The T. Eaton Company Limited (Formerly T. Eaton Holdings Limited) v. Her Majesty the Queen, [1997] 1 CTC 2082, 96 DTC 1846

Bonner J.T.C.C.: — The appellant appeals from an assessment of income tax for the 1989 taxation year. The issue is whether a payment to the appellant as consideration for the cancellation of a contractual right contained in a lease was a capital receipt or ordinary business income.

At all relevant times, the appellant carried on the business of a retail merchant. It operated a large number of retail department stores in communities located from coast to coast in Canada. Most of the stores were held by it under long-term leases.

In 1960 the appellant entered into a lease of premises located in a shopping centre at Oshawa, Ontario. The lease was for an initial term of 30 years with provision for seven 10 year renewals. The lease contained normal provisions relating to a shopping centre tenancy. It also contained a provision (the “participation clause”) giving to the taxpayer the right to receive 20 per cent of the net profit from the shopping centre. Net profit was to be calculated in accordance with a formula set out in the clause. The clause was to continue in effect throughout the term of the lease and any renewal of it. The appellant received no income pursuant to the participation clause until 1981. From 1981 to 1989 the appellant received a total of $3,894,220 pursuant to it. The appellant reported the receipts as income for tax purposes.

In 1980 the landlord approached the appellant with the view to securing agreement with respect to the possible buy-out of the participation clause. It appears that the appellant’s rights under the clause impeded the landlord’s efforts to raise new capital in order to finance an expansion of the shopping centre. Discussions between the appellant and the landlord continued off and on until July of 1987 when substantial agreement was reached on an arrangement whereby the landlord was to pay to the appellant a lump sum of 9.25 million dollars in order to terminate the participation clause. At that point, however, neither party was bound. Final agreement was reached on November 30, 1988 on which day the landlord paid the 9.25 million dollars to the appellant. This transaction did not otherwise affect the lease. It remained in force subject only to minor changes which are not now relevant. The appellant continued to carry on its business in the leased premises.

The appellant treated the consideration received as proceeds of disposition of capital property with a cost and valuation day value of nil. It reported a capital gain equal to the full amount of the consideration and a taxable capital gain equal to two-thirds thereof. In assessing tax the Minister of National Revenue (the “Minister”) included the full amount of the consideration received in computing the appellant’s income.

The issue is whether the appellant is correct in contending that the consideration was received for the disposition of a capital property.

The position of the appellant was that its rights under the participation clause constituted property as that word is defined in subsection 248(1) of the Income Tax Act (the “Act”). The rights were either a “right of any kind whatever” or a chose in action or a part of the Appellant’s leasehold interest in the store centre premises. The appellant contended that all property falls into one or the other of two categories, capital property or inventory. In this regard the appellant relied on the following statement from the reasons for judgment of Major J. in Friesen v. R. [1]

The second problem with the interpretation proposed by the respondent is that it is inconsistent with the basic division in the Income Tax Act between business income and capital gain. As discussed above, subdivision b of Division B of the Act deals with business and property income and subdivision c of Division B deals with capital gains. The Act defines two types of property, one of which applies to each of these sources of revenue. Capital property (as defined in subsection 54(b)) creates a capital gain or loss upon disposition. Inventory is property the cost or value of which is relevant to the computation of business income. The Act thus creates a simple system which recognizes only two broad categories of property. The characterization of an item of property as inventory or capital property is based primarily on the type of income that the property will produce.

[Emphasis added. I

Inventory, according to the appellant’s argument, is either property kept by a business for the purpose of resale or property held for sale in the course of an adventure in the nature of trade. The status of any particular piece of property as either inventory or capital property in the hands of a taxpayer is established at the time of the original acquisition of the property. The Act does not recognize any sort of hybrid property not kept for sale but capable upon sale of giving rise to business income. The above tests establish that the rights under the participation clause could not have been held as inventory by the appellant and so must have been capital property. The sale of rights under the participation clause was, therefore, a disposition of capital property and, as a consequence, the consideration received was on capital account.

The position of the respondent was that the appellant’s participation right was a tenant inducement. It had been given as consideration for the appellant’s agreement to undertake the obligations imposed upon it by the lease. The lease and the participation clause in it were ordinary trading contracts. The respondent argued that tenant inducement receipts are ordinary income and that the amount in issue was received in lieu of the cash flow from the participation clause. In deciding whether such a receipt is on income account or capital account it is relevant to consider whether the purpose of the payment was to replace capital or income and whether the effect of the payment was to replace capital or income. The receipt was simply the present value of the future stream of income receivable by the appellant under the participation clause. The payment in issue was made in lieu of payments over the life of the lease. Had the appellant received yearly payments under the Oshawa Participation Interest over the life of the lease, the receipts would have been on revenue account. A payment for the surrender of such future profits is also on revenue account.

In my view the decision of the Supreme Court of Canada in Friesen is not of assistance in deciding whether the contractual right surrendered by the appellant was a capital asset. At issue in that case was the timing of recognition of gains and losses from an adventure in the nature of trade. It was in that context that Major J. made the remark on which the appellant relies. Such remarks cannot be viewed as rules of universal application intended to be applied mechanically in the analysis of totally different questions.

There is an abundance of case law dealing with the tax treatment of compensation for the untimely termination of business contracts. A very useful summary of the basic principles applicable in such cases may be found in the reasons for judgment of Strayer J. in Canadian National Railway Co. v. R. [2] . In that case the taxpayer carried on the business of the transportation of goods and entered into a contract with a client for the movement of goods by road and by rail. The client failed to meet minimum tonnage provisions of the contract. The taxpayer put pressure on the client which thereupon terminated the contract and paid damages to the taxpayer for the breach. It was held that the damages in issue were ordinary income.

At page 114 (D.T.C. 6342), Strayer J. stated:

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 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^ [3] case

. . . 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 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.

As to purpose and the nature of the thing which the compensation in issue was intended to replace it is relevant to consider why the participation clause found its way into the lease in the first place. The appellant pleaded and, oddly enough, the respondent did not admit that “this Oshawa participation interest was granted to the appellant because of its importance as an anchor tenant to the landlord’s shopping centre”. Evidence was given by Terry Pollach, a Vice-President of the appellant responsible for physical plant. He was not involved in the negotiation of the lease for he joined the Eaton organization as a junior employee shortly after the agreement for the lease was negotiated. Nevertheless the evidence which he gave does suggest that in 1955 when the agreement for lease between the appellant and the developer of the shopping centre was formed, the concept of locating a department store such as the appellant’s in a suburban shopping mall was novel. It was feared that the appellant might suffer substantial losses as a consequence of unsuccessful operation of the store due to poor location. As well, Mr. Pollach agreed that the appellant, a successful retailer, by its presence was able to lend credibility to the shopping centre. In this regard Thomas Reid, chief operating officer of the appellant, indicated that the participation clause “reflected the fact that we had to be there to make the mall work”. Thus the participation clause compensated the appellant in relation to two aspects of its ordinary business operations, namely, the risk of loss from the operation of its department store in that location and the benefit to the landlord flowing from the presence of the appellant’s store in the shopping centre. It was the appellant’s business to earn profit by operating retail stores and the clause was simply a mechanism designed to gather in part of such profit. The participation clause was therefore in my view an ordinary business contract and did not form part of the appellant’s capital structure.

What then was the effect of the payment in issue? The appellant argued that the participation clause was part of its leasehold interest; that it should therefore be regarded as capital property and that the disposition should therefore be seen as a disposition of capital property. I disagree. It is wrong, and in any event quite beside the point, to regard the participation clause as part of the estate in land which is conferred on a tenant by a lease. The participation clause is simply a contractual provision contained in a lease. The nature of the document in which the clause happens to have been inserted does not imbue it with any sort of magical status. The cancellation of the participation clause did not affect the appellant’s right under the lease to remain in possession of the Oshawa store. Indeed it was admitted that the cancellation did not have any effect on the operation of the appellant’s retail merchandising business. It is clear that the cancellation of the clause did not affect either the structure of the appellant’s business as a whole or the structure of any component of it. For that reason the case is readily distinguishable from cases such as Glenboig Union Fireclay Co. v. C.LR., (sub nom. Glenboig Union Fireclay Co. v. I.R.C.) [1922] S.C. 112, 12 T.C. 427; Van Den Berghs Ltd. v. Clark, [1935] A.C. 431, 19 T.C. 390 and H.A. Roberts Ltd. v. Minister of National Revenue, [1969] S.C.R. 719, [1969] C.T.C. 369, 69 D.T.C. 5249.

The rule which applies here was stated by Diplock L.J. in London and

Thames Haven Oil Wharves Ltd. v. Attwooll [4] as follows:

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, it if had been received, would have been credited to the amount of profits (if any) arising on 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.

In that case a taxpayer’s wharf was damaged by the negligent operation of a ship. The taxpayer received damages which were intended to compensate for the loss of profits which would have been earned during the period while the wharf was undergoing repairs and was therefore out of service. The damages were held to be income. The rule in Thames Haven was applied by the Federal Court of Appeal in Manley v. R.°. [5] There the taxpayer received as damages in an action for breach of warranty of authority exactly the same amount as he would have received as profit from an adventure in the nature of trade. The Court of Appeal held that the receipt was income. There is no distinction to be drawn between the present case and cases such as Thames Haven and Manley. Just as the damages which were received to compensate for the loss of income were themselves income so also must the amount received by the appellant as compensation for voluntarily giving up its right to receive a part of the income from its business also be regarded as income from the business.

For the foregoing reasons the appeal will be dismissed with costs.

Appeal dismissed.