2002 Ruling 2002-0135143 - REPLACEMENT PROPERTY DAMAGES PAYMENT

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:

(1) Whether damages received for the unlawful cancellation of a forest licence, the total of which includes cash already received and a new forest licence to be issued, is proceeds of disposition of the original licence that is receivable in the taxation year ended in which the new licence is issued.

(2) Whether in the taxation year ended in which the new licence is issued, subsection 44(1) of the Act will apply to calculate the gain from the disposition of the original licence and capital cost for the acquisition of the new licence, on the basis that the original licence is considered a former property of the company and the new licence is considered a replacement property for the original licence.

Position:

(1) Yes.

(2) Yes.

Reasons:

(1) The settlement agreement, and court order sanctioning the settlement agreement, both describe the damage payments as "compensation for property unlawfully taken". Paragraph (b) of the definition of proceeds of disposition in both section 54 and subsection 13(21), includes "compensation for property unlawfully taken". Section 44(2) of the Act deems the proceeds of disposition to be receivable in the taxation year that the taxpayer has agreed to an amount as full compensation, and therefore, the gain is included in income in the year the new licence is issued.

(2) Given the facts of this case, it is reasonable to consider the new licence a replacement property for the old licence.

XXXXXXXXXX 2002-013514

XXXXXXXXXX, 2002

Dear XXXXXXXXXX:

Re: Advance Income Tax Ruling Request - XXXXXXXXXX

This is in reply to your letter dated XXXXXXXXXX, as amended through further written and verbal submissions (XXXXXXXXXX), in which you requested an advance income tax ruling on behalf of the above-noted company with respect to the income tax implications of a damages settlement agreement. A tentative agreement was made between the company and Her Majesty the Queen in Right of the Province of XXXXXXXXXX on XXXXXXXXXX, in respect of the Reasons for Judgment of the Supreme Court of XXXXXXXXXX dated XXXXXXXXXX.

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 a 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 a taxpayer or a related person,

(iii) is under objection by a 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 transactions and the purpose of the proposed transactions is as follows:

Definitions

1. "The Company" is XXXXXXXXXX;

2. "The Province" is the Province of XXXXXXXXXX;

3. "The Forest Act" is the Forest Act of the Province of XXXXXXXXXX;

4. "The Original Licence" is Forest Licence Number XXXXXXXXXX issued in XXXXXXXXXX under XXXXXXXXXX the Forest Act;

5. "The PGTSA" is the XXXXXXXXXX, as designated under the Forest Act;

6. "The WLTSA" is the XXXXXXXXXX, as designated under the Forest Act;

7. "The Provincial Supreme Court" is the Supreme Court of the Province of XXXXXXXXXX;

8. "The Statements of Claim" are the statements filed by the Company with the Provincial Supreme Court in a legal action against the Province on XXXXXXXXXX;

9. "The Legal Action" is the proceedings commenced in the Provincial Supreme Court pursuant to the Company's filing of the Statements of Claim;

10. "The Decision" is the Reasons For Judgment of the Provincial Supreme Court, rendered XXXXXXXXXX as a result of the Legal Action;

11. "The Settlement Agreement" is the agreement dated XXXXXXXXXX between the Company and the Province, intended to arrive at a monetary settlement in respect of the Decision;

12. "The Damages" is the amount the Province agrees to pay the Company under the terms of the Settlement Agreement, the total of which includes:

(a) "The Preliminary Cash Settlement", that is the sum of $XXXXXXXXXX";

(b) "The Land Price", that is the sum of $XXXXXXXXXX; and

(c) "The New Licence", that is a non-replaceable forest licence that will be issued to the Company by the Province under the Forest Act, with an estimated fair market value between $XXXXXXXXXX and $XXXXXXXXXX.

13. "The First Closing" is the date of the Settlement Agreement, XXXXXXXXXX, at which time the Province paid to the Company the Preliminary Cash Settlement and the Land Price;

14. "The Land" is real property the Company was leasing from a Crown corporation of the Province, which it acquired from the Province on the First Closing with the portion of the Damages that is the Land Price;

15. "The Second Closing" is a future date provided for under the Settlement Agreement, that is no later than XXXXXXXXXX, at which time the Province will issue the New Licence to the Company;

16. "The Company Act" is special legislation which will enable the Province to issue the New License to the Company under the Forest Act;

17. "The Court Order" is an order settling the Legal Action that will be executed in the Provincial Supreme Court after the Second Closing;

18. The term "taxable Canadian corporation", hereafter known as a TCC, has the meaning assigned by subsection 89(1) of the Act;

19. The term "Canadian-controlled private corporation", hereafter known as a CCPC, has the meaning assigned by subsection 125(7) of the Act;

20. The terms "depreciable property" and "undepreciated capital cost", have the meaning assigned by subsection 13(21) of the Act;

21. The term "timber limit" describes depreciable property for which capital cost allowance may be claimed under paragraph 20(1)(a) of the Act, pursuant to paragraph 1100(1)(e) and Schedule VI of the Income Tax Regulations (the Regulations);

22. The term "timber resource property" has the meaning assigned by subsection 13(21) of the Act, and describes depreciable property for which capital cost allowance may be claimed under paragraph 20(1)(a) of the Act, pursuant to subparagraph 1100(1)(a)(xxiv) and Class 33 in Schedule II of the Regulations;

23. The term "former property" has the meaning assigned by subsections 44(1) and 13(4) of the Act; and

24. The term "replacement property" has the meaning assigned by subsections 44(5) and 13(4.1) of the Act.

Facts

25. The Company is a TCC and a CCPC, incorporated under the laws of the Province on XXXXXXXXXX .

26. The Company has a taxation year-end of XXXXXXXXXX .

27. The Company is engaged in the lumber business in Canada. It owns and operates lumber mills in the Province and other Canadian provinces.

28. The Company's principal business is the manufacturing of dimension lumber in its manufacturing facility located in the Province.

29. The Company holds a major forest licence in the PGTSA , under which it harvests timber for its sawmills.

30. During the past decade, the Company has manufactured and operated modular sawmills in the Province and other Canadian provinces, either in its own right or in joint venture arrangements with others.

31. The majority of the Company's products are exported to the United States. It also exports products to Japan and sells into the Canadian dimension lumber market.

32. The Company is also involved in the business of XXXXXXXXXX .

33. The Company owns real property in the Province and other Canadian provinces.

34. In the 1970's, the lodgepole pine timber in the WLTSA was struck with an infestation of the mountain pine beetle. The consequences for the WLTSA were devastating, with substantial volumes of timber being destroyed each year without any prospect of rehabilitation, leaving behind vast acres of dead trees that created extreme wildfire hazards. The threat of infestation to other areas of the Province was also probable.

35. To avert further devastation, the Province offered short-term, low-volume licences in strategic areas in the WLTSA. The Province's objectives were to create fuel or fire breaks and to salvage dead or nearly dead timber. The attempt was unsuccessful, in substantial part because there was no existing lumber mill in the affected area and a licence on the terms the Province permitted did not provide a sufficient financial return to prospective bidders to offset the capital cost of establishing a mill in the WLTSA.

36. In 1983, the Province changed its strategy, shifting away from smaller individual licences to much larger licences. The Province made a public invitation for applications for the grant of a non-renewable forest licence under section 11 of the Forest Act. This forest licence would authorize the harvesting of 500,000m3 of beetle infested lodgepole pine timber per year from lands within the WLTSA for a period of ten years.

37. The Company proposed a bid on this forest licence based on the innovative concept of using modular mills that would be located in the licence area. The Company's bid included a plan to mill the logs where they were cut (inclusive of drying and planing), using local labour and transporting the finished lumber products to distribution centers.

38. In XXXXXXXXXX , the Province issued the Original Licence to the Company.

39. The terms of the Original Licence included the following:

(a) The Company had the right to harvest from specified Crown land in the WLTSA an allowable annual cut of XXXXXXXXXX of Crown timber every year (for a term of XXXXXXXXXX ) from areas specified in cutting permits in accordance with management and workings plans; and
(b) The Company was required to make payments to the Province as follows:

(i) A lump sum bonus of $XXXXXXXXXX ;
(ii) An annual rent of $XXXXXXXXXX , payable one year in advance; and
(iii) A security deposit of $XXXXXXXXXX .

40. The Original Licence is a depreciable property that is a timber limit with a capital cost of $XXXXXXXXXX .

41. The Company has fully deducted the capital cost of the Original Licence under paragraph 20(1)(a) of the Act, pursuant to paragraph 1100(1)(e) and Schedule VI of the Regulations.

42. The undepreciated capital cost of the Original Licence is NIL.

43. After issuance of the Original License, the Company expended capital and effort in establishing and developing an infrastructure of roads, bridges, mill yards, sawmills, planer mills and related facilities within the WLTSA.

44. On XXXXXXXXXX , the Province suspended the Original Licence, and on XXXXXXXXXX , it was cancelled.

45. At the time of cancellation of the Original Lease, the Company had XXXXXXXXXX of timber that it did not harvest.

46. As a result of the cancellation of the Original Licence, on XXXXXXXXXX , the Company commenced the Legal Action in the Provincial Supreme Court through the filing of the first of the Statements of Claim.

47. The Statements of Claim included the following allegations:

(a) After the Company commenced operations in the WLTSA under the terms of the Original Licence, the Province amended the Forest Act to require licence holders to pay the silviculture expenses in respect of areas in which they harvested timber;
(b) The Province indicated to the Company that it would have to pay for silviculture expenses for the timber it harvested under the terms of the Original Licence, pursuant to the amendments to the Forest Act;
(c) Through a series of oral and written acknowledgements, the Province later informed the Company that the amendment to the Forest Act would not apply to the Original Licence and therefore, it would not have to pay the silviculture costs in respect of the timber harvested under the terms of the Original Licence;

(d) In XXXXXXXXXX , the Province again reversed its position on the Company's liability for silviculture expenses. As a result, the Company was now obligated to pay the Province for the silviculture costs in respect of the timber harvested under the terms of the Original Licence;

(e) The Province, throughout the tenure of the Original Licence, imposed upon the Company further obligations that were contrary to the terms of the Original Licence and the Forest Act, such as the payment of higher stumpage fees;
(f) The Province frustrated the Company's ability to harvest timber under the Original Licence by withholding cutting permits, withdrawing approved development and logging plans, and imposing moratoriums upon harvesting;
(g) The Company's attempt to address these issues with the Province resulted in the suspension and cancellation of the Original Licence; and
(h) Because of the cancellation of the Original Licence, the Company's ability to export lumber to the United States was reduced, thereby lowering the export quota allocated to the Company under a treaty between Canada and the United States that was dated May 29, 1996.

48. In the Statements of Claim, the Company requested that the Province be ordered to:

(a) Pay general damages (for breach of contract, deceit and wrongful suspension and cancellation of the Original Licence);
(b) Pay special damages;
(c) Pay for the silviculture obligations of the Company;
(d) Make available to the Company a volume of XXXXXXXXXX of timber in the WLTSA;
(e) Pay punitive, exemplary or aggravated damages; and
(f) Pay the court costs of the Company.

49. In response to the Legal Action commenced by the Company, the Provincial Supreme Court rendered the Decision on XXXXXXXXXX .

50. According to the Decision:

(a) The Province's actions deprived the Company of substantially the whole benefit it was entitled to under the Original Licence;

(b) The Province breached the terms of the Original License by:

(i) Frustrating the Company's ability to harvest timber while it held the Original License; and
(ii) Suspending and eventually cancelling the Original License;
(c) The Company is entitled to an award of damages associated with the breach of terms of the Original License, as well as punitive damages;
(d) Further hearings would be postponed so that legal counsel for the Company and the Province can prepare submissions on a monetary amount the Province should pay the Company; and
(e) If legal counsel for the Company and the Province are unable to agree on an award for court costs incurred in respect of the Legal Action, they may address the court accordingly.

51. As a result of the Decision, on XXXXXXXXXX , the Company and the Province entered into the Settlement Agreement, which provides that:

(a) The Province must pay the Company the Damages for the unlawful taking by cancellation of the Original Licence; and
(b) The payment of the Damages will proceed in two stages, the First Closing and the Second Closing.

52. On XXXXXXXXXX , the First Closing proceeded in accordance with the Settlement Agreement, whereby:

(a) The Province paid the Company the Preliminary Cash Settlement and the Land Price; and
(b) The Company used the Land Price to acquire the Land from the Province.

Proposed Transactions

It is proposed that:

53. The Province will enact the Company Act so that it can issue the New Licence to the Company under the Forest Act.

54. There will be a Second Closing that will proceed on a future date that is no later than XXXXXXXXXX , and the Province will issue the New Licence to the Company. The New Licence:

(a) Will be a timber resource property;
(b) Will have a capital cost, determined without reference to paragraph 44(1)(f) of the Act, that is the total of the fair market value of the New Licence which is estimated to be between $XXXXXXXXXX and $XXXXXXXXXX , and such outlays and expenses that are related to acquisition; and
(c) Will have terms which provide that the Company has the right to harvest from specified Crown land in the PGTSA an allowable annual cut of XXXXXXXXXX of Crown timber every year for a term of XXXXXXXXXX years commencing on the coming into force of the Company Act. The XXXXXXXXXX -year term of the licence shall be extended automatically until a total of XXXXXXXXXX of timber has been harvested or a maximum term of XXXXXXXXXX years has elapsed from the date of issuance.

55. The Second Closing is conditional on:

(a) The Company receiving from the Canada Customs and Revenue Agency (the CCRA) an affirmative answer to this ruling request, but the Company has discretion to waive this requirement under the Settlement Agreement, if it so chooses; and
(b) The Province enacting the Company Act.

56. Following the Second Closing, the Court Order will be executed in the Provincial Supreme Court, and will order and declare that:

(a) The Province must pay the Company the Damages for the unlawful taking by cancellation of the Original Licence;
(b) The Legal Action is dismissed; and
(c) The Company and the Province will each bear its own court costs with respect to the Legal Action.

57. Expenses incurred by the Company in the XXXXXXXXXX taxation years with respect to the above-noted transactions, including legal and accounting fees pertaining to the Legal Action, the negotiation of the Settlement Agreement, the disposition of the Original Licence, the acquisition of the New Licence and the issuance of the Court Order, are capital expenditures that will be prorated between the calculation of the gain on the disposition of the Original Licence, and the determination of the capital cost of the New Licence.

58. In the taxation year ended in which the Second Closing occurs, the Company will elect under subsection 44(1) of the Act with respect to the disposition of the Original Licence and acquisition of the New Licence. Pursuant to subsection 44(4) of the Act, the Company will be deemed to have also elected under subsection 13(4).

59. If the Second Closing does not proceed, the Legal Action will continue in the Provincial Supreme Court.

Purpose of the Proposed Transactions

60. To settle the Legal Action by establishing compensation in full for the unlawful taking by cancellation of the Original Licence by the Province.

Rulings Given

Provided that:

(a) The preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and the purpose of the proposed transactions;
(b) The proposed transactions are completed in the manner described above; and
(c) There are no other transactions, which may be relevant to the ruling requested,

Our rulings are as follows:

A. The Damages will constitute "proceeds of disposition" of the Original Licence, pursuant to paragraph (b) of the definition of proceeds of disposition in subsection 13(21) of the Act and paragraph (b) of the definition of proceeds of disposition in section 54 of the Act, receivable in the taxation year ended in which the Second Closing occurs; and

B. Subsection 44(1) of the Act will apply to calculate the Company's gain from the disposition of the Original Licence and capital cost for the acquisition of the New Licence, in the taxation year ended in which the Second Closing occurs, on the basis that the Original Licence will be considered a former property of the Company and the New Licence will be considered a replacement property for the Original Licence.

These rulings are given subject to the limitations and qualifications set out in Information Circular 70-6R4 issued by the CCRA on January 29, 2001, and are binding on the CCRA provided that the Second Closing occurs on or before XXXXXXXXXX .

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.

Except as expressly stated, these rulings do not imply acceptance, approval or confirmation of any income tax implications of the facts or proposed transactions.

Nothing in this ruling should be construed as implying that the CCRA has agreed to or reviewed the determination of the capital cost, adjusted cost base, or fair market value of any particular asset referred to herein.

Yours truly,

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