17 January 1991 Internal T.I. 9032367 F - Indemnity Paid to Investors Caused by a Reduction of a Renunciation of CEE

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.

Subject: Indemnity Paid to Investors Caused by a Reduction of a Renunciation Pursuant to Subsection 66(12.73) of the Act

We are writing in reply to your memorandum dated November 15, 1990, wherein you request our opinion concerning the appropriate tax treatment in the scenario described below.

In 1987, a flow-through share agreement was entered into between a principal-business corporation ("PBC") and a limited partnership (the "Partnership"), such that the shares issued thereunder to the Partnership qualified as flow-through shares, as defined in paragraph 66(15)(d.1) of the Act.

In this flow-through share agreement, at paragraph.

24(1) 21(1)(b)

24(1)

24(1)

You have requested our opinion as to the treatment for tax purposes, firstly to the PBC and secondly to the partners, of the damages and interest payments to be made by the PBC to the partners under the following circumstances:

(i)     as explained above;

(ii)      the payments being made only after the PBC is sued by the partners, but prior to any Court order; and

(iii)      the payment being made according to a Court order.

Rulings Comments - Damages Paid by PBC

Generally speaking, in determining the tax treatment of damage payments/receipts, the purposes for which the payment is made or the capacity in respect of which it is received, dictates whether it is made or received on account of capital or on income account. If the payments are received to replace lost income the payments are taxable as income, but if they are received for loss of capacity to earn income, they are received on account of capital.

In our view the damages will receive the same tax treatment whether paid to the investors by the PBC as an out-of-court settlement, as a result of the PBC being sued, but being paid prior to any Court order, or if they are paid pursuant to a Court order.

This position is consistent with the broad definition of "damages" found in paragraph 3 of IT-467, wherein it states "A payment in settlement of a damages claim to avoid or terminate litigation will be considered "damages" herein even though there was no admission of any wrongdoing."

Paragraphs 4 and 5 of IT-467 set out factors to consider in order to determine whether or not the damages to be paid by the PBC would be deductible in computing income. Paragraph 5 thereof states that where damages are paid as the result of an event which is incidental to business operations, or where the potential liability to pay such damages is a risk normally inherent in those operations, the deduction of the expenditure will not be considered to be prohibited by paragraph 18(1)(a) of the Act.

Paragraph 7 of IT-467 and paragraph 16 of IT-143R2 state that in circumstances where the payment of damages is on account of capital and is made for the purposes of producing income from business, the payment may qualify as an eligible capital expenditure provided the other tests in paragraph 14(5)(b) of the Act are met.

Although not without doubt, it is our opinion that the better argument can be made that the damages paid by the PBC would be an eligible capital expenditure ("ECE") for the following reasons:

1.     The payment of the damages would be on account of capital (i.e. precluded by paragraph 18(1)(b) from being deducted as a current operating expense) as it relates to the raising of capital amounts for the business.

     The position that costs incurred in raising funds to be used in a business are capital in nature was accepted in the case Federal Court-Trial Division of Riviera Hotel Co. Ltd. v. M.N.R. (72 DTC 6142).  Therein, at page 6144 Cattanach, J. states:

      "The leading authority for the proposition that the cost of financing a business is a capital expense is in Montreal Coke and Manufacturing Co. M.N.R. (1944] A.C. 126.  In that case interest bearing bonds were converted into other securities carrying lower rates of interest.  It was claimed that the expenses of conversion were incurred "for the purpose of earning income".  The Supreme Court of Canada held that the payments on that account were not for that purpose and that, in any event the expenses  were outgoings of capital and accordingly were not deductible.  This decision was followed by the Supreme Court of Canada in Bennett White Construction Co.  Ltd. v. M.N.R., (1949] S.C.R. 287 (49 DTC 514), where it was held that commission payments were not allowable as deductible expenses since they were incurred in connection with the  financing of the business and were not related to the income earning process."

     We looked to section 20 which in some circumstances overrides paragraph 18(1)(b) to allow current expense deductions in computing income for a taxation year.  It appears that only paragraph 20(1)(b) or (e) could possibly apply in this instance and we eliminated paragraph (e) as discussed below.

     The payment of the damages by the PBC would be for breaching its flow-through share contract obligations.  Such a payment would not be incurred in the course of a specific issuance of shares of the capital stock of the PBC, as required by paragraph 20(1)(e). Therefore such a payment would not be deductible under that provision.

     In support of this position we referred to page 6183 in the Federal Court of Appeal case of M.N.R. Yonge-Eglinton Building Limited (74 DTC 6180], where Thurlow, states that:

      "... the words "In the course of" ... are not a reference to the time when the expenses are incurred but are used in the sense of "in connection with" or incidental to" or arising from" and refer to the process of carrying out or the things which must be undertaken to carry out the issuing or selling or borrowing for or in connection with which the expenses are incurred."

     In our view a payment for damages for breach of contract would be too far removed to be considered "in connection with" or "incidental to" or "arising from" a specific issuance of shares and would thus not meet the requirements of paragraph 20(1)(e).

2.     The damages will be paid by the PBC for the purpose of gaining or producing income from the PBC's business, in the broad sense of the meaning of the words.  The payment of these damages will be somewhat of a goodwill gesture by the PBC (In order to maintain a good reputation with investors)  which will help to facilitate the future raising of working capital through share issuances, which proceeds can be used to earn business Income.

     We considered and rejected the notion that the payment for damages would not be deductible at all by the PBC because the damage payments were not laid out for the purpose of earning Income.

     In this regard reference was made to the Exchequer Court case of Imperial v. M.N.R. [47 DTC 1090].  At page 1098, Thorson, P. rejected the Minister's contention that when Imperial paid damages in an out-of-court settlement to another company for destruction of its ship, resulting from collision with Imperial's oil tanker, that the expenditure was not laid out for the purpose of earning profit at all, but solely to satisfy a legal liability and thus keep the sheriff away from Imperial's door.

     At page 1099 of the same case, Thorson, P. states:

     "It is no answer to say that an item of expenditure is not deductible on the ground that it was not made primarily to earn the income but primarily to satisfy a legal liability.  This was the kind of argument that was expressly rejected by the High Court of Australia in the Herald & Weekly Times, Ltd. case (supra), and it should be rejected here."

3.     The amount of damages to be paid (i.e. the additional tax and interest to be paid by the partners as a result of the PBC's failure to renounce eligible CEE to the Partnership) appears to be reasonable in that it merely puts the partners back into the tax position they would have otherwise been in had the PBC fulfilled its contractual obligations by renouncing the proper amount of CEE. ...5

4.     We also looked to subparagraphs 14(5)(b)(vi) to (vi) to see if any of the exclusions noted therein applied to deny ECE treatment.  If such was the case and ECE treatment was denied, then the damage payments would not be deductible at all by the PBC.

      In our view a weak argument can be made that subparagraph (iv) would apply to deny ECE treatment if we view the investors as being creditors of the PBC and if we view the amount of the damages to be a deb owed by the PBC to the partners.

      In light of the reference to bond or debenture in subparagraph (iv), we believe that debt was meant to apply more to something in the nature of a loan as opposed to the damages in our case.

     Subparagraph (v) also does not appear to apply to deny ECE treatment since the scope of that provision is limited administratively by paragraph 3(d) of IT 143R2.  Also there is an argument that subparagraph (v) does not apply because the damages are to be paid to the partners and not to the Partnership which is the shareholder of the PBC.

     Subparagraph (vi) has no application to this case.

Damages Received by Partners

The damages are in respect of lost tax deductions which the partners will not have access to because the PBC failed to renounce the agreed amount of CEE to the Partnership.

Although this matter is not without doubt, it is our view that the partners' receipt of damages from the PBC would be on capital account to the partners and would be a non-taxable receipt.

These damages are not on income account, so would not be taxed as income to the partners. They are on account of capital but do not appear to be in respect of the loss of a capital asset, so would not be treated as proceeds of disposition for a capital asset.

Upon receipt of the damage payments the partners relinquish their rights to tax deductions that the PBC previously agreed to transfer to the partners, pursuant to the flow-through share agreement. Although, it is our position that these rights to tax deductions are part of the bundle of rights and privileges inherent in the flow-through shares, it is also our view that the shares are not being disposed of and the damages are merely being paid for breaching the flow-through share agreement and not as proceeds of a disposition for the shares.

As illustrated by the following examples, the partners are merely being put back to where they expected to be when they invested in the PBC's flow-through share program.

Example A

If a partner in a 50% tax bracket invested $100 in the Partnership which funds were used to acquire flow-through shares under which the PBC agreed to and did renounce $100 of CEE to the Partnership (which CEE in turn is allocated to the partner at the end of the year in which the CEE is renounced to the Partnership and which CEE can be deducted by the partner in computing his taxable income for the year), the partner would expect to have a net cash outflow of $50 (i.e. $100 investment in the Partnership minus $50 tax refund in respect of his $100 CEE deduction = %50 net cash outflow)

Example B

If the facts in example A above are the same except that the PBC fails to renounce CEE to the Partnership and in respect of this failure to renounce, the PBC pays damages to the partner of $50 (calculated at the amount of the tax loss to the partner for not being able to deduct $100 of CEE), that partner will still have a net cash outflow of $50 (i.e. $100 investment minus $0 tax refund minus $50 damages payment received from PBC = $50 net cash outflow).

Since the partner has not gained any sort of advantage over what he was supposed to receive in the first place, it is reasonable in our view that the receipt of damaged payments from the PBC, as described herein, should not be subject to tax.

(23)

Interest Paid by PBC

The interest to be paid by the PBC to the partners is to reimburse the partners for interest paid by them on any additional income tax they will pay because of the PBC's failure to renounce the agreed upon amount of CEE.

In our view, this interest payment by the PBC would constitute a component of the damages and would also be characterized as an ECE.

Arguably, this position is consistent with paragraph 11 of IT-467 which states:

      "The interest element, if any, in an award for damages is considered to be a component of the damages.  Such interest included with damages awarded will be deductible if the damages themselves are deductible.  In a case where damages are partially deductible the interest element will be deductible in the same ratio."

The above position is also supported in the Federal Court-Trial Division case of Sunshine Mining Company v. The Queen [75 DTC 5126], affirmed without written reasons [76 CTC xvi (FCA)], where it was accepted that the amount of interest paid in connection with a damages award would be characterized to be of the same nature as the damages to which it related.  Reference is made to page 2129 therein where it states:

      "At the trial, counsel for the defendant agreed that if the damage award ... was deductible, then the items of interest, legal fees and costs ... would also be deductible because of the deductible nature of the matter in respect of which they were paid.  Thus, the sole issue to be determined ... is the deductibility or nondeductibility of the award of damages...

In that case, the payment of damages was found to be on account of capital and non-deductible by the payor.  Presumably the same treatment was afforded interest expenses incurred thereon and legal fees in respect thereof.

In the present scenario, we considered and rejected the possibility that paragraph 20(1)(c) could apply to allow the PBC a deduction for the interest component of the damages paid.

In our view subparagraph 20(1)(c)(iii) and (iv) definitely did not apply. Also, there would not be a borrower/lender relationship between the PBC and the partners, as would be required to have "borrowed money", in order to qualify for a deduction pursuant to subparagraph 20(1)(c)(i).  In this regard reference was made to the Supreme Court of Canada case of M.N.R. v. T.E. McCool Limited [49 DTC 700]

In addition, we did not accept that the interest would constitute "an amount payable" for property acquired" as required by subparagraph 20(1)(c)(11).

We note that is the Sunshine Mining case (supra) no argument was presented to allow a deduction for the interest expenditure under paragraph 11(1)(c) (predecessor of 20(1)(c)).  We can only speculate that the argument was not made for the reasons we quote above for not allowing the PBC a paragraph 20(l)(c) deduction in this case.

Interest Received by Partners

In this instance the settlement calls for the PBC to pay damages calculated as being equal to the amount of any additional income tax paid by the partners as a result of the PBC's failure to renounce the agreed amount of CEE, plus any interest paid by the partners to the Government in respect of such additional tax paid.

It is our view subject to our comments below on the possible application of paragraph 12(1)(x), that these payments in respect of interest paid to the Government by the partners and would constitute a component of the damages received by the partners and would also be characterized as a non-taxable receipt.

If there was an additional element of interest paid by the PBC to the partners computed on the total damages (i.e. interest computed on the total additional taxes plus interest paid to the Government), then the amount of such additional interest would be taxable as interest income in the partners' hands.  This is in accordance with paragraph 12 of IT-396R, where it states in part:

      "Consequently, it is the Department's position that where, after 1983, an award for damages is made either by a court or by means of an out-of-court settlement which includes, or is augmented by, an amount stated, either by the court or in the terms of the settlement, to be in fact interest on all or a portion of the award, such  will constitute interest income in the hands of the recipient thereof for all Purposes of the Act.  This position arises from the fact that a liability for damages is considered to originate on the date on which an injury occurred and there is therefore an amount owing to, or belonging to, the injured party from that date."

The fact that we are recommending ECE treatment of this interest payment to the PBC does not necessarily require the same characterization of the receipt of such interest in the partners'hands.  This proposition is supported by paragraph 8 of IT-467 where it states:

      "The tax treatment of the damages in the hands of the recipient, and the size of the payment generally are not relevant facts in determining whether or not the payor is entitled to a deduction".

Possible Application of Paragraph 12(1)(x) of the Act

We considered whether paragraph 12(1)(x) would apply to the damages received by the partners and concluded as follows:

1.     The amount of damages in respect of the additional tax paid by the partners would not be considered a payment subject to paragraph 12(1)(x) in that the payment of those damages would not be an inducement (for the purposes of subparagraph 12(1)(x)(iii) and would not be "... in respect of the cost of property or in respect of an expenses" (for the purpose of subparagraph 12(1)(x)(iv) as the provision read prior to December 17, 1990.  Note that subparagraph 12(1)(x)(iv) was amended (Royal Assent December 17, 1990) such that the reference to "in respect of the cost of property or in respect of an expense" was changed to read "in respect of the cost of property or in respect of an outlay or expense (underlining is ours).  This amendment is effective with respect to amounts received after January, 1990).

2.     The amount of interest paid as damages to the partners before February, 1990 would not be included as an amount that is subject to the provisions of paragraph 12(1)(x).  There is an argument that the interest portion of the damages could be a reimbursement in respect of an expense (i.e. the expense incurred by the partners in paying interest on their income tax reassessments) as contemplated at subparagraph 12(1)(x)(iv).   However, it is our position, which was adopted in 1990, pursuant to a legal opinion and supported by Finance's May 23, 1985 budget papers concerning subparagraph 12(1)(x)iv), that "expense" referred to therein means "deductible expense" under the Act.  Since the partners are not able to deduct the interest paid to the government on overdue taxes, the reimbursement of that interest by the PBC would not meet the requirements in subparagraph 12(1)(x)(iv).

3.     The amount of damages (in respect of taxes and interest) received by the partners after January, 1990, would be included as an amount that is subject to the provisions of subparagraph 12(1)(x)(iv).

This is so because the subparagraph has been amended to refer to "an outlay or expense" rather than merely an "expense" as it did previously.  In our view the overdue taxes and interest paid by the partners to the Government in respect of those overdue taxes is unquestionably an "outlay".

Note that new subsection 12(2.2) of the Act would provide relief to the partners from the taxation of these damage payments. Subsection 12(2.2) allows taxpayers to elect to net outlays and expenses, which are incurred within a given time period, with related reimbursements, in order to determine the income inclusion pursuant to paragraph 12(1)(x) in respect of the reimbursements.

Summary

Our position is as follows:

1.     The damages and interest paid by the PBC would constitute ECE to the PBC.

2.     The amount of "damages" received by the partners in respect of additional taxes and interest paid to the Government would be non-taxable capital receipts, subject to the possible application of subparagraph 12(1)(x)(iv) to the damages as discussed above.

If you have any queries on this matter please contact the writer.

Acting/DirectorBilingual Services & Resource Industries DivisionRuling Directorate

General

The basic question posed to us by Special Audits was what would be the proper tax treatment for damages plus interest payments made by a corporation ("PBC") to partners of a partnership which invested in flow-through shares ("FTS") issued by the PBC.

24(1)

Issue #1

Would different tax treatment be given if the damages were paid as

1)     an out of court settlement,

2)     after the PBC is sued by the partners but prior to any court order; or

3)     pursuant to a court order?

Position #1

The tax treatment would be the same in any of the 3 scenarios noted above.

This position is supported as follows:

(1)     (23)

(ii)     ParagrAph 3 of IT-467 includes out-of-court settlements in the broad definition of damages.

(iii)     November 17, 1989, opinion letter from J.D. Jones to 19(1) confirms our position that the interest element in out-of-court settlements will be treated in the same manner as court awarded damages (refer to "O" in section `e' of working papers).

Issue #2

What is the proper tax treatment for the damages (not including interest) paid by PBC?

Position #2

The amount of the damages paid by the PBC would be an eligible capital expenditure ("ECE") to the PBC.

In our view the expenditure would be on capital account and incurred for the purpose of gaining or producing income from the PBC's business.

Initially we were concerned that the PBC might experience a more favourable net cash outflow by us allowing ECE treatment for the damages as illustrated below (This would be the case where the PBC was in a higher tax bracket)

21(1)(b)

For further details supporting our ECE position, reference is made to the outgoing memo on this file which is self-explanatory.

Issue #3

What is the proper tax treatment for the damages (excluding interest) received by the partners from the PBC?

Position #3

Subject to our comment re: Issue #6 concerning paragraph 12(1)(x), the amount of the damages received by the partners would be a non-taxable capital receipt.

(23)

For a further discussion, refer to the outgoing memo on this file which is self-explanatory.

Issue #4

What is the proper tax treatment of the interest paid by the PBC to the partners?

Position #4

The interest payment would constitute a component of the damages and would also be characterized as an ECE to the PBC.

Refer to the outgoing memo on this file for the rationale used to support this position.

The fact that the partners will be taxed on income account, in respect of this interest (see Position #5 below), will not in and of itself require that the interest payment be deductible by the PBC.  This proposition is supported by paragraph 8 of IT-467 where it states:

The tax treatment of the damages in the hands of the recipient, and the size of the payment generally are not relevant facts in determining whether or not the payor is entitled to a deduction.

Issue #5

What is the proper tax treatment of the interest received by the partners?

Position #5

Subject to our comments re: Issue #6 concerning paragraph 12(1)(x), the interest received in respect of additional interest paid to the Government would constitute a component of the damages and would also be characterized as a non-taxable receipt.

Consistent with paragraph 12 of IT-396R, any "additional" interest paid by the PBC to the partners computed on the total damages (i.e. interest computed on the total of additional taxes plus interest paid to the Government) would be taxable as interest income in the partners' hands.

We were advised by M. Beaulieu that no such "additional" interest is involved in the present scenario.

Issue #6

Does paragraph 12(1)(x)(iv), as it read prior to the enactment of Bill C-62 on December 17, 1990, and/or as it read after December 17, 1990, apply to the damages received by the partners?

Note

The reference to "expense" in subparagraph 12)(1)(x)(iv) was amended by Bill C-62 to read "outlay or expense", effective for payments received after January, 1990.

Position #6

The portion of the damages in respect of unpaid taxes would not constitute an "inducement" (for the purposes of subparagraph 12(1)(x)(iii) and would not be "in respect of the cost of property or in respect of an expense" for the purposes of subparagraph 12(1)(x)(iv) as the provision read prior to December 17, 1990.

The interest portion of the damages received by the partners before February, 1990 would not be included in paragraph 12(1)(x) (i.e. not an inducement and not a reimbursement of an expense). Reference is made to the December 4, 1990 memo from J. Chan to E. H. Gauthier (Item `Q' in working papers section 'e') concerning the Taxation of Quebec Mining Tax Credits.  Therein, at page 7, he discusses a legal opinion dated March 28, 1990 from Lucie Frenette to John Chan and Finance's May 23, 1985 budget papers to support his position that "expense" in subparagraph 12(1)(x)(iv) (prior to the December 17, 1990 amendment) meant "deductible expense" for tax purposes.

We have adopted that same view in this file.  The amendment to subparagraph 12(1)(x)(iv) to exchange "expense" to "outlay or expense" expands the application of the provision.  Consequently, the damages received by the partners after January, 1990, would constitute a reimbursement to them in respect of outlays of taxes and interest paid to the government and as such would be included in subparagraph 12(1)(x)(iv).

Relief may be available if the partners meet the conditions of new subsection 12(2.2) (enacted December 17, 1990).  This provision allows for a netting of outlays and expenses that are incurred within a given time period with related reimbursements to determine the income inclusion pursuant to paragraph 12(1)(x) in respect of the reimbursements.  Reference is again made to John Chan's December 4, 1990 memo to E.H. Gauthier where at pages 9 and 10 there is a good discussion on subsection 12(2.2).

Initially it was our opinion that 12(1)(x) would not apply in respect of damages.  This was based on a memo (item 'I' in section 'e' of working papers) from C.D. McDonald, Current Amendments to Robert M. Beith.  However, this position was reversed when we reviewed decision summary 9021-3 from the Review Committee (item 'S' in section 'e' of working papers).  In that instance damage payments for breach of contract were treated as being subject to 12(1)(x) indicating that the earlier memo (item "I" referred to above) was not being followed.

We also note in a memo dated August 11, 1988 from R. Langevin to Legal Services (item 'T' in section 'e' of working papers) that Current Amendments reconsidered (apparently not in writing) their view, previously outlined ln item 'I' of section 'e' of the working papers, such that they agreed that subparagraph 12(1)(x)(iv) could apply to damage settlements.

Issue #7

Does the payment of damages alter either the paid-up capital or the adjusted cost base of the flow-through shares?

Position #7

The damages are to compensate the partners for additional taxes and interest paid by them as a result of the PBC not renouncing "good" CEE as it had previously agreed to do.  The damages are not a return of capital by the PBC to the investors. (23) Consequently, the PBC's payment of the damages does not alter either the PUC or ACB of the flow-through shares, and no deemed dividend would result from the payment of such damages.  (For further analysis on this point reference is made to item `C' of working papers).

We considered the possibility of an abusive situation where in a non-arm's length scenario a corporation could transfer funds to a shareholder on a tax-free basis as follows:

(i)     The shareholder and PBC enter with a flow-through share ("FTS") agreement whereunder PBC agrees to incur and renounce the $ 1,000  received from the shareholder for the FTS.

(ii)     PBC purposely fails to incur and renounce the $ 1,000.

(iii)     PBC pays $ 500 "tax loss"  damages to the shareholder (assumes shareholder is in a 50% tax bracket and would have to pay an additional $ 500 in taxes due to PBC not renouncing the $ 1,000).

(iv)     PBC returns $ 1,000 investment to the shareholder as a return of capital and an equal amount is recorded as a paid-up capital reduction.  Pursuant to 84(4) there is no dividend as a result of this payment. If the PBC was a public corporation 84(4.1) would apply but in this non-arm's length scenario the PBC is not a public company.

(v)     Because of the paid-up capital reduction noted in (iv) above, 53(2)(a)(ii) would apply to grind the adjusted cost base of the flow-through shares to $ 1,000.i.e. 66.3(3) deems FTS to have an ACB of O and 53(2)(a)(ii) adjustment thereto reduces the ACB to S 1,000>.

This negative ACB is subject to the provisions of subsection 40(3) (i.e. deemed capital gain) and would be available for the capital gains exemption.

21(1)(b)

Issue #8

What effect does the receipt of damages have on the adjusted cost base of the partners' partnership interests in the Partnership?

Position #8

The damages are paid by the PBC to the partners to compensate the partners for additional tax and interest paid by them as a result of the PBC not renouncing "good" CEE as it had previously agreed to do.

We looked to subsection 53(1) and(2) of the Act and determined that the receipt of these damages would not effect the adjusted cost base of the partners' partnership interests.

The damages would not be in respect of a disposition of a partnership interest nor would there be a distribution of partnership capital, as referred to in subparagraph 53(2)(c)(v) of the Act, since the payment comes from the PBC and not the partnership.