2002 Ruling 2002-0118423 - damages settlement

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 CCRA.

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

Principal Issues: Whether an award of "damages" is a non-taxable receipt, business income or a combination of different amounts.

Position: In this particular case, a combination of both.

Reasons: The Corporation recovered an amount in respect of misappropriated business income, an amount as damages and punitive damages and a reimbursement of legal and professional fees

XXXXXXXXXX 2002-011842

XXXXXXXXXX, 2002

Dear XXXXXXXXXX:

Re: Advance Income Tax Ruling
XXXXXXXXXX
XXXXXXXXXX

This is in reply to your letter dated XXXXXXXXXX in which you requested an advance income tax ruling on behalf of the above named taxpayers.

We understand that, to the best of your knowledge and that of the taxpayers involved, none of the issues involved in the ruling request:

(i) is in an earlier return of the taxpayer or a related person,

(ii) is being considered by a tax services office or taxation center in connection with a previously filed tax return of the taxpayer or a related person,

(iii) is under objection by the taxpayer or a related person,

(iv) is before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has not expired, and

(v) is the subject of a ruling previously issued by the Directorate;

Unless otherwise stated, all references to a statute are to the Income Tax Act R.S.C. 1985 (5th Supp.), c.1, as amended, (the "Act") and all terms and conditions used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.

Our understanding of the facts, proposed transaction and the purpose of the proposed transaction is as follows:

Definitions

(a) The "Corporation" is XXXXXXXXXX;

(b) The "Taxpayer" is XXXXXXXXXX;

(c) The "Employee" is XXXXXXXXXX;

(d) The "Statement of Claim" is the Statement of Claim filed by the Company with the XXXXXXXXXX

(e) The "Settlement" is the Judgment issued by the Superior Court of Justice on XXXXXXXXXX;

(f) "Capital dividend account" has the meaning assigned by subsection 89(1) of the Act;

(g) "Capital dividend" has the meaning assigned by subsection 83(2) of the Act.

Facts

1. The Corporation is a Canadian-controlled private corporation incorporated under the laws of the Province of XXXXXXXXXX with its head office located in XXXXXXXXXX. The Corporation deals with the XXXXXXXXXX Tax Services Office and has been assigned account number XXXXXXXXXX.

2. The Taxpayer is the sole shareholder of the Corporation and deals with the XXXXXXXXXX Tax Services Office. The Taxpayer's social insurance number is XXXXXXXXXX.

3. The Employee was with the Corporation from XXXXXXXXXX. During that time the Employee was in charge of cash receipts, sales recording, banking and bookkeeping. As a result of the duties of the Employee, the Employee was in a position of trust and a fiduciary of the Corporation.

4. The Taxpayer discovered discrepancies in the cash deposits in XXXXXXXXXX. The Employee had been converting cash belonging to the Corporation to her own use. The Taxpayer contacted the police. The Employee was arrested and charged and the Employee's employment was terminated.

5. The Statement of Claim included, amongst others, claims for the following:

(a) Payment of $XXXXXXXXX;

(b) Damages in the amount of $XXXXXXXXXX for breach of fiduciary duty, breach of trust and for theft of this amount of money;

(c) Punitive damages in the amount of $XXXXXXXXXX for breach of fiduciary duty, breach of trust and theft;

(d) Pre-judgment interest pursuant to the Courts of Justice Act;

(e) Costs of this action on a solicitor and client basis; and

(f) Such further and other relief as this Honourable Court may deem just.

6. On XXXXXXXXXX Court of Justice (Provincial Division) awarded the Corporation a payment in the amount of $XXXXXXXXXX "by way of compensation pursuant to Section 725 of the Criminal Code". This amount was included in computing the business income of the Corporation in the XXXXXXXXXX fiscal period. The Corporation claimed $XXXXXXXXXX in legal fees related thereto as an expense in the XXXXXXXXXX fiscal period.

7. The Corporation was in great financial difficulty as a result of the theft. The Corporation did not have the funds to hire a lawyer to pursue the matter. In XXXXXXXXXX, a lawyer agreed to take the case on a contingency basis. It was agreed that the lawyer would receive between XXXXXXXXXX percent of any ultimate recovery.

8. As a result of the theft, the capital base of the Corporation was significantly impaired in the years XXXXXXXXXX. During that period, the Corporation was unable to acquire new capital equipment that was necessary to operate in the XXXXXXXXXX industry. During that period, the Company also lacked the funds necessary to hire the appropriate number of employees to operate the business at its optimum level. The Taxpayer was working approximately XXXXXXXXXX hours per week for remuneration ranging from $XXXXXXXXXX to $XXXXXXXXXX during this period. In addition, the Taxpayer's wife served the Taxpayer with divorce papers in XXXXXXXXXX. The theft, loss of faith in trusted employees, financial difficulties, inability to develop growth in the business and health issues, contributed greatly to the divorce and capital impairment of the Corporation.

9. The Taxpayer and his former spouse attempted to determine the amount of the funds misappropriated by the Employee. Their best efforts determined that approximately $XXXXXXXXXX was misappropriated by the Employee. A forensic accountant was hired to substantiate this figure but the report prepared by the forensic accountant contained numerous mistakes. It was ultimately decided that the report could not be used as testimony and could, in fact, be detrimental if the matter were to proceed to the courts. This factor was a major consideration in agreeing to the Settlement.

10. The Settlement resulted in the Corporation being entitled to an additional $XXXXXXXXXX. The Corporation has received the $XXXXXXXXXX, net of $XXXXXXXXXX of legal fees withheld as payable to the lawyer. The fiscal period of the Corporation ends XXXXXXXXXX.

11. The Corporation incurred other legal and professional fees in the amount of $XXXXXXXXXX. These fees were incurred in respect of the filing of the Statement of Claim, the proceedings in the XXXXXXXXXX Court of Justice (Provincial Division) and receiving the Judgment from the Superior Court of Justice.

12. The divorce settlement between the Taxpayer and his former spouse provides that the two parties will each be entitled to one-half of the amount received by the Corporation pursuant to the Settlement.

Proposed Transaction

13. The Settlement will be finalized and the proceeds received by the Corporation will be allocated as follows:

(a) $XXXXXXXXXX will be reported/included as business income. This amount is considered to be in respect of the business income that was misappropriated by the Employee;

(b) $XXXXXXXXXX will be included in the retained earnings of the Corporation as a receipt on account of capital. $XXXXXXXXXX of this amount is considered to be in respect of damages and punitive damages for breach of trust, breach of fiduciary duty and theft. $XXXXXXXXXX of this amount is in respect of the reimbursement of legal and professional fees incurred by the Corporation and that are not deductible by the Corporation in computing business income for tax purposes;

(c) $XXXXXXXXXX will be included in income as a recovery of the legal and professional fees incurred in respect of the proceedings commenced against the Employee and the Settlement of those proceedings;

(d) No amount was awarded to the Corporation as Pre-judgment interest and the Honourable Court did not provide any other/further relief to the Corporation.

Purpose of the Proposed Transaction

The purpose of the proposed transaction is to finalize the Settlement and to enable the Taxpayer and his former spouse to finalize their divorce proceedings.

Rulings

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transaction and the purpose of the proposed transaction, and provided the proposed transaction is completed in the manner described above, and further provided that there are no other transactions which may be relevant to the rulings requested, our rulings are as follows:

A. The $XXXXXXXXXX of Settlement proceeds will be included in the computing the Corporation's business income, pursuant to subsection 9(1) of the Act, in the XXXXXXXXXX fiscal period of the Corporation.

B. The $XXXXXXXXXX of the Settlement proceeds received as a non-taxable capital receipt for damages will not be business income of the Corporation and will not be included in the computation of the Corporation income for the XXXXXXXXXX fiscal period of the Corporation.

C. The $XXXXXXXXXX of the Settlement proceeds, received as a reimbursement of non-deductible legal and professional fees incurred in respect of the proceedings commenced against the Employee and the Settlement of those proceedings, will not be income to the Corporation nor will it reduce the deductible professional fees incurred by the Corporation.

D. The $XXXXXXXXXX of the Settlement proceeds in B above, and the $XXXXXXXXXX of the Settlement proceeds in C above, do not qualify for inclusion in the capital dividend account of the Corporation.

These rulings are given subject to the limitations and qualifications set out in Information Circular 70-6R4 issued by the Canada Customs and Revenue Agency on January 29, 2001, and are binding provided that the transaction is completed in the XXXXXXXXXX fiscal period of the Corporation.

These rulings are based on the Act in its present form and do not take into account any proposed amendments to the Act which, if enacted, could have an effect on the rulings provided herein.

Comments

The Corporation incurred $XXXXXXXXXX of legal and professional fees from the time it commenced the legal proceedings against the Employee until the time that the judgment was issued by the Superior Court of Justice. In our view, the Corporation's proposal to allocate one-half of the legal and professional fees as having been in respect of the $XXXXXXXXXX recovery of business income and one-half as being in respect of the $XXXXXXXXXX receipt of damages and punitive damages is a reasonable allocation of these costs.

Subsection 248(1) of the Act defines the expression "retiring allowance". To qualify as a retiring allowance, amongst other things, the payment must be received "on or after retirement of a taxpayer from an office or employment in recognition of the taxpayer's long service" or it must be received "in respect of a loss of an office or employment of a taxpayer". Where a payment satisfies all of the requirements in the definition of retiring allowance in subsection 248(1) of the Act, the fact that the amount was not paid until after the conclusion of lengthy legal proceedings, in and of itself, would not disqualify the payment from being a retiring allowance. In general terms, the payment of remuneration, including retiring allowances, is an outlay or expense incurred for the purpose of gaining or producing income from a business and would therefore be deductible in computing the income of the Corporation in the year such amounts are paid.

Yours truly,

XXXXXXXXXX
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch