Citation: 2008TCC322
Date: 20080528
Docket: 2004-4143(IT)G
BETWEEN:
GOFF CONSTRUCTION LIMITED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Miller J.
[1]
Goff Construction
Limited (“Goff”) appeals the reassessment of the Minister of National Revenue of
its 1999 taxation year. The Minister included in Goff’s income an amount of
$400,000 which Goff received as damages in the settlement of a lawsuit. Goff
maintains the settlement amount was on capital account as it represented
compensation for capital expenditures, and relying on the surrogatum
principle, was therefore a non-taxable capital receipt. The Respondent relied
on the principle of symmetry and argued that because the settlement amount
replaced costs that the Appellant had deducted, it necessarily must fall into
income. The Appellant countered that the capital expenditures were only made
deductible by the application of paragraph 20(1)(cc) of the Income
Tax Act, and that should not alter the character of the settlement amount
as capital.
[2]
The parties helpfully
provided an Agreed Statement of Facts which is worth repeating in its entirety.
The parties to this proceeding admit, for the purposes
of this proceeding only, the truth of the following facts:
A.
Background
1. The Appellant is a corporation resident in
Canada for the purposes of the Income Tax Act (Canada) (the “Act”). At all material times, the Appellant was controlled
and operated by members of the Goff family.
2. From the time of the Appellant’s
incorporation in 1959 until the early 1970s, the Appellant carried on a land
development and construction business. Since the early 1970s, the Appellant has
carried on an investment business, consisting mainly of the rental of buildings
previously constructed by it, the earning of income from investments and the
holding of land previously acquired by it. In the years ended September 30,
1992, 1993, 1994, 1995 and 1996, the Appellant’s income consisted primarily of
interest income from its investment business (generally, from marketable
securities). In the year ended September 30, 1999, the Appellant’s main
business was the earning of management and consulting fees.
B.
Agreement to Sell Vacant Land
3.
In October 1987, the Appellant entered into an
agreement of purchase and sale (the “Agreement”) to sell 17.6 acres of vacant
land in the City of Woodstock,
in the County of Oxford (the
“Subject Lands”) to 572257 Ontario Limited (the “Purchaser”). The
Agreement was conditional on the Purchaser obtaining, at the Purchaser’s
expense, rezoning of the Subject Lands for commercial use and any required
amendment to the Official Plan of the County of Oxford.
4.
In September 1988, Mr. Richard Arblaster and his
law firm, Aird & Berlis (the “Defendants”), on behalf of the Purchaser and
the agent for the project proposed to be developed on the Subject Lands,
submitted to the County of Oxford applications to amend the application zoning
by-law and the Official Plan. The applications were rejected,1 and the Purchaser and the agent
instructed the Defendants to file a referral request to the Minister of
Municipal Affairs and an appeal to the Ontario Muncipal Board (the “OMB”)
with respect to the Official Plan amendment and zoning by-law, respectively.
The Appellant did not instruct or retain the Defendants with respect to taking
these actions.
C.
The OMB Hearing
5.
On April 30, 1992, following a 52-day hearing
(the “OMB Hearing”), the OMB decided against the proposed development of
the Subject Lands by the Purchaser and held all parties that the Defendants
purported to represent to be jointly and severally liable for costs on a
solicitor and client basis (which amount was ultimately determined to be
$1,350,000). The OMB concluded that solicitor and client costs were
warranted on the basis that the conduct of the Defendants and the parties
purportedly represented by the Defendants was “clearly unreasonable and akin to
the abuses of process intended by the words ‘frivolous’ or ‘vexatious’,” and
resulted in a “vastly and needlessly prolonged hearing”.
6.
Since the Defendants had represented in the course
of the OMB Hearing that the Appellant was both their client and an applicant at
the hearing, the Appellant was held to be jointly and severally liable for
the cost award.
D.
The OMB Rehearing
7.
Following the decision at the OMB Hearing, the
Appellant retained legal counsel and brought an application under the Ontario
Municipal Board Act to have the cost award against it reduced or eliminated
(the “OMB Rehearing”) on the basis that it had no involvement in or control
over the conduct of the OMB Hearing.
8.
The Appellant was largely successful at the OMB
Rehearing. In a written decision dated February 24, 1995, the OMB reduced the
Appellant’s liability to $135,000 (10% of the total cost award), which amount
was paid by the Appellant. The Appellant incurred significant time and expense
in achieving this result, including its cost of retaining legal counsel to
conduct the OMB Rehearing.
9.
In filing its tax returns and computing its
income for tax purposes for the 1992 to 1997 taxation years, the Appellant
deducted the cost award it paid to the OMB and the expenditures it made in
seeking to have the cost award against it reduced or eliminated (in the years
that such expenditures were incurred) as follows:
|
Year
|
Reported Income
|
Total Expenses
|
OMB Expenses (incl. in Total Expenses
|
|
1992
|
$140,106
|
$139,975
|
$57,9432
|
|
1993
|
$53,421
|
$190,794
|
$68,7993
|
|
1994
|
$38,571
|
$269,045
|
$225,8624
|
|
1995
|
$46,623
|
$334,938
|
$283,6375
|
|
1996
|
$38,281
|
$50,633
|
$20,7986
|
|
1997
|
$32,822
|
$98,838
|
$4,8807
|
|
Total
|
|
|
$661,919
|
|
10.
For the 1992 to 1997 taxation years, the Appellant’s
deduction of the OMB expenditures reduced its taxable income in the year
of the relevant expenditure and/or gave rise to non-capital losses, a portion
of which were carried back and forward to reduce the Appellant’s taxable income
in other taxation years, in accordance with the provisions of the Act.
E. The Statement of Claim
11.
In August 1996, the Appellant filed a statement
of claim against the Defendants (the “Statement of Claim”) claiming, inter
alia, damages in the amount of $635,000 resulting from the Defendants’
false or negligent representations that they acted for the Appellant or, in the
alternative, the Defendants’ negligence in carrying out the duties and
responsibilities owed by a solicitor to a client.
12.
Paragraph 1 of the Statement of Claim provides
that the Appellant claimed: (a) damages in the amount of $135,000, which was
paid by or on behalf of the Appellant as costs pursuant to the decision of the
OMB at the OMB Hearing; (b) damages in the amount of $500,000 for all
expenses (including but not limited to legal fees) incurred by the Appellant in
seeking to have the cost award against it eliminated or reduced; (c) pre‑judgment
and post-judgment interest in accordance with the provisions of the Courts
of Justice Act, R.S.O. 1990, c. C-43, as amended; (d) costs of the action
on a solicitor and client basis together with Goods and Services Tax
thereon; and (e) such other relief as to the court seemed just. The claim for
damages of $500,000 was an estimate of the costs (primarily legal fees) that
were incurred by the Appellant in seeking to have the cost award against it
reduced or eliminated.
F. The Settlement
13.
In March 1999, the Appellant reached a
settlement with the Defendants. The Appellant agreed to accept a payment of
$400,000 in damages (the “Settlement Amount”) from the Defendants in
exchange for a full and final release of the Defendants (the “Settlement
Agreement”) from any and all actions or claims arising out of, or in any way
related to, the decision made at the OMB Hearing, any subsequent hearings or
appeals and the Statement of Claim.
14.
The Settlement Agreement does not make any
reference to the cost award or the expenses incurred by the Appellant in
seeking to have the cost award against it reduced or eliminated, and it does
not provide for an allocation of the Settlement Amount among these or any other
items.
15.
The Appellant did not include the Settlement
Amount in computing its income for tax purposes.
G. The Reassessment
16.
By notice of reassessment dated July 7, 2003,
the Minister of National Revenue (the “Minister”) reassessed the Appellant for
its taxation year ended September 30, 1999 to include the Settlement Amount in
the Appellant’s income. On August 23, 2004, the Minister varied the
reassessment dated July 7, 2003 by permitting the Appellant to apply non‑capital
losses from other taxation years to offset a portion of the reassessed income.
17.
The Minister issued the reassessment on the
basis that the Settlement Amount was income from a business pursuant to
subsection 9(1) of the Act or, alternatively, that the Settlement Amount was
income from an unenumerated source pursuant to section 3 of the Act. The
Minister has since abandoned his position that the Settlement Amount was income
from an unenumerated source pursuant to section 3 of the Act.
______________
1 Because the sale of the Subject Lands was conditional on the
rezoning permission, the sale did not proceed. The Appellant sold the Subject
Lands in later taxation years and reported the sales on capital account in
accordance with the Act.
2 41% of total expenses.
3 36% of total expenses.
4 84% of total expenses.
5 85% of total expenses. This amount included the OMB costs award of
$135,000.
6 41% of total expenses.
7 5% of total expenses.
[3]
The issue is whether
the damages of $400,000 is to be taxed as income. The parties agree this
is a clash of the surrogatum principle and the principle of symmetry in
the Act. I prefer however to look at this case as an opportunity to
clarify the surrogatum principle for tax purposes. Is the surrogatum
priniciple a principle by which the tax treatment of the damages or settlement
payment is:
(i) dependent upon the
capital or income nature of the payment it is intended to replace; or
(ii) to be the same as
the tax treatment of whatever the payment is intended to replace?
[4]
Depending on how you
define the surrogatum principle, the answer will be either taxable or
non-taxable. To be clear, if the surrogatum principle relates to the tax
treatment of the payment to be replaced, in this case the legal expenses and
OMB costs of $135,000, which were deducted for tax purposes, then, applying the
principle such payments should now be included in income. If, on the other hand,
the surrogatum principle relates only to the nature of the payment as
capital or income, then there is an argument that the legal costs and $135,000
OMB costs were in fact in the nature of capital (only deductible as a result of
the application of paragraph 20(1)(cc)), and consequently, the
settlement amount likewise should be considered capital and therefore not on
income account and not taxable.
[5]
The Appellant’s
argument in favour of the latter approach to the application of the surrogatum
principle is a clever, intriguing and perhaps even logical argument, but it
fails to acknowledge that the surrogatum principle is a tax principle –
it does not operate in a vacuum. It is a principle to apply to ensure appropriate
tax treatment, not to engage in an esoteric exercise of distinguishing income
from capital simply for the sake of the distinction. The distinction is
meant to have a tax impact.
[6]
The starting point for
the analysis is the recent Supreme Court of Canada case of Tsiaprailis v. R.
Justice Charron described the surrogatum principle as follows:
…the tax treatment of the item will depend on what the amount is
intended to replace.
[7]
She goes on to cite the
authors Hogg, Magee and Li in the Principles of Canadian Income Tax Law,
4th edition. In their latest edition (6th), those authors
describe the principle as follows (which is not dissimilar from the earlier
edition):
A person who suffers harm caused by another may seek compensation
for (a) loss of income, (b) expenses incurred, (c) property destroyed, or (d)
personal injury, as well as punitive damages. For tax purposes, damages or
compensation received, either pursuant to a court judgment or an out-of-court
settlement, may be considered as on account of income, capital, or windfall to
the recipient. The nature of the injury or harm for which compensation is
made generally determines the tax consequences of damages.
Under the surrogatum principle, the tax consequences of a
damage or settlement payment depend on the tax treatment of the item for which
the payment is intended to substitute:91 (emphasis
added)
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 recovery of an expense is not income, unless the expense was
deducted.
______________
91 This principle was articulated by
Diplock L.J. in London & Thames Haven Oil Wharves Ltd. v. Attwooll,
[1966] 3 All E.R. 145; reversed [1967] 2 All E.R. 124 134 (C.A.). It has been adopted and applied by
the Federal Court of Appeal in Manley, note 92, below, and Schwartz, note
29.
[8]
The Appellant argued
that the deductibility of legal expenses and OMB costs is not relevant as it is
simply the nature of those payments which is important. The nature of the legal
costs and OMB costs were capital expenditures captured by paragraph 20(1)(cc).
The Respondent did not dispute this characterization and I accept it
without going into detail of the Appellant’s argument. The deductibility
of these amounts pursuant to paragraph 20(1)(cc) indeed highlights that
these are capital expenditures, but subjected to special treatment by virtue of
that particular section permitting their deduction.
[9]
It is important to bear
in mind that at issue before me is the recovery of expenses, not a direct loss
of profits. Cases cited by Appellant’s counsel dealing with lost profits, for
example, the case of Prince Rupert Hotel (1957) Ltd. v. Canada, are not persuasive. The Appellant did
however raise two cases, Coughlan v. R.
and Ipsco Inc. v. R.
to support the proposition that notwithstanding legal expenses may be deducted,
it is the characterization of the payment as capital that is determinative of
the tax treatment to be applied to the settlement amount. I am not persuaded
these cases stand for that proposition.
[10]
In Coughlan,
Justice Bowie was dealing with a damage award of approximately $2.9 million for
the loss of indemnity and $493,000 for the loss of insurance benefits. Only in
the alternative was it argued that if such damages could be viewed as a reimbursement
of legal costs, should the Court look to their capital nature as opposed to
looking at whether such legal costs had been deducted. Justice Bowie did comment
on the reimbursement of legal expenses but found the damages were not such, but
were damages for failure to maintain insurance and to indemnify. He indicated
though that given the capital nature of those amounts, it was surprising the
Crown would have permitted the deduction of the legal expenses. He did not have
to face the issue of the recovery of legal expenses properly deducted.
[11]
Similarly in Ipsco,
the issue before Justice Rowe was whether a $4.8 million receipt for damages,
clearly on capital account, should have gone to reduce the amount of capital
cost allowance available on the capital item in question. Ipsco treated
the $4.8 million as a non-taxable receipt. The Minister deducted it from the
capital cost of the asset in question on the basis it constituted proceeds of
disposition. Justice Rowe found the amount was paid in respect of additional
construction and installation costs, not recovery of legal expenses, though
Justice Rowe did state that “in accepting the deduction for legal fees, it
seems the Minister bobbled the ball”. He found there was no specific deduction
to reduce the capital cost of an asset (such as subsection 13(7.1) of the Act).
[12]
Neither of these cases
stand for the proposition that recovery of properly deductible legal expenses
are not taxable by application of the surrogatum principle, though
Justice Rowe’s finding that the settlement amount was a non‑taxable
capital receipt does not recognize the tax consequences of reducing the capital
cost of the asset in question. In effect, he engaged the surrogatum
principle to identify the damages as capital, and could find no specific
deduction to adjust the undepreciated capital cost accordingly. This was not
the case of recovery of legal expenses.
[13]
The Appellant went on
to distinguish its position from that of the Appellant in the case of Mohawk
Oil Co. v. R.,
where a taxpayer sought to be made whole by including compensation for lost
profits. The Federal Court of Appeal found the settlement was partly taxable as
income and partly as capital gain. Goff never sought compensation for lost
profits. As I indicated earlier, this is a recovery of expense issue and not a
direct lost profits issue.
[14]
Goff paid a significant
amount in legal fees to reduce the OMB costs awarded against it to $135,000.
These amounts go to the capital of Goff’s business on the basis the costs award
related to a disposition of capital property and legal expenses related to
preserving a capital asset (money). I do not disagree. The only thorny issue to
tackle is where capital expenditures, such as those before me, are deductible,
how is the surrogatum principle to be applied? The case law referred to
by the Appellant does not persuade me that the authors Hogg, Magee and Li have
got it wrong. The tax consequences of a settlement payment depend on the tax
treatment of the item for which the payment is intended to substitute. Where,
as here, the amount is recovery of expenditures, as opposed to lost profits,
one must look to the tax treatment of those expenditures. In this case, those
expenditures were properly deducted for tax purposes and consequently, applying
the surrogatum principle, the settlement amount should fall into income.
This principle should not be extended to rely upon deductions improperly made
as would have been the case in both Coughlan and Ipsco. Two
wrongs should indeed not make a right.
[15]
This conclusion is not
a conclusion that the settlement amount was compensation for current expenses;
it is a conclusion that the settlement amount was compensation for deductible
capital expenditures.
[16]
I believe that as a
judge-made tax principle, the surrogatum principle must relate to tax
treatment, not just to the nature of the payment, though in most cases the two
will go hand-in-hand. This case happens to involve a situation of a capital
expenditure receiving income treatment by a provision of the Income Tax Act
permitting its deductibility. The surrogatum principle should apply to
assist in reaching a tax result in accordance with the tax legislation, not to
encourage a result of either windfall at one end of the spectrum, or double
taxation at the other end. The surrogatum principle should apply to
maintain tax neutrality of damages.
[17]
For these reasons, I
dismiss the appeal with costs to the Respondent.
Signed at Calgary, Alberta,
this 28th day of May 2008.
“Campbell J. Miller”
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