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 a contract termination payment is a capital or current expenditure?
2) Whether the receipt of a contract termination payment is on account of capital or income?
Position: In the situation described - 1) eligible capital expenditure of the payor; and 2) income to the recipient
Reasons:
1) The purpose of the termination payment from the payor's perspective was to terminate an obligation that it could no longer fulfill following the sale of the taxpayer's business. The payment represents liquidated damages for failure to comply with the terms of a supply contract. This type of payment is a non-depreciable capital outlay. In the circumstances, we would allow the payor to treat the payment as an eligible capital expenditure.
2) The payment was received in consideration for waiving the right to acquire XXXXXXXXXX from the taxpayer at a discount and to absorb the shock of one of the normal incidents (i.e. having to change suppliers) of business. To the extent that the discount related to the cost of inventory, the payment compensated the recipient for additional costs of acquiring XXXXXXXXXX elsewhere and should be included in computing the income of the recipient.
June 12, 2003
Mr. Joe Joseph HEADQUARTERS
Toronto West Tax Services Office Shaun Harkin, CMA
V&E Division
Attention: Mr. Joseph
2003-001100
Tax Treatment of Contract Termination Payment
We are writing in reply to your memorandum of March 28, 2003 wherein you requested our views on the treatment of a contract termination payment to the payor and recipient in the situation described below:
1) On XXXXXXXXXX purchased the assets of XXXXXXXXXX from its receiver XXXXXXXXXX.
2) In order to fund the purchase of XXXXXXXXXX assets XXXXXXXXXX borrowed $XXXXXXXXXX from XXXXXXXXXX.
3) XXXXXXXXXX agreed to guarantee the obligations of XXXXXXXXXX for up to $XXXXXXXXXX. This guarantee was removed after one year.
4) XXXXXXXXXX entered into a XXXXXXXXXX supply agreement (hereinafter referred to as the "Supply Agreement") with XXXXXXXXXX. Pursuant to the Supply Agreement, XXXXXXXXXX agreed to supply and XXXXXXXXXX agreed to purchase all products from XXXXXXXXXX in such quantities as determined by XXXXXXXXXX at a XXXXXXXXXX% discount.
5) On XXXXXXXXXX entered into an asset purchase agreement with XXXXXXXXXX whereby XXXXXXXXXX agreed to pay $XXXXXXXXXX for the assets of XXXXXXXXXX plus amounts for inventory and prepaid expenses. The closing date of the sale was XXXXXXXXXX.
6) On XXXXXXXXXX negotiated a settlement with XXXXXXXXXX to terminate the Supply Agreement. The amount of the contract termination fee paid to XXXXXXXXXX to extinguish the Supply Agreement was $XXXXXXXXXX.
Your Opinion
In your opinion, the facts indicate that the contract termination fee was capital in nature to XXXXXXXXXX. It is your view that, as a result of the proposed sale of assets XXXXXXXXXX had to free itself of its obligations under the Supply Agreement, which, in the circumstances, was a capital outlay. You cite the case of Eagle Motors Ltd. v. M.N.R., 64 DTC 829, as support for this view.
With respect to the recipient of the payment, it is your view that the receipt of the payment should be considered on account of income. You referred to the case of Canadian National Railway Company v. M.N.R., 88 DTC 6340 (FCTD), as support for this view.
Representative's Opinion
XXXXXXXXXX representative is of the view that the fee paid to terminate the Supply Agreement was incurred in the ordinary course of XXXXXXXXXX business and, accordingly, should be deductible as a current expense in accordance with paragraph 18(1)(a) of the Income Tax Act (the "Act"). The representative referred to the cases of Angostura International Ltd. v. The Queen, 85 DTC 5384 (FCTD); Automatic Toll Systems (Canada) Ltd. v. MNR (FCTD), 74 DTC 6060; and Dymo of Canada Limited v. MNR, 73 DTC 5171 (FCTD), as support for this view.
In cases where contract termination payments are made, the distinction between income and capital payments is often difficult to make. The Act does not define "income" or "capital". It describes sources of income and prescribes methods of computing income. It is, therefore, necessary to find the answer by reference to the decided cases. The courts have indicated that a decision has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. The resolution in any particular case depends on which fact or set of facts is dominant. In BP Australia Ltd v. Commissioner of Taxation of Australia (1966) AC 224, Lord Pearce summarized this principle at page 264:
The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a common sense appreciation of all the guiding features which must provide the ultimate answer.
A. The Payor
Assuming that the termination fee was made for the purpose of earning income, the determination of whether it would be on account of capital or income depends on the purpose and the effect of the payment. In Canadian National Railway Company v. M.N.R., 88 DTC 6340, the Federal Court Trial Division applied the following test to determine whether a termination payment was on account of capital or income: 1) was the purpose of the payment to replace capital or income; and 2) was the effect of the payment to replace capital or income?
You did not provide us with a copy of the cancellation agreement and, as a result, we do not know if the purpose of the termination fee is expressly referred to in that document. However, based on the other material provided, it appears that the purpose of the termination fee is not in dispute (i.e., to terminate an obligation that XXXXXXXXXX could no longer fulfill following the sale of the business). Our conclusions are reinforced by the representative's letter of February 6, 2003, wherein the representative states, "...XXXXXXXXXX". Further, XXXXXXXXXX in the agreement of XXXXXXXXXX between XXXXXXXXXX and XXXXXXXXXX states:
"XXXXXXXXXX."
Under the terms of the Supply Agreement between XXXXXXXXXX, the Supply Agreement could not be terminated without mutual agreement of the parties. As a result of the sale of its assets, XXXXXXXXXX could no longer fulfill its obligations under the contract and would be in breach of contract unless it could come to an agreement with XXXXXXXXXX to end its obligations for a fee. Thus, XXXXXXXXXX had to compensate XXXXXXXXXX in order to avoid a lawsuit. In our view, the timing of the termination payment (being in relation to the cessation of business by the taxpayer) suggests the payment was made on account of capital. The fact that the payment was made after an agreement to sell the assets of XXXXXXXXXX had been made diminishes the view that XXXXXXXXXX made the expenditure in the ordinary course of XXXXXXXXXX business.
The criteria generally adopted by the courts, as stated in Johnston Testers Ltd. v M.N.R., 65 DTC 5069 (Exch .Ct.), are that if the termination payment either (a) creates a capital asset of enduring or permanent character as, e.g., plant, machinery, etc.; or (b) if it is a payment in respect of a capital asset in order to go out of business, it will be categorized as a capital expenditure, but if, (c), the commutation payment does not create a capital asset even though it is made in respect of a capital asset and the business or that part of it continues after such payment, and such payment was made for the purpose of such continuing business, then the payment will be categorized as an income expenditure. In the XXXXXXXXXX situation, in order for the termination payment to be considered an income disbursement it would have to satisfy the conditions described in (c) above. The conditions in (c) could not be satisfied since the payment was made because XXXXXXXXXX was going out of business.
We note that the courts have held that a termination payment is deductible as a current expense in situations where the payment was made, inter alia, to eliminate an onerous annual expense and for enhancing the income-earning potential of a continuing business. See, for example, Johnston Tester and Automatic Toll Systems (Canada) Ltd. v. MNR, (1974) DTC 6060 (FCTD)). However, these cases are distinguishable from the facts in the XXXXXXXXXX situation in that the termination payments in those cases were not made to facilitate the sale of a business but were essentially made to gain freedom from an existing obligation that had become unsatisfactory in order to carry on the business more profitably.
In summary, the termination payment was required because the taxpayer was selling its business and was not made in the ordinary course of the taxpayer's business. As a result, we believe that the better view is that it is a non-depreciable capital outlay. In the circumstances, we would allow the taxpayer to treat the termination payment as an eligible capital expenditure.
B. The Recipient
As stated above, the determination of whether the receipt of an amount would be on account of capital or income depends on both the purpose and the effect of the payment.
The fact that the method used to calculate the termination payment was based on lost future profits of XXXXXXXXXX suggests that the purpose of the termination payment was to replace lost income. The document of XXXXXXXXXX states that XXXXXXXXXX would be foregoing an average yearly discount of $XXXXXXXXXX. Over the balance of the term of the supply agreement this discount would amount to approximately $XXXXXXXXXX. It is noted in this document that the $XXXXXXXXXX lost profit was negotiated down to $XXXXXXXXXX. If the termination payment was intended to replace the cost of obtaining another discounted supply agreement then one would expect the method to calculate the termination payment would be based on the expected cost of obtaining a new discounted supplier.
With respect to the effect of the termination payment, in Commissioners of Inland Revenue v. Fleming & Co. (Machinery) Ltd., (1951) 33 Tax Case 57, Lord Russell expressed the view that when the advantages surrendered on cancellation are such as to destroy or materially cripple the whole structure of the recipient's profit making business then the termination could be considered a capital receipt. In this situation, that does not appear to be the case. It is true that the profits of XXXXXXXXXX may be decreased in the short term as a result of the cancellation. However, XXXXXXXXXX did not have a monopoly in the particleboard supply business that would result in XXXXXXXXXX having to terminate its business. The effect of the termination payment was similar to the effect in Canadian National Railway, that being to absorb the shock of one of the normal incidents (i.e. having to change suppliers) of business and to compensate XXXXXXXXXX for waiving the right to receive a discount on the sale of XXXXXXXXXX. To the extent that the discount related to the cost of inventory, the payment compensated the recipient for additional costs of acquiring XXXXXXXXXX elsewhere.
Accordingly, it is our view that both the purpose and the effect of the termination payment suggest that the contract termination payment received by XXXXXXXXXX should be included in computing its income.
We trust the above comments are of assistance.
Daryl Boychuk, LL.B
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
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