5 November 2003 Internal T.I. 2003-0043297 - CONTRACT TERMINATION 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: Request to review the taxpayer's representations and to advise the TSO if such representations affect our view expressed in 2003-001100 that a contract termination payment was a capital expenditure.

Position: The characterization of the payment depends on what the taxpayer was trying to effect from a practical and business perspective.

Reasons: The tax treatment of the payment would normally be on income account if the contract were settled in the course of an ongoing business. However, if the payment were made to settle an obligation as a consequence of the termination of a business, such a payment would normally be considered to be a non-depreciable capital outlay that we would allow the taxpayer to treat as an eligible capital expenditure.

		November 5, 2003

Mr. Joe Joseph	HEADQUARTERS
	Toronto West Tax Services Office	Shaun Harkin, CMA
	V&E Division

	Attention: Mr. Joseph
		2003-004329

Capital v. Current Expense

This is in reply to your memorandum of October 9, 2003 and further to our letter of June 12, 2003 wherein you requested our views on the tax treatment of a contract termination payment made by the taxpayer. Your memorandum asks us to review the submission from the taxpayer's counsel to determine if it would affect our views outlined in our memorandum of June 12, 2003 (Document 2003-001100).

Our Comments

As we understand it, the basis of the taxpayer's submission is that the taxpayer made the payment to avoid potentially costly litigation and, therefore, the amount paid, being in lieu of damages for breach of the Supply Agreement, is properly treated as on income account. In support of its position the taxpayer states that the payment should not draw its character from the sale of the business and that it could have fulfilled its obligations under the Supply Agreement after the sale of its assets but was persuaded that this would have resulted in significant losses. We note that, on a factual basis, this assertion appears to be in conflict with the taxpayer's previous position that it did not have either the capability or the intention, after selling its assets, to honour the Supply Agreement. In this respect, we refer you to the statement by the taxpayer's accountant in the letter of February 6, 2003, which states, "... XXXXXXXXXX ". For the purpose of this memorandum, we have assumed that, even if it were possible for the taxpayer to fulfill its obligations under the Supply Agreement, it was neither reasonable nor practical to attempt to do so.

In our view, the connection between the payment and the sale of the business is relevant to the characterization of the payment. As authority, we refer you to Frankel Corporation Limited v. MNR, 59 DTC 1161 (SCC). In that case, the appellant sold one of its business operations including inventory. The Supreme Court of Canada held that since the sale was not made in the course of the company's business but as part of the sale of its business, the proceeds from the sale of the inventory were on capital account. We believe that this same line of reasoning would apply to payments made on the sale of a business thus converting what would otherwise be a current outlay into a capital expense.

We agree with the taxpayer that, in assessing the tax treatment of damages for breach of contract, the payment and receipt of such damages are normally characterized by reference to the nature of the underlying interest that is settled. In this respect, we acknowledge that, if the payment had been incurred in the course of an ongoing business because the taxpayer believed that the termination of the Supply Agreement would allow it to pursue more profitable opportunities, the payment would have been currently deductible. However, the payment in this case was not a normal business expense intended to allow the taxpayer to pursue more profitable contracts elsewhere. In addition, it is not clear that the "interest settled" is necessarily on income account. The courts generally characterize the nature of the interest settled on a contract termination by analyzing a number of factors, including, but not limited to, the length of the contract and whether the cancellation of the contract was a normal, foreseeable part of the business.

We also agree with the taxpayer that, in cases where the facts can support either income or capital treatment, the courts have emphasized that characterization must be governed by what the expenditure was designed to effect from a practical and business perspective. In Johnson Testers Ltd. v. MNR, 65 DTC 5069 at 5075, the Court acknowledged that the business purpose of the payment must be carefully analyzed:

In the final analysis, however, it would appear that no one criterion can be used universally in all cases. Instead, the business purpose of a commutation payment in each case must be analyzed carefully for the object of categorization and then one or more of the various criteria may be employed to assist in determining the correct category of such payment, that is, whether the payment truly is an income disbursement or one out of capital account.

With the foregoing in mind, and having had the opportunity to consider the taxpayer's further submissions, we submit that the purpose of the payment was to settle an obligation that, from a practical and business perspective, could no longer be fulfilled because of the termination of the taxpayer's business. Thus, we confirm that, in our opinion, the payment was on account of capital.

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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