29 January 2001 External T.I. 2001-0066625 - settlement of lawsuit

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: Nature of receipt for settling lawsuit re non payment of royalties.

Position: Question of fact

Reasons: Question of fact

		2001-006662
XXXXXXXXXX 	Denise Dalphy, LL.B.
(613) 957-9231
January 29, 2001

Re: Taxation of Proposed Legal Settlement

We are writing in reply to your facsimile transmission of January 19, 2001 wherein you requested an opinion on the income taxation of an amount that may be paid as a legal settlement.

Written confirmation of the consequences inherent in particular transactions are given by this directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R3, a copy of which is enclosed. Where the particular transactions are partially completed or completed, the enquiry should be addressed to the relevant Tax Services Office. However, we are prepared to provide the following comments which are of a general nature.

You have advised us of the following facts:

1. A Canadian resident and an Ontario corporation assigned their right to a US Patent to an Ontario corporation "under an agreement, subject to royalty payments".

2. The non-payment of royalties resulted in court action.

3. A legal settlement of the court action, whereby the litigation is settled on the payment by the assignee to the assignors, may occur.

We do not have copies of either the Assignment Agreement or the draft Settlement Agreement. We also do not know whether the patent rights will be returned to the assignor or will remain with the assignee after the settlement is reached. This information is critical in ascertaining the nature, and income tax consequences, of the payment.

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.

Interpretation Bulletin IT-365, Damages, settlements and similar receipts, discusses the income tax treatment of damages and settlement from the point of view of the recipient. Paragraph 8 states:

"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-365 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, 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."

The key question in determining the nature of the receipt is: "What is this amount intended to replace?" In B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, [1966] A.C. 224 the Court said:

"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 Commissionner of Taxation."

Whether the patent is retained by the assignee will be a significant factor in making this determination.

We would also add that, even if the amount is considered a capital receipt, if it is to replace payments that are described in paragraph 12(1)(g) of the Income Tax Act (the "Act"), the total amount of the payment will be taxed as business or property income, and not as a capital gain. The text of paragraph 12(1)(g) of the Act is included in Appendix A to this letter.

The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R3, the above comments do not constitute an income tax ruling and accordingly are not binding on the Canada Customs and Revenue Agency. Our practice is to make this specific disclaimer in all instances in which we provide an opinion.

Yours truly,

Steve Tevlin
for Director
Business and Partnerships Division
Income Tax Rulings Directorate

Encl.

Appendix A

The text of paragraph 12(1)(g) of the Income Tax Act follows:

"12(1) Income inclusions - There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

(g) payments based on production or use - any amount received by the taxpayer in the year that was dependent on the use of or production from property whether or not that amount was an instalment of the sale price of the property, except that an instalment of the sale price of agricultural land is not included by virtue of this paragraph;"