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: Tax treatment of settlement proceeds received from vendor for release from purchase/sale agreement of land that was going to be used in a residential housing development. Are the proceeds received an income receipt or a capital receipt and if a capital receipt, is it an eligible capital amount.
Position: An income receipt
Reasons: Had the development project proceeded as planned, the income would have been reported as business income. If there has been no destruction of or damages to the whole profit making apparatus of the Developer and the Financing company, then we would consider the settlement proceeds received (as a result of the vendor backing out of the agreement to sell the land) to be a surrogatum for future profits lost and therefore, an income receipt rather than a capital receipt.
Tim Fitzgerald, CGA
XXXXXXXXXX (519)973-7999 ext. 6509
2005-013941
August 25, 2005
Dear XXXXXXXXXX:
Re: Tax treatment of proceeds from a lawsuit settlement
This is further to your letter of June 24, 2005 wherein you requested an interpretation from Canada Revenue Agency (CRA) in respect of proceeds received from a lawsuit settlement.
Your questions are:
1. Would CRA consider the settlement proceeds, referred to in the fact situation below, to be a capital gain, an eligible capital amount or an income receipt?
2. Would the conclusion change if the shareholders noted below were purchasing the land as joint venture partners rather than as shareholders of the company purchasing the land? Specifically, would the businesses that Develco and Investco are in, result in a different tax treatment for each of their respective share of the proceeds from the settlement?
Based on your letter and our telephone conversation we understand the facts to be as follows:
1. Landco has been incorporated for the single purpose of purchasing a parcel of land to be used for a housing development.
2. There are two 50% shareholders of Landco; Develco, which is in the business of building homes and Investco, which is mainly in the investment banking business and management business and has provided financing for previous housing development projects.
3. Both Develco and Investco are Canadian Controlled Private Corporations.
4. Develco and Investco are arm's length corporations, but have done business together in the past.
5. The housing development project would have been managed by Develco.
6. Landco entered into an agreement to purchase the parcel of land noted in #1. However, prior to the scheduled closing date, the vendor refused to proceed with the sale. Landco then initiated legal action against the vendor.
7. The vendor admitted no liability but agreed to settle the dispute by paying Landco $3,000,000.
8. The settlement agreement does not indicate how the $3,000,000 figure was arrived at or what it is for, other than to end the purchase agreement and associated litigation.
9. Landco has estimated that if it had been able to proceed with the intended housing development project, its profit from sale of houses would have been approximately $8,000,000. This profit would have been treated as business income.
10. Upon completion of the development project, the intention was that Landco would have been dissolved, not carried on.
11. As Landco is a single purpose company, the proceeds received from the settlement will be distributed to Develco and Investco as dividends. Landco will then be dissolved.
12. Since the time of the out-of-court settlement, Develco and Investco have continued to carry on in their respective businesses.
A determination of the tax consequences of any damage settlement is a question of fact requiring a review of all pertinent documentation, which may include an examination of articles of incorporation, business contracts, statements of claim, relevant correspondence between the parties, the settlement agreement or court order, and any other relevant documentation. A written confirmation of the tax implications of particular transactions is given by this directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R5, dated May 17, 2002. Therefore, in response to your letter, we offer the following comments, which are of a general nature but which, we trust will be of assistance.
Generally speaking, an amount received by a taxpayer in lieu of the performance of the terms of a business contract may, depending on the facts, be either an income or a capital receipt. If the receipt relates to the loss of an income-producing asset, it will be considered to be a capital receipt; on the other hand, if it is compensation for the loss of income, it will constitute business income.
We will address your second question first and consider the more direct situation where Develco and Investco, are joint venture partners that enter a purchase agreement with the vendor to buy land. To be released from this commitment, the vendor agrees to settle out-of-court with the joint venture partners each of which receives their respective share of the settlement proceeds paid out by the vendor. In this situation, if the impact of the demise of land purchase deal is not of such magnitude as to cripple the whole profit making apparatus of either respective venture partners, such that Develco is able to continue in the business of building houses and Investco is able to continue in its business of lending etc., then this would indicate that the proceeds of the settlement are most likely an income receipt for both parties (we refer you to paragraph 8 of IT-365R2, Damages, Settlements and Similar Receipts).
We now turn to your first question, involving the indirect situation wherein Develco and Investco are equal common shareholders of Landco. Landco enters into a purchase agreement with the vendor to buy land. The vendor backs out and agrees to pay Landco an out-of-court settlement to be released from its commitment to sell the land.
In the facts presented above, Landco had no particular asset that was sold, destroyed or abandoned as a result of the vendor's release from the purchase agreement (we refer you to paragraph 9 of IT-365R2). Hence, it cannot be said that the compensation received was of a capital nature on account of any particular asset. Alternatively, for the proceeds from the settlement to be considered that of a capital nature, it would have to shown that the whole profit-making apparatus of Landco's business was crippled as a result of the vendor's release from the purchase agreement. One might argue that when the deal fell through, the settlement amount received by Landco was in compensation for the destruction of or damages to the whole profit-making apparatus of its business and as such, should be treated as an "eligible capital amount" for the purpose of subsection 14(1) and subparagraph 14(5)(a)(iv) of the Income Tax Act. We would caution that the determination of whether a receipt is on account of income or capital has often been the subject of court decisions. Therefore, in examining this question, we would make our determination in light of the overall context of the situation.
You indicate in your letter that Landco was a single purpose corporation. We understand that the initial intention was to dissolve Landco at the end of the development project once all the houses had been built and sold off. The business profits would eventually flow up to the shareholders by way of dividends. Such an arrangement is common practice in the construction industry. Developers often set up separate corporations for the many projects they undertake. Having served out their purpose, these single purpose corporations are often dissolved upon completion of the project.
In our view, it is an economic question of fact, whether the whole profit-making apparatus of a taxpayer has been destroyed. It begs the question, what was Landco's profit making apparatus? If Landco had no machinery or equipment with which to carry out the work, had no employees of its own nor possessed the expertise to manage such a development project on its own, then it would seem Landco possessed no profit-making apparatus of its own. Within the economic context thus described, we are given to understand that the initial intention and arrangement was such that Investco would provide the financing and Develco would provide the actual workers, expertise and equipment to manage and carry out the project. In conjunction with perhaps other tangible and intangible contributions of Develco and Investco, these are the essential elements that indirectly make up the profit-making apparatus of Landco. If the outcome were such that both Develco and Investco were able to absorb in stride, the initial shock of the thwarted land purchase deal, and they were able to carry on their respective businesses in the normal course, it would be counter intuitive to conclude that Landco's whole profit-making apparatus was somehow crippled.
The construction industry is fraught with risks, one of which would be, as happened here, that a vendor could back out of an agreement to sell their real property and imperil a particular development project. Investco and Develco are so fashioned as to absorb such shocks as one of the normal incidents of their respective businesses (we refer you to paragraph 8(b) of IT-365R2). If there has been no destruction of or damages to the whole profit-making apparatus of the respective businesses of Develco or Investco, then in our view, the settlement amount received by Landco would be a surrogatum for future profits lost. We understand that had the project proceeded as planned, Landco would have reported its income from the sale of the houses as business income. For the reasons given, we would consider the compensation amount received by Landco to be an income receipt rather than a capital receipt.
We trust our comments are helpful. If you require further assistance, please contact the Client Assistance Division of your local Tax Services Office.
Yours truly,
Phil Jolie
Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch
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