11 February 2005 Internal T.I. 2005-0112841I7 - Damages Payment Supplementary XXXXXXXX Licence

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: Whether a damages payment made by the Department of Fisheries and Oceans in respect of its denial of a supplementary XXXXXXXXXX licence, is taxable? If so, is it taxable on account of income or capital?

Position: Taxable on account of income.

Reasons: Denial of the licence did not result in a material crippling or destruction of the profit-making apparatus of the taxpayers' business. The damages payment is based on the income loss during the years in which the licence was denied. The taxpayers were subsequently issued such a licence that they use to fish and earn income.

		February 11, 2005

	XXXXXXXXXX 	HEADQUARTERS
	V&E Division	Randy Hewlett, B.Comm.
	XXXXXXXXXX  	613-941-7239
	   Tax Services Office
		2005-011284

Damages Payment - Supplementary XXXXXXXXXX Licence

We are writing in response to your request for our opinion on the taxable status of a damages payment made by the Department of Fisheries and Oceans ("DFO") in respect of its denial of a supplementary XXXXXXXXXX licence to XXXXXXXXXX.

Our understanding of the relevant facts is as follows:

XXXXXXXXXX.

Our Comments

The general position of the Canada Revenue Agency regarding the taxable status of amounts received as damages for the loss of property or income is outlined in Interpretation Bulletin IT-365R, Damages, Settlements and Similar Receipts. This position is based on numerous court decisions rendered on this issue. The courts have generally determined that where damages are intended to compensate the taxpayer for lost profit, the amount will be considered on account of income and must be included in the taxpayer's business income pursuant to subsection 9(1) of the Income Tax Act (the "Act"). Where the damages relate to a particular asset that is sold, destroyed or abandoned, the amount will be considered proceeds of disposition for purposes of determining the gain on the asset. Where the amount received does not relate to a particular asset and the damages are awarded because there was a destruction or material crippling of the whole structure of the profit-making apparatus of the taxpayer's business, the amount will be considered an "eligible capital amount" for purposes of determining the taxpayer's income inclusion under subsection 14(1) of the Act. Another important principle coming out of jurisprudence on this issue is that, regardless of the description given to an amount or the process that gave rise to its award, such amounts often being described as damages, the underlying basis for the award must be examined to determine its taxable status.

Described below are three of these court decisions that we regard as relevant in this situation:

(a) Canadian National Railway Company v. The Queen (1988 DTC 6340, FCTD)

In this case, the Northern Alberta Railways ("NAR"), which later amalgamated with Canadian National, received a damages payment from a customer in respect of the early termination of a railway transportation contract. NAR reported the amount as capital and was reassessed on the basis that the amount was business income. The FCTD determined that regardless of the characterization of the payment as damages or compensation for termination of a contract, "[t]he more relevant question is, what was the purpose of this payment: to compensate for loss of capital or for loss of income?" The FCTD concluded that the amount should be included in business income because the early termination of the contract did not destroy or materially cripple NAR's profit-making apparatus. The FCTD made this conclusion notwithstanding the fact that the contract was a long-term contract and that NAR made certain financial business decisions based on this premise. In the FCTD's view, the contract was "not a discrete operation separate from NAR's other railway activities", nor was its termination a "sterilization of a capital asset".

(b) Pe Ben Industries Company Ltd v. The Queen (1988 DTC 6347, FCTD)

This case was tried together with Canadian National and arises out of essentially similar facts and involves the same principles of law. Pe Ben was a subcontractor of NAR. Pe Ben received a payment from NAR is respect of the termination of their contract, which ultimately resulted from early termination of NAR's contract as described above. In this case, the FCTD concluded that the amount was received on account of capital and was an eligible capital amount for purposes of subsection 14(1) of the Act. The FCTD noted that "[t]he critical factual distinction between Pe Ben Industries and Canadian National is that, in the former case, the taxpayer's intermodal carrier business consisted of one substantial contract which had been prematurely terminated. However, the transportation contract in Canadian National was simply an ordinary trade contract and its termination was not of critical significance to the taxpayer's business operations. In summary, it is clear that in appropriate circumstances compensation paid for the cancellation or breach of a trade contract may be a capital receipt. Admittedly, the general rule is that such compensation is on income account."

(c) The T. Eaton Company Limited v. The Queen (1999 DTC 5178, FCA)

The issue in this case was the taxable status of an amount received by Eaton in respect of the buy-out of a lease "participation clause" by its former landlord who operated a shopping centre. The participation clause related to a long-term lease entered into by Eaton that entitled it to receive 20% of the shopping centre's annual net profits over the duration of the lease term and any renewal period. Eaton reported the amount as a capital receipt, but was reassessed to include the amount in income on the basis that it replaced amounts that would otherwise have been included in business income. The FCA ruled that the participation clause was "an integral component of the lease" that "profoundly affects the value of a capital asset, namely, a leasehold estate in land" and therefore, concluded that the buy-out was received on account of capital. The FCA went on to say, "At the end of the day, there are two sets of prescription lenses that can be used to determine whether compensation for the loss of future profits arising from the cancellation of a participation clause is on income or capital account. Using the Minister's prescription, the buy-out of the participation clause replaces an income source and is, therefore, an income receipt. According to the taxpayer's prescription, the buy-out diminishes the value of a capital asset for which compensation must be characterized as a capital receipt. Were it not for the fact that the participation clause in question is an integral component of the lease, the Minister's prescription would have been the only acceptable one."

In our view, the denial of the supplementary XXXXXXXXXX licence by DFO did not result in a material crippling or destruction of the profit-making apparatus of the Taxpayers' business. We recognize that the decisions rendered by the XXXXXXXXXX courts indicated that the Taxpayers made certain financial business decisions in anticipation that a supplementary XXXXXXXXXX licence would be issued to them. However, these decisions also indicate that the Taxpayers' business continued relatively unchanged as it was prior to the DFO decision to deny the issuance of the supplementary XXXXXXXXXX licence; they had other licences and continued to fish between XXXXXXXXXX and thereafter. Moreover, the Taxpayers were later issued a supplementary XXXXXXXXXX licence by DFO that is used to earn income from XXXXXXXXXX fishing in subsequent years. Were it not for the issuance of the supplementary XXXXXXXXXX licence our conclusion may have been different. On the whole, we are unable to come to any other conclusion but that the payment was to replace income lost by the Taxpayers between XXXXXXXXXX. Consequently, we are of the opinion that the payment received by the Taxpayers is on account of income and accordingly, must be included in business income.

We would like to also note that the manner in which the Taxpayers plan on sharing the payment as described above, may not agree with the proper reporting of their respective share of the payment under the Act. The proper reporting of the payment should be in accordance with the terms of the revenue sharing arrangement in place during the years to which the payment relates (XXXXXXXXXX). It is apparent that there is no written agreement with respect to their revenue sharing arrangement, however, we are of the view that the manner in which the Trial Division determined the award to be allocated is a more appropriate basis to determine the proper reporting of their respective share of the payment under the Act (see paragraph XXXXXXXXXX of the decision).

We trust our comments are of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

John Oulton, CA
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch