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 amounts paid to terminate a business arrangement are deductible as current expenses notwithstanding that the payments were considered capital receipts to the recipient.
Position: Based on the information presented, and assuming the parties were dealing at arm's length, the portion of the payment relating to the elimination of future obligations under the terminated agreement would probably be deductible where those future payments would have been deductible.
Reasons: Consistent with paragraph 16 of IT-467R2 and existing case law.
January 27, 2004
XXXXXXXXXX HEADQUARTERS
Basic File Auditor Wayne Antle, CGA
Verification and Enforcement Division (613) 957-2102
XXXXXXXXXX Tax Services Office
2003-004476
Deductibility of Contract Termination Payments
This is further to your memorandum faxed to us on October 22, 2003, concerning the deductibility of amounts paid by XXXXXXXXXX Real Estate Investment Trust (the "REIT") to XXXXXXXXXX ("Amalco") to terminate a management agreement.
We previously provided our comments on the tax treatment to Amalco of amounts received from the REIT to end the business arrangement (File No. 2002-014796). We have reviewed the information provided with your referral, as well as the information faxed to us on December 5, 2003 and the documentation submitted with the earlier referral. Our understanding of the facts is as follows:
1. 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. Mr. A and Mr. B were management trustees of the REIT, before and after the reorganization. There were four independent trustees of the REIT.
4. XCo, YCo, Mr. A, and Mr. B, each dealt at arm's-length with the REIT.
5. 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.
6. While the Advisory Agreement had a finite term, it was expected to be renewed for successive terms, unless XCo was not fulfilling the terms of the contract.
7. XCo derived almost all of its revenue from the Advisory Agreement wherein it received fees for providing acquisition, disposition, financing, and development services.
8. YCo derived over one-half of its revenue from the provision of co-management and advisory services to the REIT on behalf of XCo.
9. 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.
10. 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.
11. On XXXXXXXXXX, XCo amalgamated with its parent company, YCo, and the new company continued under the name of Amalco.
12. The Termination Agreement became effective on XXXXXXXXXX.
13. Under the terms of the Termination Agreement, the REIT would pay to Amalco the sum of $XXXXXXXXXX (the "termination payment") 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.
14. The amount of the termination payment represents the fair market value of the Advisory Agreement as determined by XXXXXXXXXX.
15. The Termination Agreement also provided for the transfer of some of the employees of XCo to the REIT, as well as the transfer of certain capital assets.
16. 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").
17. 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.
18. 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.
19. In conjunction with the Termination Agreement, Amalco, Mr. A, and Mr. B have entered into an Allocation Agreement dated XXXXXXXXXX (the "Allocation Agreement").
20. The Allocation Agreement provides that $XXXXXXXXXX of the termination payment 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.
21. 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.
22. Mr. B has since become the CEO of the REIT. Mr. A is no longer employed by the REIT but he is a major unit holder.
23. For financial reporting purposes, the REIT deducted the full $XXXXXXXXXX for the fiscal period ending XXXXXXXXXX, plus related expenses of $XXXXXXXXXX. However, for income tax purposes, the REIT capitalized $XXXXXXXXXX, and claimed the remaining $XXXXXXXXXX as an expense.
Taxpayer's View
The REIT determined the deductibility of the termination payment by looking at the purpose of the payment. The portion that related to the cancellation of fees that would otherwise have been deductible was considered on income account, with the remainder being capitalized. The representative feels that the amount is properly deductible as a current expense for the following reasons:
First, in accordance with the guidelines set out in Canderel v. HMQ (98 DTC 6100), the REIT has presented a true picture of income consistent with the Act, established case law principles and rules of law, and well accepted business principles. The termination payment was deducted for financial reporting purposes in accordance with GAAP and consistent with the method followed by other real estate investment entities. The portion that was on account of capital, and therefore not deductible by virtue of paragraph 18(1)(b) of the Act, was properly capitalized by the REIT in computing its income for tax purposes.
Secondly, the portion of the termination payment that was deducted for income tax purposes was not on account of capital based on existing case law and the CCRA's position set out in paragraph 16 of IT-467R2. Paragraph 16 of the bulletin states:
Where amounts originally payable under a contract would have been eligible for deduction from income had they been paid, amounts paid to terminate and settle that contract will also generally be eligible for deduction from income. It is not material that the termination is by way of a lump sum payment as opposed to instalment payments.
This position is supported by a line of cases including Johnson Testers Ltd. v. MNR (65 DTC 5069), Dymo Canada Ltd. v. MNR (73 DTC 5171), and Bomag (Canada) Ltd. v. the Queen (84 DTC 6363). Since the purpose of the portion of the termination payment that was deducted by the REIT was to eliminate future expenses that would have been deductible as current expenses, then this portion of the termination payment would likewise be deductible.
Your Opinion
In your view, the entire amount of the termination payment should be capitalized as an eligible capital expenditure. You feel that the REIT has acquired an advantage that confers on it an enduring benefit Since the termination agreement provided, not only for the ending of the business arrangement, but also for the hiring of the key employees of Amalco and the transfer of certain capital assets, then the REIT has in effect acquired the know-how and business of Amalco. You also feel that the position set out in paragraph 16 of IT-467R2, and the cases cited, are not applicable to this case because the advisory agreement had no effective end date.
Our View
The criteria generally adopted by the courts, as stated in the Johnston Testers case, are that if the termination payment either creates a capital asset of an enduring or permanent character (for example, plant, machinery, goodwill), or 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. On the other hand, if (a) the commutation payment does not create a capital asset even though it is made in respect of a capital asset, (b) the business or that part of the business continues after such payment, and (c) the payment was made for the purpose of the continuing business, then the payment will be categorized as an income expenditure.
We have not reviewed the basis upon which the REIT allocated the termination payment between capital and current expenditures. However, based on the facts presented, we are inclined to agree with the position put forward by the REIT that the portion of the proceeds relating to the termination of the REIT's obligation to pay future deductible current expenses would likely be deductible as a current expense consistent with our position in paragraph 16 of IT-467R2, and existing case law. In reaching this conclusion, we have relied on the following facts:
1. Mr. A, Mr. B, Xco, Yco, and Amalco were each dealing at arm's length with the REIT.
2. The amount of the termination payment represents the fair market value of the Advisory Agreement as determined by an independent appraisal.
3. The appraisal was based on the savings achieved by not having to pay the ongoing fees required under the Advisory Agreement.
4. The stated purpose of ending the advisory agreement was to internalize the management of the REIT's properties, and save the fees paid under the Advisory Agreement.
5. The capital assets acquired were only minor relative to the amount of the termination payment.
6. While, the key employees of Amalco were hired, and paid salaries and bonuses by the REIT, the Termination Agreement does not identify any of the termination payment as being for the acquisition of know-how or other intangible property.
We note, however, that Mr. A was instrumental in the formation of the REIT and continues to be a major unit holder in the REIT. If it can be shown that Mr. A was not, in fact, dealing with the REIT at arm's length with respect to the negotiation of the Termination Agreement, and the assumptions used by XXXXXXXXXX in appraising the Advisory Agreement were not reasonable in the circumstances, then we would need to consider whether the termination payment was incurred to earn income pursuant to paragraph 18(1)(a) of the Act, and reasonable in accordance with section 67 of the Act. Please refer to Interpretation Bulletin IT-419R Meaning of Arm's Length for more information concerning whether unrelated persons are, in fact, dealing with each other at arm's length.
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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