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 amounts received on the termination of a contract would constitute income or capital receipts. 2. Whether part of proceeds on termination of contract relating to a non-competition clause would be taxable to the recipient.
Position: 1. Amount would probably be considered capital in nature. 2. Amount would likely be taxed as employment income.
Reasons: 1. Courts have established that you must consider both the purpose and the effect of the payment. In this case the purpose is not entirely clear. However, the effect of the cancellation of the contract was to effectively end the profit making apparatus of the businesses carried on by the companies. 2. The non-competition clause is an essential element of the employment agreement signed by the chief shareholder of the company that provided services to the REIT.
December 20, 2002
XXXXXXXXXX HEADQUARTERS
Verification and Enforcement Division Wayne Antle, CGA
XXXXXXXXXX Tax Services Office (613) 957-2102
2002-014796
XXXXXXXXXX
This is in response to your email of June 19, 2002, concerning the income tax implications of amounts received by XXXXXXXXXX for the termination of a management agreement.
We have reviewed the information provided in your email as well as the documents faxed to us on September 11, 2002, October 29, 2002, and November 26, 2002. Our understanding of the facts is as follows:
FACTS
1. XXXXXXXXXX Real Estate Investment Trust (the "REIT") invests in various real estate ventures, and generates rental revenue, as well as income from the purchase and sale of real property. As a REIT, it sells units to the general public.
2. XXXXXXXXXX ("XCo") was owned by XXXXXXXXXX . ("YCo"). YCo, in turn, was XXXXXXXXXX % owned by a subsidiary of a holding company owned by XXXXXXXXXX ("Mr. A") and his wife. The other XXXXXXXXXX % was owned by XXXXXXXXXX ("Mr. B") and a family trust through its holding company.
3. XCo, YCo, Mr. A, and Mr. B, each dealt at arm's-length with the REIT.
4. On XXXXXXXXXX , XCo, Mr. A and Mr. B entered into an advisory agreement (the "Advisory Agreement") with the REIT to provide advisory services and manage the REIT's property managers. XCo was paid a fee, plus commissions on the purchase and sale of real property.
5. While the Advisory Agreement had a finite term, it was automatically renewed unless XCo was not fulfilling the terms of the contract.
6. XCo derived almost all of its revenue from the Advisory Agreement wherein it received fees for providing acquisition, disposition, financing, and development services.
7. YCo derived over one-half of its revenue from the provision of co-management and advisory services to the REIT on behalf of XCo.
8. In order to save the fees being paid to XCo, the REIT decided to terminate the Advisory Agreement. It obtained the requisite approval from the unit holders to take steps to end this arrangement.
9. On XXXXXXXXXX , XCo, Mr. A, Mr. B, and the REIT entered into a Termination Agreement (the "Termination Agreement") to facilitate the ending of the Advisory Agreement.
10. On XXXXXXXXXX , XCo amalgamated with its parent company, YCo, and the new company continued under the name of XXXXXXXXXX ("Amalco").
11. The Termination Agreement became effective on XXXXXXXXXX .
12. Under the terms of the Termination Agreement, the REIT would pay to Amalco the sum of $XXXXXXXXXX as follows:
a. $XXXXXXXXXX as a promissory note bearing interest payable to Amalco on XXXXXXXXXX ,
b. $XXXXXXXXXX by issuing XXXXXXXXXX units of the REIT based on XXXXXXXXXX % of the weighted average trading price of the units for a XXXXXXXXXX period immediately preceding the Agreement. The units were not permitted to be sold for at least XXXXXXXXXX from the closing date of the Agreement.
c. $XXXXXXXXXX in cash put in an escrow account. The money is to be used to purchase, on the open market, units of the REIT when the units are selling at or below the ceiling price ($XXXXXXXXXX per unit). The units purchased are held in the escrow account. On the XXXXXXXXXX anniversary of the closing date of the Agreement, XXXXXXXXXX of the units are released to Amalco. The remaining money and units are released on the XXXXXXXXXX anniversary of the closing. Amalco is paid interest monthly on the money held in the escrow account.
13. The Termination Agreement also provides for the transfer of some of the employees of XCo to the REIT, as well as the transfer of certain capital assets.
14. The Termination Agreement provides that Mr. A and Mr. B will enter into employment contracts with the REIT in substantially the form set out in appendices to the Termination Agreement (the "Employment Contracts").
15. The Employment Contract with Mr. A provides that he will act as the Chief Executive Officer of the REIT and receive compensation in a mix of salary and bonuses.
16. An integral component of the Employment Contract with Mr. A is a non-competition clause, which essentially provides that Mr. A will not engage in any investing or advisory activities in competition with the REIT during his period of employment and one year thereafter.
17. In conjunction with the Termination Agreement, Amalco, Mr. A, and Mr. B have entered into an Allocation Agreement dated XXXXXXXXXX (the "Allocation Agreement").
18. The Allocation Agreement provides that $XXXXXXXXXX of the Proceeds be allocated to Mr. A as consideration for entering into the non-competition clause in the Employment Contract. The exact mix of consideration (cash and REIT units) is to be determined by the parties.
19. Only Mr. A was paid compensation for the non-competition clause in his Employment Contract because he was only required to devote XXXXXXXXXX % of his time to the REIT whereas Mr. B was required to devote all his time to the REIT. The payment was made to compensate him for not competing with the REIT in the pursuit of his other activities during the remaining XXXXXXXXXX % of his time.
20. Amalco reported proceeds of $XXXXXXXXXX with respect to the Termination Agreement, after deducting the following amounts:
a. $XXXXXXXXXX to reflect the fact that the units issued by the REIT were valued at XXXXXXXXXX % of market value.
b. $XXXXXXXXXX to reflect the fact that the units would decline in price if YCo sold them over a short period of time,
c. $XXXXXXXXXX allocated to Mr. A for the non-competition covenant included in Mr. A's employment contract,
d. $XXXXXXXXXX with respect to units directed to Mr. A for the non-competition covenant in his employment contract, pursuant to the Allocation Agreement,
e. $XXXXXXXXXX to reflect the liquidity on the units to be purchased with the funds held in escrow.
21. In computing the capital gain with respect to the Agreement, Amalco stated that the Agreement had an adjusted cost base of $XXXXXXXXXX being its investment in XCo.
ISSUES
You have asked us to consider three issues with respect to the above transactions:
1. Would the amount received by Amalco be considered a capital or income receipt?
2. Is the capital gain reported by Amalco calculated correctly having regard to the determination of the ACB of the Agreement, and the deductions from proceeds listed in paragraph 20 above?
3. What amount should be reported by Mr. A in respect of the proceeds receivable by him pursuant to the Allocation agreement?
Our comments on each issue are as follows:
Issue 1
The determination of whether amounts received on the cancellation of a contract or business arrangement are capital or income in nature is a question of fact. This issue has been considered by the courts in a line of cases that have established some guiding principles.
In Canadian National Railway Company v. HMQ (88 DTC 6340) and Pe Ben Industries Company Limited v. HMQ (88 DTC 6347), the Federal Court Trial Division considered whether an amount received on the cancellation of a transportation contract was a capital or income receipt. These cases were heard at the same time, and were based on the same essential facts. In the Canadian National case, Strayer, J. set out the relevant legal principles to follow in making such a determination:
It appears to me that there are two aspects which a court must consider in examining such a situation retrospectively: was the purpose of the payment to replace capital or income; and, whether or not the purpose can be reliably determined, was the effect of the payment to replace capital or income? It appears to me to be a dual test because the purpose may not be discernible, or it may not be reliably discernible in the sense that parties to settlements should not, by misstating the real purpose, determine the tax consequences of the receipt of such compensation. It is therefore necessary to look at both purpose and effect.
With respect to purpose, the essential question is to determine what the compensation - whether paid pursuant to a contract, a court award of damages, or otherwise - is intended to replace. In some cases the contract providing for compensation may be clear. The measure employed for calculating compensation is not always determinative: potential lost income may be taken into account in calculating a capital sum to be paid. Nor on the other hand does the fact that an amount is paid as damages for breach of a contract necessarily make it a capital sum and not income. On the contrary it appears to me that whatever the source of the legal right to the compensation, be it the contract or the law of damages, the substantive issue is: what is this amount intended to replace?
With respect to the effect of the termination of the business arrangement and the role of compensation in respect thereto, I believe the two possibilities are well expressed in the judgment of Lord Russell in the Fleming case: [Commissioners of Inland Revenue v. Fleming & Co. (Machinery) Ltd., (1951) 33 Tax Cas. 57]
". . .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 sterilisation of a capital asset and is therefore a capital and not a revenue receipt. . . .On the other hand when the benefit surrendered on cancellation does not represent the loss of an enduring asset in circumstances such as those above mentioned 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."
It will be noted that to apply such criteria it is necessary to make value judgments as to the severity of the impact on the taxpayer of the termination of certain business activities in respect of which compensation has been paid.
The approach outlined by Strayer, J. in the above cases has been followed by the Federal Court of Appeal in other cases such as Schofield Oil (92 DTC 6022), Mohawk Oil (92 DTC 6135) and Charles R. Bell (92 DTC 6472).
Essentially, it is necessary to consider the true purpose for which the payment was made, and the effect of the payment in order to determine whether it is an income or a capital receipt. In order for the amount paid under the Agreement to be considered an income receipt, it must be established that the payment was a replacement for income under the contract, and that the cancellation of the contract did not materially cripple the business carried on by Xco or Amalco.
With respect to purpose, the Termination Agreement does not lead to any clear conclusions. The Termination Agreement acknowledges that, under the terms of the Advisory Agreement, the REIT must pay an amount equal to the fair market value of this agreement, if it is terminated. Of course, the future income that would be earned by Amalco is inherent in the determination of the Advisory Agreement's fair market value. A strong argument can be made that Amalco has disposed of capital property, being its rights under the Advisory Agreement, and the payment therefore represents proceeds of disposition. Alternatively, one could argue that the payment represents a substitute for the future income that would have been earned under the Advisory Agreement. The true purpose of the payment is therefore not evident from a review of the documents submitted.
With regard to the effect of the payment, it must be determined whether the termination of the contract destroyed or materially crippled the whole structure of XCo's and Amalco's profit-making apparatus. Based on the facts presented, it appears that XCo derived almost all of its revenue from the Advisory Agreement with the REIT. Under the terms of the Termination Agreement, most of XCo's employees, as well as its capital assets, were assigned to the REIT. Accordingly, it would seem that XCo's business was effectively ended when the Advisory Agreement was cancelled.
However, since Amalco assumed the rights under the Advisory Agreement just prior to its termination, it is also necessary to consider the effect of the Termination Agreement on Amalco's business. Amalco derived over XXXXXXXXXX of its revenue from the Advisory Agreement, with the remainder coming principally from real estate management services provided to XXXXXXXXXX . not related to the REIT. Amalco has terminated its arrangements with these companies, as well as with the REIT. It would appear that Amalco had, in effect, terminated its existing business when the Termination Agreement was signed.
Consequently after reviewing the facts and documents submitted, it is our view that the amount received by Amalco under the agreement would be considered capital in nature. While the purpose of the payment is not entirely clear, the effect of the cancellation of the Advisory Agreement appears to have ended XCo's and Amalco's businesses.
In arriving at our opinion, we have not examined the past business practices and activities of Xco, YCo, Amalco, and any related companies. If these companies show a pattern of routinely entering into management agreements, and terminating them after some time, it may be possible to argue that the amount received was on income account. However, we have seen no evidence of this.
The issue of how such a payment should be reported was considered in the Pe Ben case wherein Strayer, J. stated:
This leaves the question as to whether the amount in question was the proceeds of disposition of an asset thereby rendering it potentially subject to treatment as a capital gain. It may first be noted that both the plaintiff and the defendant contend as an alternative that the sum in question should be so treated. I am in agreement that it should in accordance with the various definitions in the Income Tax Act. Paragraph 39(1)(a) indicates that a capital gain arises "from the disposition of any property". Subsection 248(1) of the Act defines "property" as meaning "property of any kind whatever" including "(a) a right of any kind whatever, a share or a chose in action. . . " I believe that the plaintiff's rights under the contract with NAR which it gave up in return for a final payment would constitute such a right or a chose in action. Further, a "disposition" of property is defined by [former] subparagraph 54(c)(i) as including "any transaction or event entitling a taxpayer to proceeds of disposition of property". This would cover the payment made by NAR to the plaintiff, whether one regards it as payment pursuant to the contract or for termination of the contract. This view is reinforced by the definition in subparagraph 54(h)(iii) of "proceeds of disposition" to include "compensation for property destroyed. . . " The money paid by NAR to the plaintiff was for termination of any claim which the plaintiff might have against NAR under the contract which claim was thus "destroyed".
Based on the facts presented, it is likely that the amount received by Amalco on termination of the Advisory Agreement would constitute proceeds of disposition of a capital property, and therefore give rise to a capital gain.
Finally, you have asked whether the payments made by the REIT could be deducted as a business expense by the REIT if Amalco is treating the amounts as capital. Whether the amount paid by the REIT is a capital or current expenditure is not determined by the tax treatment of the amount to the recipient. This determination can only be made after reviewing all of the facts and documentations. Please refer to the draft of Interpretation Bulletin IT-467R2 Damages, Settlements, and Similar Payments for a discussion of the guidelines used to determine whether payments made on the cancellation of a contract are capital or current in nature.
Issue 2
With respect to the amounts deducted from the proceeds, the fact that the agreement acknowledges a termination payment of $XXXXXXXXXX is prima facie evidence that the total amount received by Amalco is, in fact, $XXXXXXXXXX. However, it appears that $XXXXXXXXXX of the proceeds relates to a non-competition clause included in Mr. A's Employment Contract. Accordingly, the value of the Advisory Agreement may actually be $XXXXXXXXXX. If Amalco is contending that the fair market value of the Advisory Agreement and the consideration received was less than $XXXXXXXXXX, you may wish to discuss their submission with your equity valuations section.
Concerning the determination of the ACB of the Agreement, we would expect that the agreement would have a nil adjusted cost base. However, we cannot provide any definitive comments without reviewing all of the facts and documentation including the basis upon which Amalco calculated the ACB.
Issue 3
As noted in the facts above, it appears that Mr. A received $XXXXXXXXXX for his agreement not to compete with the REIT. You have indicated that he did not include this amount in his income citing the decision of the Federal Court of Appeal in Fortino v. HMQ (2000 DTC 6060). The tax treatment of the amount received by Mr. A for the non-competition covenant will depend upon whether the amount was received in connection with his employment with the REIT.
Where an amount is paid to an employee to compensate the employee for the inclusion of a non-competition clause in the employment contract, it is our view that the payment would be taxed as employment income under section 6 of the Act. If the employee has been paid an amount to not compete with the employer before or after the period of employment, then this amount would be deemed to be remuneration pursuant to paragraph 6(3)(e) of the Act. Essentially, paragraph 6(3)(e) deems an amount received by a person under an agreement entered into immediately prior to, during, or immediately after the period of employment to be employment income where the amount was received as consideration for a covenant to do, or not do, an action before or after the period of employment.
On the other hand, if the payment is made to compensate the person for not competing with the employer during the period of employment, then it would be included in income from employment pursuant to section 5 and paragraph 6(1)(a) of the Act as either remuneration, or the value of a benefit received in respect of the employment.
In our view, a compelling argument can be made that Mr. A received the non-competition payment in connection with his employment with the REIT. The non-competition clause was an essential component of the Employment Agreement with Mr. A. In fact the non-competition provisions of the Employment Agreement conclude by stating, "...the covenants...not to enter into competition with the trust [the REIT] are essential elements to this agreement and that, but for the agreement of the Executive [Mr. A] not to enter into such covenants, the Trust would not have agreed to hire the Executive...". Furthermore, the Allocation Agreement signed in conjunction with the Termination Agreement recognizes that a portion of the amount paid to Amalco should be allocated to Mr. A as consideration for agreeing not to compete with the REIT for the duration of his employment with the REIT and one year thereafter. Accordingly, it is our view that the amount of $XXXXXXXXXX received by Mr. A would likely be taxable to him as employment income in the year he receives the payments.
Even if it could be argued that the payment for the non-competition agreement did not constitute employment income, in our view the decision in Fortino would not make it non-taxable. Our position on situations similar to Fortino was discussed at the 2000 Canadian Tax Foundation conference. At that conference we expressed the view that non-competition payments will generally constitute proceeds of disposition of capital property, that being the right to compete with the purchaser. We were prevented by the courts from arguing this position in Fortino. For more information in this regard please refer to our Round Table Discussion held at the 2000 Canadian Tax Foundation meetings. However, as noted above, we do not feel that the decision in Fortino is applicable to this situation since the non-competition covenant was part of Mr. A's employment contract.
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We trust that our comments will be of assistance.
John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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