13 June 1994 External T.I. 9335135 - TAXATION OF SETTLEMENT PROCEEDS

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether receipt of settlement relating to compensation of a client for overpayment of income taxes due to poor financial advise is a taxable capital receipt.

Position TAKEN:

Question of Fact. In our view, based on the limited information provided, the partial compensation amount is a receipt on account of capital and the amount may be non-taxable.

Reasons FOR POSITION TAKEN:

This view is based on the fact that income tax is not a deductible expense and it would seem to follow that an amount paid to compensate an injured party for such taxes in the circumstances should not be included in income (unless specifically provided in the Income Tax Act).

		933513
XXXXXXXXXX	D. Zion

Attention: XXXXXXXXXX

June 13, 1994

Dear Sir\Madam:

Re: Taxation of Settlement Proceeds - Scientific Research Tax Credit

We are writing in response to your correspondence of November 24, 1993, wherein you requested the Department's interpretation of the taxability of an out of court settlement reached by one of your clients with its financial advisers. We apologize for the delay in replying.

As we understand the situation, this settlement relates to the partial compensation of your client for the overpayment of income tax resulting from inappropriate advice on the part of their financial advisers with respect to the purchase of a Scientific Research Tax Credit. You have arrived at the opinion that this payment should be characterized as a capital receipt and further that as a capital receipt to which the eligible capital rules and capital gains rules are inapplicable it should be considered a "nothing" and not subject to taxation.

The characterization of damages received as either taxable or non-taxable is a question of fact to be determined after a review of all of the relevant circumstances in each case. As the situation briefly outlined in your correspondence involves completed transactions and the main issue is dependent on the facts of a specific case, the tax status of this settlement should be discussed with an audit official of your local district taxation office. We are therefore not in a position to give you a definitive response. We will however, provide the following general comments which may be of assistance to you.

Our Comments

A payment in settlement of a damages claim to avoid or terminate litigation will generally be accorded similar treatment as damages for tax purposes even though there was no admission of any wrongdoing. In reviewing the tax repercussions of certain receipts the courts, as you note in your letter, have stated "With respect to purpose, the essential question is to determine what the compensation - whether paid pursuant to a contract, a court award of damages, or otherwise - is intended to replace.... it appears to me that whatever the source of the legal right to the compensation, be it the contract or the law of damages, the substantive issue is: what is this amount intended to replace?" (London and Thames Haven Oil Wharves Ltd. v. Attwooll (1967) 2 All. E.R. 124 (C.A.); followed in The Queen v. Manley (1985) 85 DTC 5150 (F.C.A.)).

Damages can be received either on account of income or on account of capital. Interpretation Bulletin IT-365R2, in paragraphs 8 and 9, discusses the distinction between an income receipt and a capital receipt in the context of non-performance of business contracts. We are of the view, given the limited information that you have provided in your letter, that the "partial compensation" amount for the additional income taxes paid in that year, could be considered a receipt on account of capital and that the amount could indeed be a non-taxable capital receipt. This view is based on the fact that income tax is not a deductible expense and it would seem to follow that an amount paid to compensate an injured party for such taxes in the circumstances should not be included in income (unless specifically provided in the Income Tax Act). However, this determination can only be made upon a complete review of all facts of the matter, as well as all documentation including the statement of claim and settlement agreement.

We caution you that these comments represent our opinion of the law as it applies generally and, as stated in Information Circular 70-6R2 dated September 28, 1990, are not binding on the Department. Nevertheless, we hope our comments will be of assistance to you.

Yours truly,

P.D. Fuoco
for Director
Business and General Division
Rulings Directorate
Legislative and Intergovernmental
Affairs Branch