Date: 20090227
Docket: A-344-08
Citation: 2009 FCA 60
CORAM: DESJARDINS
J.A.
EVANS
J.A.
RYER
J.A.
BETWEEN:
GOFF CONSTRUCTION LIMITED
Appellant
and
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT
RYER J.A.
[1]
This
appeal from a decision of the Tax Court of Canada (the Tax Court), Goff
Construction Ltd. v. Canada, 2008 TCC 322, by Mr. Justice Campbell Miller (the
Tax Court Judge), concerns the tax treatment of an amount received by the
appellant in settlement of a lawsuit framed in the tort of negligence.
The facts
[2]
The
facts are not in dispute. They can be summarized in the following manner.
[3]
A
third party (the purchaser) agreed to purchase some vacant land from the appellant provided that
the land could be re-zoned. The law firm that represented the purchaser
appealed the initial unfavourable re-zoning application to the Ontario
Municipal Board (the OMB). The appeal was unsuccessful and the OMB held the
purchaser and the appellant jointly and severally liable for costs in the
amount of $1.35 million.
[4]
The
appellant applied to the OMB to have the cost award against it reduced or
eliminated on the basis that it had no involvement in or control over the
initial OMB proceeding. The application was largely successful in that the OMB
reduced the cost award against the appellant to $135,000.
[5]
In
its 1992 to 1997 taxation years, the appellant deducted approximately $662,000
on account of the OMB cost award and expenses incurred in seeking the reduction
or elimination of the initial OMB cost award. These deductions were accepted by
the Minister of National Revenue.
[6]
In
1996, the appellant filed a claim in negligence against the law firm that
erroneously purported to represent it in the initial proceeding before the OMB.
[7]
In
1999, a settlement in the amount of $400,000 was reached between the law firm
and the appellant.
[8]
The
appellant did not include this settlement payment in computing its income for its
1999 taxation year. It claimed that the settlement payment was a non-taxable
capital receipt. The Minister of National Revenue reassessed the appellant for
its 1999 taxation year to include the settlement payment on the basis that it was
income from a business pursuant to subsection 9(1) of the Income Tax Act,
R.S.C. 1985, c. 1 (5th Supp.) (the Act).
[9]
The
appellant appealed to the Tax Court of Canada.
Tax
Court of Canada Decision
[10]
The
Tax Court Judge made a factual finding that the settlement payment was intended
to compensate the appellant for expenditures incurred by it on capital account
(specifically, the cost award and the expenses incurred by the appellant in
seeking a reduction in the cost award). The Tax Court Judge agreed that the cost
award and legal expenses incurred by the appellant, despite being on capital
account, were deductible pursuant to paragraph 20(1)(cc) of the Act. He
held that the surrogatum principle required the appellant to include the
settlement payment in income, notwithstanding that the settlement payment and
the underlying expenditures were on capital account, considering that the
settlement payment was intended to compensate the appellant for expenditures
that were deductible.
Issue
[11]
The
issue to be decided in this appeal is whether the appellant must include the
settlement payment in computing its income under subsection 9(1) of the Act for
the taxation year 1999.
[12]
The
appellant recognizes that the resolution of this issue depends on the
interpretation and application of the surrogatum principle. It submits
that the Tax Court Judge erred in law in applying the surrogatum
principle in the way that he did. The appellant states at paragraph 28 of its
memorandum that “the case law establishes that the tax treatment of the
expenditures underlying a damages or settlement payment (i.e., whether they are
deductible or deducted) is not relevant to the application of the surrogatum
principle and the tax consequences of receiving the damages payment. In the
cases where the damages relate to a recovery of expenditures, the Courts have
continued to hold that the surrogatum principle looks to the nature of
the damages payment and the underlying outlays as income or capital, and the
tax treatment to the recipient is determined under the Act based on such
characterization”.
Analysis
[13]
The
surrogatum principle is a judge-made law which operates in the following
manner as described by Charron J. in Tsiaprailis v. R., [2005] 1 S.C.R. 113, at paragraph 7.
Commenting on the principle that awards and settlement payments are inherently
neutral for tax purposes, she wrote:
…
in assessing whether the monies will be taxable, we must look to the nature and
purpose of the payment to determine what it is intended [page118] to replace.
The inquiry is a factual one. The tax consequences of the damage or settlement
payment is then determined according to this characterization. In other words,
the tax treatment of the item will depend on what the amount is intended to
replace. This approach is known as the surrogatum
principle….
[14]
Further down, at paragraph 15, she suggested the following two
steps for analysis:
The determinative
questions are: (1) what was the payment intended to replace? And, if the answer
to that question is sufficiently clear, (2) would the replaced amount have been
taxable in the recipient's hands?
[15]
At paragraph 7 of her decision, Charron J. cited
the authors Hogg, Magee and Li in the Principles
of Canadian Income Tax Law, 4th edition. In
their latest edition (6th), those authors describe the principle as follows
(which is not dissimilar from the earlier edition):
A person who suffers harm
caused by another may seek compensation for (a) loss of income, (b) expenses
incurred, (c) property destroyed, or (d) personal injury, as well as punitive
damages. For tax purposes, damages or compensation received, either pursuant to
a court judgment or an out-of-court settlement, may be considered as on account
of income, capital, or windfall to the recipient. The nature of the injury or
harm for which compensation is made generally determines the tax consequences
of damages.
Under the surrogatum principle, the tax
consequences of a damage or settlement payment depend on the tax treatment of
the item for which the payment is intended to substitute:
Where, pursuant to a legal
right, a trader receives from another person, compensation for the trader's
failure to receive a sum of money which, if it had been received, would have
been credited to the amount of profits (if any) arising in any year from the
trade carried on by him at the time when the compensation is so received, the
compensation is to be treated for income tax purposes in the same way as that
sum of money would have been treated if it had been received instead of the
compensation.
...
The recovery of an expense is
not income, unless the expense was deducted.
[Emphasis added.]
[16]
The
appellant concedes that a compensatory payment received in replacement for an
expenditure that is made on revenue account must be included in the income of
the recipient. However, where the expense in respect of which the compensatory
payment is received is made on capital account, the appellant contends that the
recipient is not required to include the receipt in its income. According to
the appellant, this is so even if the Act permits the full amount of the
capital expenditure to be deducted in the taxation year in which that amount is
paid.
[17]
In support
of this proposition, the appellant cites a number of cases: Ipsco Inc. v.
R., [2002] C.T.C. 2907(T.C.C.); Prince Rupert Hotel (1957) Ltd. v. Canada, [1995] 2 C.T.C. 212
(F.C.A.); Coughlan v. R., [2001] 4 C.T.C. 2004 (T.C.C.); Westcoast
Energy Inc. v. R., [1991] 1 C.T.C. 471, aff’d [1992] 1 C.T.C. 261 (F.C.A.);
Ikea Ltd. v. R., [1998] 1 S.C.R. 1996 and Consumers’ Gas Co. v. R.,
[1987] 1 C.T.C. 79 (F.C.A.).
[18]
In my
view, none of these cases were concerned with a situation in which a taxpayer
received an amount as compensation for a capital expenditure, which the
taxpayer was required to incur, the whole amount of which was properly
permitted as a deduction in the year that the amount was paid.
[19]
In Ipsco,
an amount received by the taxpayer as compensation for damage to its pipeline,
a capital property the cost of which was subject to the capital cost allowance
provisions of the Act, was not required to be included in the income of the
taxpayer under subsection 9(1) of the Act.
[20]
In Prince
Rupert Hotel, an amount received by the taxpayer as compensation for
negligence on the part of a law firm was held to have been received in
replacement for business profits that the taxpayer failed to receive, and not
for the loss or destruction of a capital property. Accordingly, that amount was
required to be included in the income of the taxpayer.
[21]
In Coughlan,
an amount received by a taxpayer as compensation for costs incurred in
conducting litigation that was required to protect his reputation as a
businessman was not required to be included in the income of the taxpayer under
subsection 9(1) of the Act. In this case, Mr. Coughlan had been allowed to
deduct certain legal costs that he had incurred in the litigation, although the
trial judge observed that such deduction had been improperly allowed.
[22]
In Westcoast,
an amount received by the taxpayer as compensation for damages to its pipeline,
a capital property the cost of which was subject to the capital cost allowance
provision of the Act, was not required to be included in the income of the
taxpayer under subsection 9(1) of the Act.
[23]
In Ikea,
an amount received by the taxpayer as part of its ordinary business operations
and not linked to any capital purpose was required to be included in the income
of the taxpayer under subsection 9(1) in the year of the receipt.
[24]
In Consumers’
Gas, amounts received by the taxpayer as contributions in respect of the
cost of relocating pipelines, capital properties the costs of which were
subject to the capital cost allowance provisions of the Act, were not required
to be included in the income of the taxpayer under subsection 9(1) of the Act.
[25]
Each of these
cases required a determination of the nature of the amount received by the
taxpayer in question. However, as indicated, none of them considered an amount
received in replacement for a capital expenditure, the whole amount of which
was properly permitted as a deduction in the year that such amount was paid.
Accordingly, none of these cases establishes that the Tax Court Judge erred in
his understanding of the surrogatum principle and its application to the
circumstances.
[26]
At
paragraphs 14, 15 and 16 of his reasons, the Tax Court Judge stated:
[14] Goff paid a significant amount in
legal fees to reduce the OMB costs awarded against it to $135,000. These
amounts go to the capital of Goff's business on the basis the costs
award related to a disposition of capital property and legal expenses related
to preserving a capital asset (money). I do not disagree. The only thorny
issue to tackle is where capital expenditures, such as those before me, are
deductible, how is the surrogatum principle to be applied? The case law
referred to by the Appellant does not persuade me that the authors Hogg, Magee
and Li have got it wrong. The tax consequences of a settlement payment
depend on the tax treatment of the item for which the payment is intended to
substitute. Where, as here, the amount is recovery of expenditures, as
opposed to lost profits, one must look to the tax treatment of those
expenditures. In this case, those expenditures were properly deducted for
tax purposes and consequently, applying the surrogatum
principle, the settlement amount should fall into income. This principle
should not be extended to rely upon deductions improperly made as would have
been the case in both Coughlan and Ipsco. Two wrongs should indeed not make a right.
[15] This conclusion is not a conclusion
that the settlement amount was compensation for current expenses; it is a
conclusion that the settlement amount was compensation for deductible capital
expenditures.
[16] I believe that as a judge-made tax
principle, the surrogatum principle must relate
to tax treatment, not just to the nature of the payment, though in most cases
the two will go hand-in-hand. This case happens to involve a situation of a
capital expenditure receiving income treatment by a provision of the Income Tax Act permitting its deductibility. The surrogatum principle should apply to assist in reaching a
tax result in accordance with the tax legislation, not to encourage a result of
either windfall at one end of the spectrum, or double taxation at the other
end. The surrogatum principle should apply to
maintain tax neutrality of damages.
[Emphasis
added.]
[27]
In Tsiaprailis and London & Thames
Haven Oil Wharves, Ltd. v. Attwooll, [1967] 2 All E.R. 124 (C.A.), compensatory payments received as a
consequence of the affected party’s failure to receive certain amounts
(disability insurance payments and lost profits) were characterized by the
courts. Then, the tax treatment of the receipt of those payments was held to be
the same as that which would have applied to the amounts that the affected
parties failed to receive.
[28]
In the present circumstances, the compensatory
payment was received by the appellant as a consequence of its having been
required to make certain expenditures rather than its having failed to receive
an expected amount. This factual distinction does not preclude the use of the surrogatum
principle to characterize the compensatory payment that was received by the
appellant. Thus, where the payment is intended to replace monies that have been
expended by the recipient, the tax treatment to be accorded to that payment
must be determined by reference to the tax treatment of the expenditures that were
made. Hence,
where an expenditure has been deducted in computing the income of the recipient
of a compensatory payment, the amount received should be included in the income
of the recipient.
[29]
In my view, the Tax Court Judge correctly
applied the surrogatum principle in the circumstances. The amount
received by the appellant from the law firm was intended to replace the OMB award
and related legal costs that were paid by the appellant in its 1992 to 1997
taxation years. While those expenditures were capital in nature, they were
nonetheless fully deductible by the appellant in the taxations years in which
they were paid. It follows that the amount received by the appellant from the
law firm in its 1999 taxation year must be included in the appellant’s income
for that taxation year.
[30]
For these reasons, I would dismiss the appeal
with costs.
“C. Michael Ryer”
“I
concur. Alice Desjardins J.A.”
“I
agree. John M. Evans J.A.”
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