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.
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 the receipt of the contract termination payment is on account of income.
Position: The receipt of the contract termination payment is on account of income.
Reasons: The payment did not destroy or material cripple the taxpayer's business and the payment was calculated based on lost future profits.
June 4, 2004
Mr. Joe Joseph HEADQUARTERS
Toronto West Tax Services Office Shaun Harkin, CMA
V&E Division
2004-007195
Technical Interpretation Request: Capital v. Income
This is in reply to your memorandum of April 14, 2004, and further to our letter of June 12, 2003, wherein you requested our views on the tax treatment of the receipt of a contract termination payment 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).
As we understand it, the basis of the taxpayer's submission is that the taxpayer received the payment for cancellation of a capital asset. Accordingly, the receipt of the payment is a capital receipt. The taxpayer's counsel is of the view that since the supply contract for the long-term supply of XXXXXXXXXX formed a fundamental part of XXXXXXXXXX business structure, the contract should be considered a capital asset.
We agree with the comment of the taxpayer's counsel that the courts have generally found that the determining factor in this type of issue is the importance of the contract to the business operation. The general rule is that compensation received for the cancellation of a trade contract is on income account. However, it is clear that in appropriate circumstances compensation paid for the cancellation of a trade contract may be a capital receipt. Those circumstances, noted in T. Eaton Company Limited v. The Queen, 99 DTC 5178 (FCA), as the "Fleming exception", are where the cancellation of a contract destroys or materially cripples the whole structure of the recipient's business.
The taxpayer's counsel cites the cases of T. Eaton Company Limited; BP Canada Energy Resources Co. v. The Queen, 2002 DTC 2110 (TCC); and Aallcann Wood Suppliers Inc. v. The Queen, 94 DTC 1475 (TCC) to support his views. It is our view that the facts in these cases can be distinguished from the facts of the XXXXXXXXXX contract termination payments.
In T. Eaton Company Limited, the taxpayer received a payment for the cancellation of a participation clause in its lease. The court ruled that the cancellation of the participation clause had the effect of reducing the value of the leasehold interest. The participation clause was not only an integral component of the lease, but it also profoundly affected the value of a capital asset, namely, a leasehold estate in land. Therefore, the compensation paid for the diminution in value of the leasehold interest, a capital asset, was on capital account.
In BP Canada Energy Resources Co., the taxpayer had entered into long-term contracts wherein natural gas was supplied indirectly to customers in California. These contracts formed a significant part of the structure of the appellant's business. Under the terms of these contracts, certain reserves on particular fields were dedicated to particular contracts. The contract termination payments were not merely for the cancellation of a supply agreement. The payments were an aspect of the entire decontracting arrangements that involved a major restructuring of a significant part of the appellant's business. The Court found that the dedication of the gas reserves on the lands to particular contracts affected the value of the associated contracts and, reciprocally, the commitment of the contracts to particular fields affected the value of these lands, which were obviously capital assets. Put more simply, the lands were an integral part of the contracts. Similar to the analogy of the effect of the participation clause on the leasehold interest in T. Eaton Company Limited discussed above, the cancellation of the contracts reduced the value of the associated capital assets, the lands. Further, the Court found that the payments made to the appellant were not based on the income that the appellant expected to receive from the contracts, and were not made to compensate for a loss of a "stream of income".
In Aallcann Wood Suppliers Inc., the supply contract was not cancelled but was sold allowing another party the benefit, as a matter of reasonable commercial expectation, of being able to stand in the taxpayer's shoes year after year and obtain a succession of such contracts with the customer. Aallcann decided to go out of the pulpwood business and to go into an entirely different type of enterprise, the business of manufacturing fence posts.
In order to determine whether a particular payment is on account of capital or income, as stated by Judge Bowman in BP Canada Energy Resources Co:
"One must avoid the temptation to pluck felicitous phrases from the cases, which can support almost any conclusion, and thereby to lose sight of the real purpose of the enquiry, that of determining whether the payment is made for the termination, disposition or sterilization of a capital asset or is one of the ordinary incidents of an ongoing business so that the receipt properly forms part of the normal receipts of the trade".
It is our general view that when the method used to calculate the termination payment is based on lost future profits, and the taxpayer is able to obtain another supplier and continue to carry on business, then it is reasonable to conclude that the compensation received for the cancellation of the contract should be included in computing income.
In the XXXXXXXXXX situation, we do not feel that the facts support the taxpayer's view that the supply contract formed a fundamental part of the taxpayer's business. We do not feel the business was destroyed or materially crippled by the cancellation of the contract. The effect of the termination payment was 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 . XXXXXXXXXX did not have a monopoly in the XXXXXXXXXX supply business and, albeit with some difficulty, XXXXXXXXXX was able to find another supplier. To the extent that the discount related to the cost of inventory, the payment compensated the recipient for additional costs of acquiring XXXXXXXXXX elsewhere.
Further, 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 future income as XXXXXXXXXX carried on business with another non-discounted supplier.
Based on the above, we feel that a compelling argument can be made that the contract termination payment received by XXXXXXXXXX is not a capital receipt, and should be included in computing its income.
We trust the above comments are of assistance.
Wayne Antle, CGA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
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