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: (a) Would the damage/compensation receipts be taxable for income tax purposes? (b) Would these receipts be included in computing resource profits if they are on account of income?

Position: (a) Generally Yes (depending on the facts of the situation) (b) Generally No (depending on the facts of the situation)

Reasons:

(a) It is always a question of fact as whether a damage/compensation receipt, either pursuant to a court judgment or an out-of-court settlement, would be considered as on account of income, capital or windfall to the recipient and whether it would be taxable. It is necessary to look at the true nature of both the purpose and the effect of the receipt. A damage/compensation receipt could be considered as on account of income under section 9 of the Act if such receipt is intended to compensate the recipient for its loss of profits. However, a damage/compensation receipt which is intended to compensate the recipient for its loss of profits resulting from destruction or materially crippling the whole structure of the recipient's profit-making apparatus, such a receipt would be considered as a price paid for the loss or sterilization of a capital asset and would therefore be a capital and not an income receipt. A damage/compensation receipt which is on account of capital would be taxable if it could be considered as "eligible capital amount" for the purpose of section 14 of the Act or if there would be "disposition" and "proceeds of disposition" of "property" for the purposes of sections 13, 38, 39, 40 and 54 and subsection 248(1) of the Act. It is our view that a damage/compensation receipt would not be taxable for the income tax purposes only if it is considered as true "windfall" within the criteria as stated in the case of Cranswick, including a receipt in respect of personal injury, exemplary or punitive damage.

(b) By analogy to the case of Cominco, it is our view that a damage/compensation receipt which is not directly related to the actual resource production should not be included in the resource profits calculation under paragraph 1204(1)(b) of the Regulations.

National Oil and Gas Co-ordinating Meeting
Edmonton, Alberta
May 28-31, 2001

Re: Damage/Compensation Receipts
Prepared by Peter Lee
Income Tax Rulings Directorate
May 25, 2001 (#2001-008500)

Background

Notwithstanding that there is ample jurisprudence in respect of the subject matter, many taxpayers have argued that their damage/compensation receipts should not be taxable for income tax purposes, relying on the cases of Alan M. Schwartz, 96 DTC 6103 (SCC), Fortino, 2000 DTC 6060 (FCA), Westcoast Energy Inc., 92 DTC 6253 (FCA), Cranswick, 82 DTC 6073 (FCA), Frank Beban Logging Ltd., 98 DTC 1393 (TCC.), and Cartwright and Sons Limited, 61 DTC 499 (TAB). Furthermore, many of them have also argued that even if the amount is included in income, such amount should be included in computing resource profits too. This paper is going to examine these issues.

Our Comments

1. It is always a question of fact as whether a damage/compensation receipt, either pursuant to a court judgement or an out-of-court settlement, would be considered as on account of income, capital or windfall to the recipient and whether it would be taxable. It is necessary to look at the true nature of both the purpose and the effect of the receipt. (See the case of London and Thames Haven Oil Wharves, Ltd., [1967] 2 All E.R. 124 (C.A.) which was quoted with approval in many Canadian court cases, such as Albert Manley, 85 DTC 5150 (FCA), Canadian National Railway Company, 88 DTC 6340 (FCTD), and Schofield Oil Limited, 89 DTC 5128 (FCTD), affirmed 92 DTC 6022 (FCA).)

2. By analogy to the cases of Mohawk Oil, 92 DTC 6135 (FCA), Schofield Oil, 92 DTC 6022 (FCA), Canadian National Railway, 88 DTC 6340 (FCTD), and A. Janin & Compagnie Limitee, 73 DTC 5267 (SCC), a damage/compensation receipt could be considered as on account of income under section 9 of the Act if such receipt is intended to compensate the recipient for its loss of profits (i.e., the Court in the case of Mohawk Oil provided certain principles as follows: (a) a windfall is in the nature of a gift, accordingly, a payment made as partial satisfaction of a binding settlement resulting directly or

indirectly from a business operation could scarcely be regarded as being "akin to a windfall"; (b) the motives of the payor were not relevant in determining the nature of the payment; and (c) the point of view of the recipient was to govern the character of the receipt based on the U.K. jurisprudence such as the case of London and Thames Haven Oil Wharves, Ltd.). However, see 3 below for exception in certain circumstances.

3. Further to 2 above, by analogy to the cases of Pe Ben Industries Company Limited, 88 DTC 6347 (FCTD), and Fleming & Co. (Machinery) Ltd., [1951] 33 T.C. 57 (Ct. of Sess.), a damage/compensation receipt which is intended to compensate the recipient for its loss of profits resulting from destruction or materially crippling the whole structure of the recipient's profit-making apparatus, such a receipt would be considered as a price paid for the loss or sterilisation of a capital asset and would therefore be a capital and not an income receipt.

4. By analogy to the case of Westcoast Energy, 92 DTC 6253 (FCA), a damage/compensation receipt would not be considered as a "reimbursement" for the purpose of paragraph 12(1)(x) of the Act. It is also our view that generally, such a damage/compensation receipt would also not be considered as a "refund, contribution, allowance or assistance" for the purpose of paragraph 12(1)(x) of the Act. (See also 9 below.)

5. A damage/compensation receipt which is on account of capital would be taxable if it could be considered as "eligible capital amount" for the purpose of section 14 of the Act or if there would be "disposition" and "proceeds of disposition" of "property" for the purposes of sections 13, 38, 39, 40 and 54 and subsection 248(1) of the Act.

6. Subsection 14(1) of the Act requires a consideration of whether an amount in respect of damage/compensation, had it been paid rather than received by a taxpayer, would be an "eligible capital expenditure" (i.e., the mirror principle). If that is the case, such a damage/compensation receipt would be considered as an "eligible capital amount" for the purpose of section 14 of the Act. (See the cases of Goodwin Johnson, 86 DTC 6185 (FCA), Pe Ben Industries Company Limited, and Fortino.)

7. Paragraph 39(1)(a) of the Act indicates that a capital gain arises from the disposition of capital property. Similarly, there may be recapture of capital cost allowance under subsection 13(1) of the Act as a result of the disposition of depreciable property.

8. The term "property" is defined in subsection 248(1) of the Act as "property of any kind whatever whether real or personal or corporeal or incorporeal... includes... a right of any kind whatever, a share or a choice in action...." There is not much Canadian jurisprudence in respect of the issue on capital gain resulting from disposition of a right or a choice in action. According to the Simon's Direct Tax Services, a right to provide services under a contract would be considered as a property (i.e., unfortunately this issue was never argued and considered by the Courts in the case of Alan M. Schwartz). However, a person's general freedom to trade would not be considered as a property (i.e., nevertheless this issue in the context of a non-competition compensation receipt was brought up in the hearing of the case of Fortino by the Crown, but it was not allowed by the Courts to examine and decide on the issue because it was not specifically raised in the pleadings when the trial started). It is our understanding that CCRA would prepare to take another case to Courts in order to deal with the issue of whether the compensation receipt in respect of disposition of a competition right (or non-competition covenant) would be considered as proceeds of disposition resulting in a capital gain. In the case of Wise et al., 86 DTC 6023 (FCA), in concluding that the deposit forfeited to the vendors under a defrauded real estate purchase offer would not result in a capital gain, Pratt J. commented for the Court as follows:

... even it is assumed, for purposes of discussion, that Grovedale disposed of property (right to claim damage under the purchase offer) within the meaning of 54(c)(ii)(B) when it received the payment of $65,000 (the deposit amount), the record does not allow us to say that the adjusted cost base of the property disposed of by Grovedale was less than $65,000... the cost of the property disposed of by Grovedale has not been shown to be less than the $65,000 it received... the sum... does not constitute a capital gain.

9. With respect to a capital property, pursuant to section 54 and subsection 13(21) of the Act, "proceeds of disposition" of the property includes:

... (c) compensation for property destroyed, and any amount payable under a policy of insurance in respect of loss or destruction of property,

... (e) compensation for property injuriously affected, whether lawfully or unlawfully or under statutory authority or otherwise,

... (f) compensation for property damaged and any amount payable under a policy of insurance in respect of damage to property, except to the extent that such compensation or amount, as the case may be, has within a reasonable time after the damage been expended on repairing the damage (see the corresponding provision in paragraph 12(1)(f) of the Act)...

Pursuant to section 54 and subsection 13(21) of the Act, "disposition" of any property, except as expressly otherwise provided, includes:

... (a) any transaction or event entitling a taxpayer to proceeds of disposition of property...

By virtue of the broad scope of the wording of "disposition" and "proceeds of disposition", a damage/compensation receipt in respect of disposition of a capital property would be considered as proceeds of disposition. Accordingly, capital gain or/and recapture of capital cost allowance would be resulted under sections 13, 38, 39 and 40 of the Act because of such a disposition. We note that notwithstanding this strong argument, in the case of Westcoast Energy, the Crown withdrew its argument that the out-of-court settlement amount received by Westcoast constituted compensation for property injuriously affected or compensation for property damaged which would have had the combined effect of reducing the undepreciated capital cost claimed by Westcoast (see also 4 above). It is our view that the case of Westcoast Energy does not preclude CCRA to make the argument of injuriously affected or damaged property in another situation similar to that of Westcoast.

10. It is our view that a damage/compensation receipt would not be taxable for the income tax purposes only if it is considered as true "windfall" within the criteria as stated in the case of Cranswick, including a receipt in respect of personal injury, exemplary or punitive damage. (See the cases of Brenda Bellingham, 96 DTC 6075 (FCA), Frank Beban Logging Ltd., and Cartwright and Sons Limited.)

11. With respect to the issue of whether a damage/compensation receipt, which is considered as on account of income, should be included in the resource profits calculation under paragraph 1204(1)(b) of the Regulations, it is our view that the Cominco case, 84 DTC 6535 (FCTD), which was upheld by the Federal Court of Appeal, should be applied. The Cominco case has never been explicitly overturned by the Federal Court of Appeal or Supreme Court of Canada and therefore it is appropriate jurisprudence to rely on. In concluding that Syncrude had a business of production of petroleum for the whole year of 1978 in the case of Gulf Canada Resources, 96 DTC 6065 (FCA), Pratte, J. commented at pages 6067 and 6068 as follows:

In the first Gulf case relating to its 1974 income tax, it was held that the word "production" in a provision similar to section 1204 was used in the narrow sense of extraction from the ground and that, as a consequence, the only incomes and deductions referred to in that provision were those that were directly related to the actual production of petroleum.

In concluding that there was sufficient inter-connection or integration with the business of production of silver that a gain from hedging activities could be considered to be income from that business, Mackay, J. commented in the case of Echo Bay Mines, 92 DTC 6437 (FCTD), that the gain from settlement of forward sales contracts could be considered as income from production only to the extent such contracts corresponded to the plaintiff's actual silver production. Accordingly, it is our view that a damage/compensation receipt which is not directly related to the actual resource production should not be included in the resource profits calculation under paragraph 1204(1)(b) of the Regulations. It is our understanding that at least one case is proceeding to the Court in order to overturn the Cominco decision.