Brulé, T.C.J.:— This is an appeal involving the 1984 taxation year in which the Minister reassessed the appellant by adding $46,654 to its income for that year which had been reported as a capital receipt and not business income. The amount involves an award for damages.
Facts
The appellant company was in the plumbing and heating business. In October of 1981 it entered into a contract with Malcolm Construction (1970) Ltd. (“Malcolm”) for a project in the sum of $407,600. In order to obtain the contract the appellant obtained a performance bond in the sum of $409,000. Work was begun, but on December 31, 1981 Malcolm issued a notice of cancellation advising the appellant that its contract was terminated.
In May of 1983 an action was commenced against Malcolm for breach of contract. This action was settled in October of 1984 by the appellant accepting an amount of $62,500 representing $15,846 for legal costs, and a net settlement of $46,654.
Appellant's Position
Mr. H.C. Berntzen, the president of the appellant company, maintained in his evidence that as a result of the breach of contract the company suffered greatly. Of principal importance was the performance bond. The limit of bonding to the appellant was $500,000 and $409,000 of this represented the bond given to Malcolm. The remaining $91,000 was not sufficient to allow the appellant to bid on large contracts and only smaller projects could be undertaken.
Counsel stressed that because the bond was tied up the company was prevented from getting substantial contracts. The bond was referred to as an income producing asset. The principles involved were referred to by quoting from different sources. In Interpretation Bulletin 365R2 paragraph 8 sets out:
An amount received by a taxpayer in lieu of the performance of the terms of a business contract by the other party to that contract may, depending on the facts, be either an income or capital receipt. If the receipt relates to the loss of an income-producing asset, it will be considered to be a capital receipt; on the other hand, if it is compensation for the loss of income, it will constitute business income.
The Canadian Master Tax Guide paragraph 2045 points out:
Normally, the performance of a business contract will result in income and accordingly, damages for non-performance will also be income. On the other hand if a contract is of sufficient importance to constitute part of the company's business structure, compensation paid on its termination will be capital.
and in the same paragraph, the following:
An award of damages for loss or impairment of future income-earning capacity would appear to be a capital receipt.
Buckley, J. in London and Thames Haven Oil Wharves, Ltd. v. Attwooll, [1966] 3 All E.R. 145; reversed [1967] 2 All E.R. 124 said at page 149:
Judges have from time to time been careful to say that no clear and comprehensive rule can be formulated, and no clear line of demarcation can be drawn, by reference to which it can be determined in every case whether the sum received should be regarded as a capital receipt or as a revenue receipt to be taken into account in arriving at the profits or gains of the recipient's trade. Each case must be considered on its own facts.
Further in the case of Commissioners of Inland Revenue v. Fleming & Co. (Machinery) Co. Ltd. (1951), 33 T.C. 57, Lord Russell pointed out at page 63:
The sum received by a commercial firm as compensation for the loss sustained by the cancellation of a trading contract or the premature termination of an agency agreement may in the recipient’s hands be regarded either as a capital receipt or as a trading receipt forming part of the trading profit. It may be difficult to formulate a general principle by reference to which in all cases the correct decision will be arrived at since in each case the question comes to be one of circumstance and degree. When the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient's profitmaking apparatus, involving the serious dislocation of the normal commercial organization 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 sterlization of a capital asset and is therefore a capital and not a revenue receipt.
To further emphasize the position of the appellant as to the amounts being received as capital the Court was referred to the following cases:
Parsons-Steiner Ltd. v. M.N.R., [1962] Ex. C.R. 174; [1962] C.T.C. 231; 62 D.T.C. 1148;
Van Den Berghs, Ltd. v. Clark, [1935] A.C. 431; 19 T.C. 390;
Pe Ben Industries Co. v. The Queen, [1988] 2 C.T.C. 120; 88 D.T.C. 6347.
In each of these cases it was pointed out that future income had been prejudiced and the award of damages was held to be on capital account. Counsel argued that such should be the case here, taking into consideration all the facts and the principles set out above.
Minister's Position
The Minister’s counsel took the position that the damages settlement was a profit replacement and not a capital asset replacement. Referring to the Fleming case, supra, the Lord President (Cooper) set out at page 61, in delineating a test to be applied, the following:
The problem thus belongs to a type exemplified by a number of recent cases in which, broadly speaking, the line has been drawn in the light of varying circumstances between, (a) the cancellation of a contract which affects the profit-making structure of the recipient of compensation and involves the loss by him of an enduring trading asset; and (b) the cancellation of a contract which does not affect the recipient's trading structure nor deprive him of any enduring trading asset, but leaves him free to devote his energies and organization released by the cancellation of the contract to replacing the contract which has been lost by other like contracts. It is not possible briefly to formulate the distinction exhaustively or with complete accuracy, as the circumstances vary infinitely;
From the same case counsel for the appellant quoted Lord Russell at page 63 setting out what might be treated as a capital receipt. The Minister’s counsel pointed out that the Court should consider the rest of this passage at page 63 as follows:
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 sur- rogatum for the future profits surrendered—the compensation received is in use to be treated as a revenue receipt and not a capital receipt.
In Canadian National Railway Company v. M.N.R., [1988] 2 C.T.C. 111; 88 D.T.C. 6340 a claim for a capital receipt was denied when the Court held that 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 involved. This situation is similar to the present case, counsel said, and is different from the Pe Ben case, supra, where a capital receipt was accepted. In the Pe Ben case compensation was awarded and held to be capital because there had been a destruction of a distinct part of the taxpayer's business.
Reference was made to the case of Schofield Oil Ltd. v. Canada, [1989] 1 C.T.C. 310; 89 D.T.C. 5128 where the Court did not believe that the taxpayer corporation ever made the whole structure of its profit-making apparatus dependent on only one transitory contract. As a result the payment received because of a frustrated contract was deemed to be an income receipt. This is similar in the present case.
While the settlement was in the form of a lump sum there was no description as to what it represented but the statement of claim in the action commenced by the appellant indicated a desire to recover lost income. There was no mention of a loss of capital and there was no claim for the return of any performance bond. Counsel stressed that it was clear that the amount of damages paid was to replace the profit element of the contract and not to replace any capital asset.
Analysis
The subject amount of $46,654 taken by the appellant as compensation for his contract being terminated by Malcolm gives rise to the question: What is the amount intended to replace, lost income or lost capital?
Many cases have dealt with this problem and the matter was well placed in perspective by Strayer, J. in the Canadian National Railway Company, supra, at pages 114 and 115 (D.T.C. 6342 and 6343) as follows:
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. In some cases the contract providing for compensation may be clear. 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. 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. 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?
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.
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
1See e.g., London and Thames Haven Oil Wharves Ltd. v. Attwooll, [1967] 2 All E.R. 124 (C.A.); followed in The Queen v. Manley, [1985] 1 C.T.C. 186; 85 D.T.C. 5150 (F.C.A.). 0997_5639_5839
2See e.g., Commissioners of Inland Revenue v. Fleming & Co. (Machinery), Ltd. (1951), 33 T.C. 57 (Ct. of Sess.). 0997_5941_6143
3See e.g., The Glenboig Union Five Clay Co., Ltd. v. Commissioners of Inland Revenue (1922), 12 T.C. 427 (H. of L.) at 39-40; Barr, Crombie & Co., Ltd. v. Commissioners of Inland Revenue (1945), 25 T.C. 406 (Ct. of Sess.) at 410.
4Cf. The Queen v. Atkins, [1976] C.T.C. 497; 76 D.T.C. 6258 where the Federal Court of Appeal held that damages paid in respect of breach of a contract of employment could not be regarded as salary income received by the taxpayer "from an office or employment". While the Federal Court of Appeal has adhered to this position in The Queen v. Pollock, [1984] C.T.C. 353; 84 D.T.C. 6370 notwithstanding the doubt cast upon it by the Supreme Court of Canada in Jack Cewe Ltd. v. Jorgenson, [1980] 1 S.C.R. 812 at 814, the Court has in the Manley decision, supra, note 1 confined the Atkins principle to the particular pleadings in that case.
5See cases cited, supra, note 1.
6^Supra, note 2 at 63 (both quoted supra, one by each counsel).
If the purpose and effect of the payment is to fill a hole in the taxpayer's commercial profits, then the payment will be taxable as ordinary business income (See Burmah Steam Ship Company, Limited v. The Commissioners of Inland Revenue (1930), 16 T.C. 67 at 72).
On the other hand, a payment will be held to constitute a capital receipt if it is shown that:
(1) the payment is intended to compensate the taxpayer for the loss of some tangible capital asset (e.g. loss of a company ship) or,
(2) the contract was of such importance to the business of the taxpayer that its cancellation had the effect of completely destroying or materially crippling the whole structure of its business earning structure (or profit-making apparatus.) See /.R.C. v. Fleming & Co. (Machinery), Ltd., supra.
In the present case, I don't think it could reasonably be argued that the compensation was for the loss of some specific tangible capital asset. There is no evidence on record to support such a contention. The only specific tangible asset involved was the performance bond for which the taxpayer paid 1,400. However, the taxpayer apparently received a reimbursement of this amount from the general contractor shortly after having signed the contract for the plumbing work. It is therefore impossible to find that any part of the payment received by the taxpayer was intended to replace the loss of such a tangible capital asset.
A similar situation to the present case was dealt with in Bayker Construction Ltd. v. M.N.R., [1974] C.T.C. 2318; 74 D.T.C. 1236. In that case the company's construction contract with the Province of Alberta was cancelled, the Province paid the company $17,500, which the Minister treated as compensation for loss of profits and therefore taxable as income. The company appealed, contending that it was required to post a performance bond in respect of the contract which decreased its bonding capacity for other projects and that the $17,500 was a Capital receipt in respect of impairments of its earning structure. The appeal was dismissed on the ground that there was no evidence of any destruction or crippling of the company's earning structure. While it was brought forth in evidence that the loss of the bonding power was material, no corroborating evidence proved this to be true and also the Court held that throughout the duration of the subject contract the appellant would not have been able to bid on any other sizeable contracts.
The only question that remains to be determined then is whether the contract was of such importance to the taxpayer's business that its cancellation had the effect of completely destroying or materially crippling the whole structure of its business. To assist in making that determination, the Court must have regard to the following factors:
(i) Total length of the contract as well as the number of years remaining to it when it was cancelled or breached. However, the simple fact that a contract still has several years remaining to it when it is terminated does not necessarily make the amount received for its cancellation a capital receipt. For instance, see The Great Lakes Paper Company Limited v. M.N.R., 61 D.T.C. 564 (T.A.B.) where the payment received upon the cancellation of a contract which still had approximately 15 years to run was held to constitute business income.
Furthermore, the taxpayer will be liable to pay tax on the full amount of the payment in the year of receipt, should the Court find that the payment constitutes business income, even though the payment may represent the loss of profits which would have been earned over the course of several years. See Short Bros. Ltd. v. I.R.C. (1927), 12 T.C. 955.
(ii) Reduction in staff. See Barr, Crombie & Co., Ltd. v. C.I.R., [1945] S.C. 271; 26 T.C. 406 at 411 (Scot.), Fleming, supra, at page 63.
(iii) Disuse of facilities or relocation of business in smaller premises. See Barr, supra, at page 411.
(iv) Decrease (of a permanent nature) in sale volumes and gross profits as a result of having to shut down all or part of the taxpayer's business operation.
(v) If a legal action had been instituted by the taxpayer, the Court may look at the form of the pleadings to see under what head of damages the taxpayer had based his claim. If no action was instituted, the Court can always look at the terms of the settlement reached by the parties. The Court can also take into account the actual amount of damages (or cancellation payment) received by the taxpayer. See Wiseburgh v. Domville, [1956] 1 All E.R. 754 at 757, per Lord Evershed; Canadian National Railway, supra, at page 6342 (114 D.T.C.).
It must be remembered that no one single factor is determinative of the issue. Every case must be considered on its facts. See Barr, supra, at page 411 ; Van Den Berghs Limited v. Clark, [1935] A.C. 431 (H.L.), at pages 438-439; London and Thames,(C.A.), supra, at pages 127 and 133.
I have considered the facts in this case in light of the jurisprudence and cannot conclude other than the amount received as damages was an income receipt. The original and amended statements of claim filed by the appellant in the lawsuit indicated a claim for loss of income and profit. On receipt of the $46,654 in 1984 this amount was reflected in the company statements as "extraordinary income”. Presumably such was changed by the accountant in filing tax returns in an endeavour to treat the amount as a capital receipt.
No mention was made in either the original or amended statement of claim to recover the performance bond. No evidence was given that any negotiations took place with the bonding company to verify what was said to be the problem in preventing the appellant from obtaining other contracts.
The appellant company did not suffer any permanent damage and within a period of two years or so its profits were back to normal or greater. The intervening period commencing in 1981 and extending to 1983 was a difficult time generally in the economy and the appellant company may have been experiencing the same problems as others.
This case is similar to that of Bayker, supra. Although the taxpayer suffered to a certain extent from the cancellation of the contract, it certainly did not amount to a material dislocation of its business structure. The cancellation of the contract did not render the enterprise a hollow shell. There is no doubt in my mind that the payment received by the taxpayer simply represented the profits lost in 1982 and 1983 as a consequence of the breach of contract.
The appeal is dismissed.
Appeal dismissed.
Email this Content