20 December 2000 Internal T.I. 2000-0043937 - DAMAGE AWARDS

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Is compensation received following an alleged infringement of patent, capital or income in nature?

Position TAKEN:

Question of fact. No position taken. Not enough information to make a definite determination. However, per the facts, it can be determined that the amount will be taxable (not a windfall).

Reasons FOR POSITION TAKEN:

No clear guidelines have come from the courts. The decisions are always based on the facts. We need more information to try and make a determination.

December 20, 2000

Ottawa Tax Services Office                            HEADQUARTERS
Verification and Enforcement Division                 M. Filiatrault
957-2121
Attention:  Mr. Charles Rafuse

2000-004393

Interpretation request

Damages received for patent infringement

This is in reply to your memo of August 23, 2000, requesting our views on the tax treatment of damages in the amount of $XXXXXXXXXX received by XXXXXXXXXX for an alleged patent infringement.

Facts

Our understanding of the facts is as follows:

XXXXXXXXXX.

Question

You requested our opinion as to the taxability of the compensation XXXXXXXXXX received in XXXXXXXXXX. However, you have not provided us with your comments as to how this compensation should be treated for tax purposes. Also, we understand that the client has not yet had the chance to make their representations. We will therefore simply give you our comments on the situation considering the information you provided us. We would like to stress the fact that we did not review the tax treatment of the compensation XXXXXXXXXX received in XXXXXXXXXX.

Our Comments

When a taxpayer receives a payment of damages, it can be classified as capital in nature or as income in nature. When the amount is considered to be capital in nature, it can either be a non-taxable receipt or the proceeds of disposition of a capital property or an eligible capital property.

CCRA publications

Interpretation Bulletin IT-467R discusses the tax treatment of damages and settlements from the point of view of the payer. However, it makes the following comments regarding the tax treatment of the beneficiary at paragraph 8:

8. The tax treatment of damages in the hands of the recipient, and the size of the payment generally are not relevant facts in determining whether or not the payer is entitled to a deduction. The tax consequences of receiving damage payments are discussed in the current version of IT-365, Damages, Settlements and Similar Receipts.

Interpretation Bulletin IT-182, Compensation for loss of business income, or of property used in a business, sets out some criteria to determine the taxability of the amount received. Paragraph 2 mentions the following:

2. To determine the tax treatment of such payments, the nature of the property for which the compensation is paid must be ascertained. In addition, it must be determined whether the compensation was paid to the taxpayer as a voluntary payment or as proceeds of disposition to which the taxpayer was entitled.

In paragraph 4, the IT-182 goes on to say:

4. However, where a taxpayer has a right to compensation for a property or income loss because of contract, statute law, order-in-council, etc., compensation paid for loss or destruction of capital property is considered to be proceeds received on the disposition of the property, and compensation for loss or destruction of inventory or for loss of profits is considered to be income from the carrying on of the taxpayer's business.

The same idea is reflected in paragraph 8 of Interpretation Bulletin IT-365R2, Damages, settlements and similar receipts:

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.

Paragraph 8 of IT-365R2 goes on to give some factors which we consider important in making the determination between capital and income. These factors were developed following an English court case called Commissioner of Inland Revenue v. Fleming & Co (Machinery) Ltd, (1951) 33 T.C. 57.

(a) if the compensation is received for the failure to receive a sum of money that would have been an income item if it had been received, the compensation will likely be an income receipt,

(b) "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", and

(c) "when the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient's profit-making apparatus, involving the serious dislocation of the normal commercial 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 sterilization of a capital asset and is therefore a capital and not a revenue receipt."

Finally, Interpretation Bulletin IT-334R2, Miscellaneous receipts, discusses the tax treatment of, inter alia, windfalls and voluntary payments. In paragraph 3, we list a number of criteria that can be used in determining if an amount is considered to be a windfall which is non-taxable to the recipient. This list of criteria is derived from the Federal Court of Appeal case The Queen v. Cranswick, 82 DTC 6073.

Jurisprudence

We have reviewed a considerable number of cases on income/capital determination in different situations where damages are being paid or received. There are not too many tax cases dealing with the income/capital determination in a situation where an amount is received in a patent infringement case. There are no specific guidelines that come from the jurisprudence and the determination is always based on the set of particular facts. However, in a number of those cases, the key question is: "what is this amount intended to replace?"(1)

"Canadian National Railway Company v. MNR, 88 DTC 6340, (FC-TD) page 6343"

This simple question is difficult to answer when the facts point in different directions. As mentioned in The Queen v. Canadian General Electric Company Limited, 87 DTC 5070 (FCA), at page 5074:

The appropriate framework within which the determination must take place as to whether an amount received by a taxpayer is on his capital account or on his income account, was enunciated in the oft-quoted excerpt from the Judgment of the Privy Council in B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, [1966] A.C. 224 wherein Lord Pearce, speaking on behalf of the Court, said at pages 264 and 265:

The solution to the problem is not to be found by any rigid test or description. It has to be derived from aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree. That answer:

"depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process":

per Dixon J. in Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation. As each new case comes to be argued felicitous phrases from earlier judgments are used in argument by one side and the other. But those phrases are not the deciding factor, nor are they of unlimited application. They merely crystallise particular factors which may incline the scale in a particular case after a balance of all the considerations has been taken.

This statement of principle received the approval of the Supreme Court of Canada in M.N.R. v. Algoma Central Railway, [1968] S.C.R. 447 at page 449.

(our emphasis)

Donald Hart Limited v. MNR, 59 DTC 1134 (Exchequer Court of Canada) is a patent infringement case. Following a court action for patent infringement, Donald Hart Limited, the appellant, received a compensation which the Minister found to be on income account. The appellant disagreed and maintained that the damages awarded were based on a loss or diminution in value of capital assets such as its trademark or goodwill rather than a loss of profits. The judge found that it was a loss of profits. At page 1137, the judge made a reference to an English court case in which the judge gave an example of what would be considered capital in nature and what would constitute income:

"Interpreting the judgment as best I can to ascertain the true nature and quality of the award for the purposes of income tax, I have reached the conclusion that it was made for the purpose of filing the hole in the appellant's profit which it could normally have expected to make, but which had been lost to it by reason of the tortious acts of the defendant therein. Such acts constitute an injury to the appellant's trading. A case point, although one arising out of a breach of contract, is Burmah Steam Co. Ltd. v. C.I.R., 16 T.C. 67, a decision of the First Division of the Court of Sessions, in which the Lord President (Clyde) said at p. 71:

Suppose some one who chartered one of the Appellant's vessels breached the charter and exposed himself to a claim of damages at the Appellant's instance, there could, I imagine, be no doubt that the damages recovered would properly enter the Appellant's profit and loss account for the year. The reason would be that the breach of the charter was an injury inflicted on the Appellant's trading, making (so to speak) a hole in the Appellant's profits, and the damages recovered could not therefore be reasonably or appropriately put by the Appellant - in accordance with the principles of sound commercial accounting - to any other purpose than to fill that hole. Suppose, on the other hand, that one of the Appellant's vessels was negligently run down and sunk by a vessel belonging to some other shipowner, and the Appellant recovered as damages the value of the sunken vessel, I imagine that there could be no doubt that the damages so recovered could not enter the Appellant's profit and loss account because the destruction of the vessel would be an injury inflicted, not on the Appellant's trading, but on the capital assets of the Appellant's trade, making (so to speak) a hole in them, and the damages could therefore - on the same principles as before - only be used to fill that hole."

(our emphasis)

Another infringement case that we looked at is Cartwrigh and Sons Limited v. MNR, 61 DTC 499 (Tax Appeal Board). In that case, the Appellant had received $7,000 as part of an out-of-court settlement regarding a case of infringement of copyright. The Tax Appeal Board found that the amount received had no income feature and therefore was not taxable. "The appellant did not lay claim to any financial loss suffered" which the judge found somewhat unusual in this type of case. The judge found that the amount was capital in nature. The reason it was said to be a non-taxable receipt is that capital gains were not taxable at that time (before 1972).

In the case No. 442 v. MNR, 57 DTC 435 (Tax Appeal Board), the owner of a patent granted an exclusive license to an American company. The American company ultimately canceled the contract. The initial licensing contract provided for the payment of compensation to the patent owner upon cancellation of the contract by the licensee. The judge found that the appellant's share of the payment was a capital receipt not subject to income tax (again prior to 1972). The appellant, which was not in the business of buying and selling patents, granted an exclusive license to the American company, thereby precluding itself from exploiting its patents in the United States; it was found that by so doing, it parted with a portion of its capital rights in the patents. At page 443 the judge mentioned the following:

[Principles established]

From a reading of the above cases, it is my opinion that they establish the principle that, where a patentee grants an exclusive licence, thereby precluding himself from exploiting his patents in the area covered by the licence, and receives therefor a capital sum, which is estimated in advance and without any relation at all to any user of the patent, that lump sum payment is a capital receipt which is not subject to income tax.

(our emphasis)

In The Queen v. Canadian General Electric Company, 87 DTC 5070 (FCA), the judge arrived at a different conclusion even if CGE was not in the business of allowing licenses. CGE provided its "know-how" and granted a non-exclusive license of what was basically its patent in its plant operation to the government marketing body. The judge found that the essential question for decision was whether the taxpayer lost its business as a direct and necessary result of entering into the license agreement. He found that the payment received was on income account.

In the Canadian National Railway case, compensation was received on a termination of a contract. The Court considered whether the purpose of the payment was to replace capital or income, and whether the actual effect was to replace capital or income. The terms of the contract did not enable the Court to determine the purpose of the compensation, and so the Court looked at the surrounding circumstances to see its effect. The Court concluded that when the contract was terminated, 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. In this case, the compensation received was on income account. At pages 6342-6343, Judge Strayer of the Federal Court-Trial Division mentions:

"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?"

(our emphasis)

In Trans Continental Timber v. the Queen, 81 DTC 5043 (FCA), Trans Continental Timber licensed third parties to cut and remove timber from its lands. When a six-year license was canceled before expiring, Trans Continental Timber received compensation. The cancellation had little effect on the taxpayer's earnings. The Court decided that the licenses were contracts entered into in the course of Trans Continental Timber's business. There was no reason to view the contracts as capital properties. The compensation was therefore received on income account.

In Steinberg Inc v. MNR, 92 DTC 1478 (TCC), Steinberg granted to a company the exclusive rights to sell its footwear. Steinberg received compensation from the company for this exclusive right (similar to a licensing contract). At page 1490, as part of its analysis, the judge mentions: "The degree of connectedness between the transaction under study and the businesses' ordinary activities has also been taken into consideration" (also considered in Imperial Oil Ltd v. MNR, 47 DTC 1090 (Exchequer Court) and Davis v. MNR, 64 DTC 485 (Tax Appeal Board). We therefore have to look at the relation between the event that triggered the payment and the company's business.

XXXXXXXXXX situation

Non-taxable compensation

In XXXXXXXXXX situation, we believe that the amount cannot be considered to be a non-taxable receipt. In our view, when the criteria established in Cranswick are considered, it cannot be said that XXXXXXXXXX made no organized effort to receive the payment or that XXXXXXXXXX neither sought after nor solicited the payment. Furthermore, in paragraph 4 of IT-182, we consider that if the taxpayer has a right to compensation (either capital or income) because of, inter alia, statute law, it cannot be viewed as a voluntary payment (generally non-taxable per Cranswick's criteria). In the present situation, we are of the opinion that XXXXXXXXXX is entitled to receive compensation once it has established, per the Patent Act, that its patent was actually valid and infringed. In our view, the receipt will be taxable either as compensation for property (proceeds of disposition) or income loss.

In pre-1972 tax cases, Cartwright for example, the judges made the income/capital determination but at that time, income was taxable and capital was not. All the judges had to decide was if the receipt was taxable or not. This is not the case in the situation at hand since the rules have changed in 1972. We have to make the income/capital determination and if we find that the compensation is capital in nature, we have to decide, per the facts, if the capital amount is non-taxable (considering the Cranswick criteria) or if it is a proceeds of disposition of a capital property (or eligible capital property) which is taxable per the Income Tax Act.

On income or capital account

XXXXXXXXXX

Even if the courts have held over the years that the measure is not always determinative of the nature of the payment (see Canadian National Railway case), it would certainly help us to know how the $XXXXXXXXXX figure was arrived at. It might give us, at least, an idea of the purpose of the payment.

It is a fact, per the information provided, that XXXXXXXXXX was not in the business of allowing licenses. XXXXXXXXXX. However, in our opinion, it is not necessary for XXXXXXXXXX to be in the business of selling patents or allowing licenses in order to be able to consider that the payment was received to compensate the loss of income. In fact, in the Donald Hart case, the taxpayer was not in the business of allowing licenses but the compensation it received was, nevertheless, considered by the court to be income in nature. We recognize that the Donald Hart case was not often referred to by other judges but the reason might be that it did not establish new guidelines in determining the income/capital nature of a receipt. However, the facts of the Donald Hart case and the facts of XXXXXXXXXX case are similar enough to give it consideration in arriving at a determination of the nature of the receipt.

XXXXXXXXXX. However, we find that no significant variation does not automatically mean the amount is capital in nature like it is suggested in Cartwright. In that case, the judge found somewhat unusual that an infringement did not result in a variation of the company's income level. The infringement in Cartwright did not seem to create a "hole" in its income level and therefore the compensation could not be said to "fill that hole" (see reference made to the English court case of Burmah Steam Co in the above excerpt from the Donald Hart case).

XXXXXXXXXX. Answering "yes" to some of the following questions might indicate that the receipt was more of a capital nature: "Was there serious dislocation of the normal commercial organization?", "Have they cut down on staff previously required?", "Was there a permanent reduction in staff?", "Were there any significant change in the company's structure?", "Was there a reorganization of the plant?", "Was the company required to dispose of assets?", "Was it the end of the business?". Those are the kinds of questions the court would want to clarify.

It could be argued that the amount was to compensate the violation of a right that is capital in nature, i.e. the patent. However, XXXXXXXXXX would have to provide sufficient facts that the patent did loose value as a direct effect of this latest infringement, which in our opinion is not an easy thing to do. In Donald Hart, the taxpayer was unable to prove its case. In Canadian National Railway, the judge found that the cancellation of the contract did not affect any capital asset. In Cartwright the compensation was of capital nature almost by default since the judge found that it could not be in the nature of income.

It is also possible that a patent infringement could be considered as part of a business normal risks and therefore, any compensation received regarding normal business risk could be considered to be received on income account. Do patented companies generally consider the possibility of infringement as part of their normal business risk?

Conclusion

It all comes down to one question: "what is the payment intended to replace?". As mentioned in paragraph 8 of IT-365R2, if it can be determined that the violation of the patent materially crippled the structure of the recipient's profit making apparatus or that the payment was intended to compensate for the loss of a capital asset, the payment will probably be considered to replace property of a capital nature. Per the information provided, it could be said that because of the patent infringement XXXXXXXXXX lost a portion of its clientele that materialized as a loss of income. Since a clientele (goodwill) is an intangible asset and considered to be an eligible capital property, any partial disposition could trigger a capital gain. There is not a lot of jurisprudence with regards to this type of situation but we are of the view that if we find the compensation received to be capital in nature, it could possibly be viewed as proceeds of disposition of an eligible capital property (the goodwill). However, if the company structure was not significantly affected and crippled, that the income level has decreased since the violation, the payment will probably be considered to replace the lost income. Even if this is a question of fact, we are of the view that, income or capital, the compensation should be taxable.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Canada Customs and Revenue Agency's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at 613 957-0682. The severed copy will be sent to you for delivery to the client.

We trust that these comments will be of assistance. If you require additional assistance, please do not hesitate to contact us.

Ghislaine Landry, CGA
Acting manager
Individual and Business Section
Business and Publications Division
Income Tax Rulings Directorate

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