23 June 2014 External T.I. 2014-0519401E5 - Settlement payment for cancellation of lease

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: How should an amount received by a taxpayer from a landlord for the cancellation of the taxpayer's lease be treated?

Position: Question of fact.

Reasons: Generally, the treatment of a settlement payment is determined by reference to the surrogatum principle. According to this principle, a settlement payment is determined by reference to the amount it is intended to replace.

XXXXXXXXXX
J. Gibbons
2014-051940
June 23, 2014

Dear XXXXXXXXXX:

Re: Settlement payment for cancellation of a lease

This is in reply to your email dated January 30, 2014, concerning the income tax treatment of an amount received by a corporation as a settlement from a landlord. The settlement related to a lawsuit brought by the corporation against the landlord for the cancellation of the corporation's lease in respect of an office facility.

You indicated that the cancellation of the lease, which was not set to expire for a number of years, caused great inconvenience and was a major business disruption to the corporation. You wish to know whether the settlement payment would be included as business income or whether it would be considered part of the proceeds of disposition of capital property. Further, if the latter interpretation applies, you ask whether the non-taxable portion of a capital gain can be paid out to the shareholders of the corporation as a capital dividend.

Our comments

This technical interpretation provides general comments about the provisions of the Income Tax Act (the "Act") and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R5, Advance Income Tax Rulings.

The characterization of damages or settlement payments for income tax purposes is a question of fact that can only be determined after reviewing all of the relevant facts and circumstances of a particular case. In general, Canadian courts have relied on the surrogatum principle to determine the income tax consequences of a settlement payment. According to this principle, the income tax treatment of a settlement payment will generally depend on what the payment is intended to replace. As indicated in paragraph 10 of Interpretation Bulletin IT-365R2, Damages, Settlements and Similar Receipts, a settlement received by a taxpayer with respect to the loss of business income or business property may fall into one of the following four categories:

(a) a non-taxable receipt,
(b) an income receipt,
(c) a receipt resulting from the disposition of a capital property, or
(d) an eligible capital amount.

Paragraph 8 of IT-365R2 states that, depending on the facts, where an amount was received in lieu of the performance of the terms of a business contract by the other party to that contract, the amount may be either an income or capital receipt. In particular, if the amount relates to the loss of an income-producing asset, it will be considered to be a capital receipt, but if the amount is compensation for the loss of income, it will constitute business income.

As further explained in paragraph 9 of IT-365R2, where an amount is determined to be on account of capital that relates to a particular tangible or intangible asset that has been sold, destroyed or abandoned as a consequence of a breach of a contract, the amount will be considered proceeds of disposition of that asset (or a part thereof, as the case may be). On the other hand, where the amount of compensation is of a capital nature that does not relate to a particular asset, the amount will be considered as compensation for the destruction of, or as damages to, the whole profit-making apparatus of the taxpayer's business. In such cases, the amount may be treated as an "eligible capital amount" for the purposes of determining the taxpayer's income inclusion under subsection 14(1) of the Act. Described below are two of the more relevant court decisions that may assist in making this determination:

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

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

With regard to your question as to whether 50% of a capital gain arising on the receipt of a settlement could be paid out as a capital dividend pursuant to an election under subsection 83(2) of the Act, reference may be made to Interpretation Bulletin IT-66R6, Capital Dividends. Under subsection 83(2) of the Act, a private corporation may elect to pay its shareholders a dividend to the extent of its "capital dividend account." The rules for determining the balance in a corporation's capital dividend account are provided in paragraph 89(1)(b) of the Act and are described in paragraph 6 of IT-66R6.

We trust these comments will be of assistance.

Yours truly,

G. Moore
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch