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 amount paid as "damages" is deductible in computing income.

Position: Question of fact.

Reasons: A payment for damages must be incurred for the purpose of gaining or producing income from a business and otherwise meet the criteria set out in 65302 BC Ltd. v. HMQ to be deductible in computing income.

2002-015592
XXXXXXXXXX A. Seidel
(613) 957-2058
October 24, 2002

Dear XXXXXXXXXX:

Re: Payment for Damages

The XXXXXXXXXX Tax Services Office has forwarded your letter of July 18, 2002, concerning the deductibility of legal fees and a payment for damages, for our reply.

Background

As an employee (the "Employee") of a corporation (the "Employer"), the employee developed a new program that was successfully marketed to the clients of the Employer. Shortly thereafter the Employee incorporated a new corporation ("Newco"), resigned as an employee of the Employer and began to carry on business in direct competition with the Employer. Under the terms of an employment contract between the Employee and the Employer, the Employee was not permitted to solicit clients of the Employer for a period of one year after resignation. Shortly after the former Employee's resignation, a client of the Employer approached the Employee and suggested that Newco submit a bid on a contract that was in direct competition with the bid of the former Employer and one other bid. The Employee consulted with legal counsel and was informed that the submission of a bid would not be a violation of the employment contract with the Employer by virtue of the fact that the client had initiated the contact with the Employee. Newco was the successful bidder on the contract and the Employer sued the Employee for damages for breach of his/her employment contract.

You have raised two issues in your letter: Are the payments of the settlement for damages and the related legal fees deductible in computing income of the Employee or Newco? If Newco pays the damage settlement and the legal fees, is the Employee in receipt of a shareholder benefit?

The particular circumstances in your letter relate to a factual situation involving a specific taxpayer. As explained in Information Circular 70-6R5, it is not this Directorate's practice to comment on transactions involving specific taxpayers other than in the form of an advance income tax ruling. However, we are prepared to offer the following general comments which may be of assistance.

Paragraph 3 of Interpretation Bulletin IT-467R ("IT-467R") outlines the requirements for the deductibility of payments for damages. It states that payments for damages may be deductible in computing income if they meet the following tests:

(a) the outlay must have been made for the purpose of gaining or producing income from business or property (paragraph 18(1)(a) of the Income Tax Act (the "Act");

(b) the outlay must not be on account of capital (paragraph 18(1)(b) of the Act);

(c) the outlay must not be made for the purpose of gaining or producing exempt income (paragraph 18(1)(c) of the Act); and

(d) the outlay must be reasonable in the circumstances (section 67 of the Act).

The deductibility of fines and penalties was also addressed in 65302 British Columbia Ltd. v. Her Majesty the Queen (99 DTC 5799, SCC) ("65302 BC Ltd."). The Supreme Court concluded that a fine or penalty is deductible in computing income from a business where a taxpayer can establish that the a fine or penalty was incurred for the purpose of gaining or producing income from that (emphasis added) business.

Whether an individual or a corporation is entitled to deduct a payment for damages and any legal fees related thereto is a question of fact to be determined by reviewing all of the circumstances surrounding the payment. This would include a review of the "statement of claim", or other legal document, filed by the plaintiff, which would identify the cause of action, the defendant(s) and the details of the components of the claims against the defendant (recovery of lost income, breach of trust, breach of employment contract, damages, interest, reimbursement of legal fees, etc.). The final settlement of the suit would also need to be reviewed. This would provide details of the settlement agreed to by the parties or the court ordered settlement and who is liable for the payment of these amounts. Where the parties have reached a settlement before proceeding to court, all documentation pertaining to the settlement would have to be reviewed to determine the components of the payment to be made by the defendant to the plaintiff and the legal liability to make such payment.

Subsection 15(1) of the Act provides that the amount or value of a benefit conferred on a shareholder by the corporation is required to be included in computing the shareholder's income, except to the extent that the benefit is conferred by any of the items listed in paragraphs (a) to (d) or to the extent that it is deemed by section 84 to be a dividend. Whether the payment of an amount for damages and the legal fees related thereto would result in a benefit to a shareholder is a question of fact that can only be determined by reviewing all of the circumstances surrounding the payment. Generally, where a corporation pays for a personal expense of a shareholder, a benefit has been conferred on the shareholder and the amount of the benefit is included in computing the shareholders income pursuant to subsection 15(1) of the Act.

A copy of IT-467R is available at your local tax services office or may be obtained from our Internet web site (www.ccra-adrc.gc.ca).

Yours truly,

John Oulton, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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