3 March 2003 Internal T.I. 2002-0135637 - XXXXXXXXXX

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.

Principal Issues: The taxpayer received a payment from the XXXXXXXXXX in settlement of a class action suit against the company pertaining to a loss realized by the taxpayer on the disposition of the shares of the company. Only a portion of the loss was recovered.

1. How is she to report the balance of her "realized loss"?

2. How should the receipt of the amount be reported for tax purposes in Canada?

3. Is the 30% tax withheld reduced under the Canada-U.S. Income Tax Convention?

4. Can the taxpayer claim a foreign tax credit in XXXXXXXXXX for the tax withheld by XXXXXXXXXX ?

Position:

1. Likely, she has already reported the loss in the years the shares were sold. There is no further loss to report.

2. The payment is likely damages, and would be additional proceeds of disposition for the year of sale, which is probably statute-barred.

3. No.

4. Only if she has other U.S. "qualifying income" in XXXXXXXXXX .

Reasons:

1. The payment from the settlement fund was to shareholders who sold their shares between XXXXXXXXXX and XXXXXXXXXX .

2. Based on the information we have been able to obtain.

3. If our conclusions are correct, the U.S. has taxed in accordance with the Convention.

4. The additional proceeds of disposition are not taxable in XXXXXXXXXX .

								March 3, 2003

	SUMMERSIDE TAX CENTRE				HEADQUARTERS
	T1 Reassessment					Income Tax Rulings Directorate
	275 Pope Road
	Summerside PE  C1N 5Z7				S.E. Thomson
(613) 957-2122
	Attention:  Joe MacDonald
               Technical Resource Officer		2002-013563

Payment from XXXXXXXXXX

This is in reply to your memo to us on April 15, 2002, on behalf of XXXXXXXXXX letter was sent to you by the XXXXXXXXXX TSO. We apologize for the delay in responding to your memo.

The taxpayer, a resident of Canada, received a payment from the XXXXXXXXXX. The fund was established by XXXXXXXXXX in response to a class action suit by its former shareholders. The shareholders alleged that management purposely suppressed information regarding the XXXXXXXXXX. The company, without admitting guilt, established the fund to compensate former shareholders who had realized losses on shares sold between certain dates between XXXXXXXXXX and XXXXXXXXXX.

The fund was paid out to the former shareholders at the rate of XXXXXXXXXX for every dollar of realized loss. In this taxpayer's case, the realized loss was US$XXXXXXXXXX, and she was paid US$XXXXXXXXXX, less U.S. tax withheld of US$XXXXXXXXXX (i.e., 30%). The taxpayer would like to know how to report the balance of the "realized loss" that she did not recover from the settlement fund.

The fund is being administered by the XXXXXXXXXX. We spoke to a representative there, and he sent us the company's XXXXXXXXXX . From a reading of these two documents, it appears that the shareholders that are being compensated are those who actually sold shares of the company during the specified periods in XXXXXXXXXX to XXXXXXXXXX. In that case, the taxpayer, presumably, will have already reported the loss on the sale of the shares on her tax returns in those years, and there is no more loss to claim.

The taxpayer did not ask how to report the $XXXXXXXXXX and the $XXXXXXXXXX, although she did say that she reported it on her XXXXXXXXXX income tax return as "other income" and claimed a foreign tax credit. We've done quite a bit of research to determine how this amount should be taxed, and based on certain assumptions, we have concluded the following:

• The settlement fund is likely a "designated settlement fund" as set out in section 468B of the Internal Revenue Code (the "IRC"), but this was not confirmed. The rules in section 468B provide that if an account, fund or trust meets the criteria in that section, it will be taxed as a corporation. The payer (XXXXXXXXXX) can deduct the payment to the designated settlement fund from its income for tax purposes.
• We have not determined whether the settlement fund is a trust, and if it is, whether it is excluded from the definition of "trust" in subsection 108(1) of the Act. Nor have we determined whether the settlor of the trust (i.e., if there was a trust) was the group of shareholders to whom the settlement proceeds belonged, or XXXXXXXXXX. For purposes of this letter, however, we have assumed that the settlement fund is not a trust, or that the payout from the settlement can be considered received by the group of shareholders notwithstanding the funds were used to settle a trust.
• We wrote a letter to XXXXXXXXXX, asking them how they characterized the payment. One of their lawyers called us back, and all he could tell us was that the payment was deducted from income on their financial statements. He said he doubts it is punitive damages, and would suspect that it's for money damages. We would tend to agree with this characterization, based on the information we have been able to obtain.

The courts have said that damages must be considered in light of the purpose and the effect of the action in which they were awarded (CNR v The Queen 88 DTC 6340). In other words, the questions to be asked are, "what did the shareholder lose in the first place, and what is the payment intended to replace?" The funds were paid as an out-of-court settlement of a class action suit by former shareholders of XXXXXXXXXX who alleged that the actions of the company caused a drop in the value of their shares. The payment to the fund was to compensate those shareholders for their loss. In our view, the payment is compensation for property injuriously affected, and would therefore be "proceeds of disposition" by virtue of paragraph (e) of the definition of "proceeds of disposition" in section 54 of the Act (see also 9116367).

• As proceeds of disposition, the payment from the company to the beneficiaries would reduce the capital loss previously reported, pursuant to paragraphs 39(1)(b) and 40(1)(b) of the Act. However, given that the disposition of shares and the resulting capital loss occurred in the years XXXXXXXXXX through XXXXXXXXXX, it is likely that these periods are outside of the reassessment period.
• The settlement agent has withheld 30% from the payment. They state that they are required to do so under the IRC because the payment is classified as "fixed or determinable annual or periodical gains, profits and income". This appears to be a catch-all category for payments made to non-residents that are not taxed elsewhere under the code (e.g., income effectively connected with a U.S. trade or business), similar to our Part XIII tax. The IRC provides that if the payment is from a "designated settlement fund", the recipient will be taxed as if the payment was from the company.

In Canada, our view is that the receipt of the amounts from the fund is characterized as proceeds of disposition. Based on this characterization, paragraph 4 of Article XIII of the Canada-U.S. Tax Convention (the "Convention") would prevent the U.S. from taxing any of this amount (assuming there was a gain, not a loss on the disposition of the shares and assuming the shares of XXXXXXXXXX did not represent a U.S. real property interest for the purposes of paragraph 3(a) of Article XIII of the Convention).

However, we have not determined whether the U.S. also would characterize the payment as proceeds of disposition. Paragraph 9 of IT-467R2 Damages, Settlements and Similar Payments states that 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. In other words, a payment of damages may be on account of capital to the recipient, but on account of income to the payer. Given that XXXXXXXXXX has deducted the payment from its income, we suggest that the U.S. would characterize the payment as on account of income, and would not apply Article XIII. If that is the case, the only remaining provision that may be relevant is Article XXII of the Convention, which states that income arising in the U.S. may be taxed in the U.S, without reduction by the Convention.

Assuming that this is the correct interpretation of the U.S. domestic law and the U.S.'s application of the Convention, Canada is obliged to provide relief from double taxation. That is, Canada must provide a foreign tax credit for the U.S. tax withheld, to the extent allowed under the Act.

• In general terms, subsection 126(1) of the Act provides for a deduction from Part I tax otherwise payable an amount equal to the non-business-income tax paid by the taxpayer "for the year" to the government of a country other than Canada. The expression "for the year" refers to the year in which the foreign tax is exigible in the foreign country (see 2002-0144257). Therefore, the US$XXXXXXXXXX tax paid in XXXXXXXXXX may be claimed in XXXXXXXXXX, to the extent allowed by subsection 126(1) of the Act.

Again in general terms, the deduction in subsection 126(1) is limited to the lesser of the U.S. tax paid, and the result of the following formula:

Part I tax otherwise payable	X	Qualifying incomes from U.S. sources
Adjusted net income

The "qualifying incomes" of a taxpayer from U.S. sources is determined in accordance with subsection 126(9) of the Act. Note that if the taxpayer does not have any qualifying income from U.S. sources in the year, he will not be entitled to a foreign tax credit for the U.S. tax withheld. (Since we have determined that the US$XXXXXXXXXX payment is likely to be additional proceeds of disposition from the sale of the shares in a prior year, it would not be income in XXXXXXXXXX.)

The U.S. tax paid does not qualify for the deduction in subsection 20(12) of the Act, since it is not a tax on income from a business or property.

It appears that the taxpayer may not have correctly reported the payment from XXXXXXXXXX in XXXXXXXXXX.

We trust that we have been of assistance.

Yours truly,

Olli Laurikainen
Section Manager
for Division Director
International & Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch