange for the insurers' agreement to pay
this $1.5 million the [appellant] was obliged to release its
claim with respect to [the Second Action]".
[45] This brings us to the
appellant's argument that the $1.5 million was not paid
pursuant to the insurance policy but represented damages for
wrongful acts of the Insurers, namely for refusal to make, and
for delay in making, payments under the insurance policies. In
counsel for the appellant's view, this amount of $1.5 million
was paid as punitive damages, and these are not taxable. The
appellant further submitted that this amount was paid as a means
for the Insurers to rid themselves of an embarrassing and
potentially very costly contingent liability. Counsel relied on
the decision of the Federal Court - Trial Division in Mohawk
Oil Co. v. Canada,[1990] F.C.J. No. 617 (Q.L.), in
arguing that such a payment is not taxable. Before going any
further, it is important to note here that this decision was
reversed by the Federal Court of Appeal which held, in a judgment
to be found at [1992] 2 F.C. 485, that a settlement amount
cannot be viewed as being "akin to a windfall" merely
because the recipient of the payment says that it was paid by the
payer to get rid of a claim.
[46] The respondent argued finally
that if this Court were to conclude that the payment at issue was
not made under the insurance policies, that payment would
nonetheless not be a windfall. The payment would receive the same
tax treatment as that which would be given the transaction for
which the appellant was compensated. Counsel for the respondent
relied on a passage in The Queen v. Manley, 85 DTC 5150,
in which the Federal Court of Appeal applied in Canadian law the
surrogatum principle stated by Diplock L.J. in London and
Thames Haven Oil Wharves, Ltd. v. Attwooll, [1967] 2 All E.R.
124 at 134 FF. I quote the following from Manley,
supra, at pages 5154-55:
In that
case, the taxpayer had received, in settlement of a claim in
negligence, £ 21,404 for loss of use of an income earning
asset during its period of repair. The issue before the court was
the assessment of that sum to tax. While the rule itself is
stated in the second sentence of the second paragraph below, it
is desirable to quote Diplock, L.J., at some length as its
context is, in my opinion, compelling argument for its
validity.
. . . The question whether a sum of money received by a trader
ought to be taken into account in computing the profits or gain
arising in any year from his trade is one which ought to be
susceptible of solution by applying rational criteria; and so, I
think, it is. I see nothing in experience as enbalmed in the
authorities to convince me that this question of law, even though
it is fiscal law, cannot be solved by logic, and that, with some
temerity, is what I propose to try to do.
I start
by formulating what I believe to be the relevant rule. Where,
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 in 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 that sum of money would have been
treated if it had been received instead of the compensation. The
rule is applicable whatever the source of the legal right of the
trader to recover the compensation. It may arise from a primary
obligation under a contract, such as a contract of insurance;
from a secondary obligation arising out of non-performance of a
contract, such as a right to damages, either liquidated, as under
the demurrage clause in a charterparty, or unliquidated; from an
obligation to pay damages for tort, as in the present case; from
a statutory obligation; or in any other way in which legal
obligations arise.
The
source of a legal right is relevant, however, to the first
problem involved in the application of the rule to the particular
case, viz., to identify for what the compensation was paid. If
the solution to the first problem is that the compensation was
paid for the failure of the trader to receive a sum of money, the
second problem involved is to decide whether, if that sum of
money has been received by the trader, it would have been
credited to the amount of profits (if any) arising in any year
from the trade carried on by him at the date of receipt, i.e.,
would have been what I shall call for brevity an income receipt
of that trade. The source of the legal right to the compensation
is irrelevant to the second problem. The method by which the
compensation has been assessed in the particular case does not
identify for what it was paid; it is no more than a factor which
may assist in the solution of the problem of identification.
[47] In order to determine the tax
treatment of the $1.5 million settlement amount, one has to look
at the true character of the payment. It is worthwhile
reproducing the following passage written by Lord Fraser in
Raja's Commercial College v. Gian Singh & Co Ltd.,
[1976] STC 282 (P.C.) at pages 284-85, cited by the Federal Court
of Appeal in Mohawk Oil, supra, at page 499:
Questions of whether sums awarded by courts are income, liable to
income tax, or not, have arisen in a number of reported cases.
The names given to the sums awarded have varied:
'damages', 'interest', 'compensation'
have all been used, but the court has declined to be bound by the
label and has always tried to look through it and 'to solve
the question of substance' in the words of Rowlatt J in
Simpson v Bonner Maurice's Executors ((1929) 14 Tax
Cas 580, at 592) by reference to the true character of the
award. [Emphasis added.]
[48] The Statement of Claim filed by
the appellant in the Second Action claims compensatory damages
including reconstruction costs and lost revenue in the amount of
$10 million and punitive damages in the amount of $1 million. In
its claim, the appellant refers to the fact that the Insurers
were ordered, by the judgment of Bell J. in the First Action, to
indemnify the appellant under the insurance policies. The
allegations made in support of the appellant's claim in the
Second Action referred first to the Insurers' negligence in
carrying out the demolition of the sawmill building that was
destroyed by the fire. The appellant submitted in its claim that
this negligence caused damage to two adjacent buildings,
generating a replacement cost of approximately $500,000, for
which the appellant held the Insurers responsible.
[49] The other allegations made in the
Statement of Claim in the Second Action concern principally the
fact that the Insurers' failure to honour their indemnity
obligations prevented the appellant from recommencing its
business operations within the first year after the fire - that
is, within the twelve months ending on January 7, 1992 - and
thereafter. It is worth reproducing those allegations, which are
found in paragraphs 11 to 17 of the Statement of Claim in the
Second Action (Exhibit A-1, Tab 12):
11. The insurance policies referred to
in paragraph 3 hereof, provided the Plaintiff with indemnity for
business interruption losses for a maximum period of one year
which expired on or before the 7th day of January, 1992. It was
contemplated by the Plaintiff and a term of the insurance
policies that the insurance proceeds to which the Plaintiff was
entitled in the event of a fire loss, would provide the Plaintiff
with sufficient funds to rebuild the damaged sawmill and to
resume business operations. Once the Plaintiff has re-built the
destroyed sawmill building and replaced the lost contents the
Plaintiff would become entitled to the Replacement Cost benefits
under the insurance policies.
12. According to the terms of the
insurance policies the actual cash value of the destroyed
building and its contents plus the Business Interruption loss of
the Plaintiff were to have been paid by the Defendants prior to
July 1, 1991. It was the failure of the Defendants to honour
their indemnity obligations to the Plaintiff that has prevented
the Plaintiff from recommencing its business operation within the
first year after the fire, ending on January 7, 1992. The
Defendants' breach of their indemnity obligations continues
and therefore the Plaintiff has been unable to rebuild the
sawmill or to resume its sawmill operations, to this date and for
the foreseeable future.
13. In addition the Defendants refused
to co-operate in any respect with the Plaintiff's attempt to
recommence its business operations:
(a) the Defendants would not agree to postpone the
Defendants' mortgages to any financing the Plaintiff might
obtain for that purpose;
(b) the Defendants would not agree to postpone the
Defendants' mortgages or to sign a non-disturbance agreement
to permit the Plaintiff to lease its dry kiln operation to an
interested party; and
(c) the Defendants, in the spring of 1996, would not
provide the necessary assistance to the Plaintiff to prevent the
demolition of two additional structures referred to in paragraphs
7 and 8 hereof, despite their opportunity to do so.
14. The Plaintiff states that in
addition to preventing the Plaintiff from recommencing its
sawmill operations in an economic climate that would have allowed
the Plaintiff to earn substantial profit, and to pay the ongoing
expenses including the municipal taxes on the sawmill property,
the Defendants' conduct has been wanton, reckless, in bad
faith and in total disregard of the Plaintiff's rights and
the Defendants' fiduciary obligations to the Plaintiff.
15. The Plaintiff states that for each
year commencing January 7, 1992 to the date when the sawmill is
reconstructed it would have covered its operating costs,
including the municipal taxes and the ordinary maintenance costs
of the sawmill property and earned a profit in excess of
$500,000.00.
16. Because the Plaintiff has been
prevented by the Defendants from recommencing its sawmill
operations the Plaintiff has suffered the encroachment by other
sawmills into its supply of logs and to its customer base which
will reduce the Plaintiff's revenues and profit once the
Plaintiff's sawmill recommences operations.
17. As a result of the Defendants'
failure to honour their indemnity obligations to the Plaintiff in
a timely manner, the Plaintiff has suffered and will continue to
suffer damages.
[50] It is clear, in my view, that the
Second Action was launched by the appellant to seek damages for
the failure by the Insurers to honour their obligations either
under the insurance policies or under the judgment of Bell J. It
is also clear that the settlement amount was arrived at by
negotiation between the parties concerned and that there was
express agreement by those parties to mutual releases from all
actions relating to the fire (Exhibit A-1, Tab 1).
[51] Although Bell J. awarded in her
judgment an amount of $2,017,004 for the reconstruction cost of
the building, and although I recognize that this was surely
important in the negotiations between the appellant and the
Insurers, I am not convinced that the $1.5 million settlement
amount was paid in compliance with the judgment. Indeed, the
judgment imposed a requirement that the building be rebuilt,
which was never done, and Mr. Yantha testified that when the
settlement was reached in December 1996, they knew that they
would never rebuild.
[52] The question therefore remains
whether the reassessment under appeal correctly treated that
extra amount of $1.5 million as proceeds of disposition, of which
75 per cent was included in income. The reassessment allocated
$517,011 to proceeds of disposition of the buildings and $982,989
to lost income, which amount was treated as the proceeds of
disposition of intangible property, being compensation for the
entire goodwill of the business.
[53] The appellant submitted that the
whole amount of $1.5 million was paid as punitive damages and is
therefore not taxable (see Bellingham v. The Queen,
96 DTC 6075 (F.C.A.)). This argument cannot stand. First,
the amount claimed as punitive damages was $1 million and not
$1.5 million. Second, punitive damages are awarded by a court in
exceptional cases for "malicious, oppressive and
high-handed" misconduct that "offends the court's
sense of decency" (see Hill v. Church of Scientology of
Toronto, [1995] 2 S.C.R. 1130, at paragraph 196). In
Vorvisv. Insurance Corporation of British Columbia,
[1989] 1 S.C.R. 1085 at pages 1105-06, McIntyre J. wrote the
following:
When then can punitive damages be awarded? It must never be
forgotten that when awarded by a judge or jury, a punishment is
imposed upon a person by a Court by the operation of the judicial
process. . . . The only basis for the imposition of such
punishment must be a finding of the commission of an actionable
wrong which caused the injury complained of by the plaintiff.
[54] Here, there was no court order
granting punitive damages to the appellant. Indeed, the default
judgment that was later set aside granted damages in the amount
of $483,188 plus GST and $2,700,000 for lost income during six
years (1992-1997) plus pre-judgment interest. After the default
judgment was set aside, the parties finally settled, agreeing on
the payment of an extra amount of $1.5 million by the
Insurers on top of what had already been awarded by Bell J. In
reassessing the appellant, the Minister allocated an amount of
$517,011 to the buildings, based on the award for damages in the
default judgment ($483,188 + 7% GST = $517,011). In fact, this
corresponds to the amount of approximately $500,000 referred to
by the appellant in its Statement of Claim in the Second Action
as the replacement cost for two demolished buildings. The
Minister allocated the balance to lost income, as was done in the
default judgment.
[55] The appellant submitted that the
default judgment has been set aside and that there is no basis
for the allocation made by the Minister. This might be, but the
appellant had the burden of showing that this allocation is
unreasonable in the circumstances. The Full and Final Release
reflects the final lump-sum amount agreed on by the parties in
settlement of all actions but does not assign that amount to any
particular head of claim. Mr. Yantha testified that the whole
amount of $1.5 million was attributable to punitive damages. No
one from the Insurers was called to testify.
[56] In my view, the testimony of Mr.
Yantha is not relevant in that regard. He testified that the $1.5
million settlement amount should be characterized as punitive
damages only because his accountant had told him that punitive
damages were not taxable. This is self-serving evidence,
which I cannot rely upon. Bearing in mind that punitive damages
are normally awarded by a court for malicious and oppressive
misconduct, it would be surprising that the Insurers would have
voluntarily agreed to pay damages to the appellant on that
basis.
[57] Furthermore, in light of the
Statement of Claim in the Second Action, it is reasonable to
believe that the $1.5 million constituted compensation for
the destroyed buildings and for lost income. Indeed, it can be
inferred from the judgment of Bell J. and from the pleadings in
the Second Action that, while the Insurers would not agree
thereto, the appellant sought from the outset, and presumably
throughout the settlement negotiations, to be made whole. This
included compensation for lost profits and for destroyed
property. As was said in Mohawk Oil, supra, such
compensation cannot be regarded as akin to a windfall.
[58] The situation here is
distinguishable from that which prevailed in Bellingham,
supra, referred to by counsel for the appellant. In
deciding that a punitive award constituted a windfall gain,
Robertson J.A. stated that "[t]he critical factor is that
the punitive damage award does not flow from either the
performance or breach of a market transaction"
(page 6082). In Bellingham, the true source of the
punitive award was the Expropriation Act of Alberta, which
dictated as a matter of public policy that expropriating
authorities be obligated to pay a penal sum in circumstances
where their behaviour falls below a prescribed standard.
Therefore, "[t]he payment in question [did] not flow from
either an express or implied agreement between the parties. There
[was] no element of bargain or exchange. There [was] no
consideration. There [was] no quid pro quo, on the part of
the taxpayer. The payment [was] simply a windfall and, therefore,
not income under paragraph 3(a) of the Act".
(See Bellingham, supra, page 6082.)
[59] In the present case, none of the
above is true. There is simply no evidence to justify the
characterization of the payment of the settlement amount as
punitive damages. It is my opinion that the evidence supports the
allocation made by the Minister. The Minister considered the
amount allocated for lost income as proceeds of disposition of
intangible property, with the result that the amount included in
income was 75 per cent of the settlement amount. It is my
understanding that the Minister took the position that the
appellant's business was materially crippled after it had
waited for so long before being compensated, so as to amount to a
total loss of goodwill. This led the respondent to conclude that
the appellant had disposed of an intangible property. That
position is to the advantage of the appellant, which was not
taxed on the full amount received but only on 75 per cent
thereof.
[60] The appellant argued its case on
the sole basis that none of the settlement amount was taxable. In
view of my conclusion, it is not necessary for me to determine
whether the Minister was right in treating the settlement amount
as proceeds of disposition of intangible property rather than
income. Indeed, it is not in the power of this court to increase
federal tax liability.
[61] In the circumstances, I find that
the appellant has not shown on a balance of probabilities that
the Minister was in error in reassessing the appellant as he
did.
[62] For these reasons, I will dismiss
the appeal with costs.
Signed at Ottawa, Canada, this 14th day of April 2003.
J.T.C.C.
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