Prince Rupert Hotel (1957) Ltd. v. The Queen, 93 DTC 5243, [1993] 1 CTC 427 (FCTD), aff'd 95 DTC 5227 (FCA)

Pinard, J.:—This is an appeal by the plaintiff of reassessments by the Minister of National Revenue in respect of its 1984, 1985 and 1986 taxation years. At issue in this matter is whether the sums of $187,500 and $93,791 received by the plaintiff as out-of-court settlements of two actions in which the plaintiff claimed damages from its former solicitors for breach of contract and negligence in the provision of legal services, should be characterized as income payments, as the defendant claims, or as capital payments, as urged by the plaintiff.

The following facts are clearly established by the evidence:

— the plaintiff is a company incorporated under the laws of the province of British Columbia, having a year end for taxation purposes of August 31;

— at all material times the plaintiff was a member of the Blackcomb Lodge joint venture and the Mountainside Lodge joint venture which had been formed to develop and operate the Blackcomb Lodge and the Mountainside Lodge at Whistler, British Columbia;

— the fiscal year end of the Blackcomb Lodge joint venture is July 31, and the fiscal year end of the Mountainside Lodge joint venture is December 31;

— at all material times, the plaintiff was also one of four general partners of the Blackcomb Lodge Ltd. partnership which was created to carry on the business of operating the Blackcomb Lodge as a hotel on behalf of the limited partners;

— at all material times the plaintiff was also one of six general partners of the Mountainside Lodge Ltd. partnership which was created to carry on the business of operating the Mountainside Lodge as a hotel on behalf of the limited partners;

— it was agreed by the partners that the general partners would receive management fees allocated to them from the income of the limited partnerships in consideration for their management services in respect of the Blackcomb Lodge and the Mountainside Lodge, which fees, when earned, were reported by the joint ventures as income;

— the plaintiff, as a general partner in both limited partnerships, was allocated a 30 per cent share of the management fees allocated in respect of the Blackcomb Lodge, and a 15 per cent share of the management fees allocated in respect of the Mountainside Lodge;

— the plaintiff, together with the other general partners of each limited partnership, retained solicitors to prepare the limited partnership agreements, and instructed their solicitors to do the legal work necessary to form each limited partnership;

— due to a solicitors’ error, the Blackcomb Lodge Ltd. partnership agreement executed by all the limited partners provided for management fees calculated on the basis of 25 per cent of "partnership operating income”;

— due to a solicitors' error, the Mountainside Lodge Ltd. partnership agreement executed by some 50 of the limited partners contained a similar error with respect to the calculation of the management fees payable to the general partners, while the agreement executed by others of the limited partners correctly set out the basis of the calculation;

— the general partners of both limited partnerships commenced actions against the solicitors who had made the errors referred to above, and sought compensation for the additional costs incurred by them and for the value of management fee income lost to them due to the errors in the limited partnership agreements;

— to substantiate their claim for lost management fee revenue, the general partners retained an accounting firm which prepared a report for the purpose of calculating the cumulative present values of the income lost as a result of the errors in the limited partnership agreements;

— the said accounting firm reported that the cumulative present values of the income lost as a result of the solicitors’ errors was $993,903 in the case of the Blackcomb Lodge Ltd. partnership, and $849,004 in the case of the Mountainside Lodge Ltd. partnership, and determined that the errors had resulted in an estimated loss of management fee revenue to December 31, 1984 of $234,291 in the case of the Blackcomb Lodge, and $138,625 in the case of the Mountainside Lodge;

— an out-of-court settlement was reached whereby the solicitors agreed to compensate the general partners of both limited partnerships in accordance with a settlement agreement which provided for payment on or before February 25, 1985, of an amount of $1,250,000 by the solicitors to the general partners;

— of the $1,250,000 settlement amount, $625,000 was referable to the Blackcomb Lodge Ltd. partnership, and the plaintiff was allotted $187,500 as its share in its 1985 taxation year from the Blackcomb Lodge joint venture's year end of July 31 ending in the plaintiff's 1985 taxation year;

— the remaining $625,274 of the settlement amount was referable to the Mountainside Lodge Ltd. partnership and the plaintiff was allotted $93,791 as its share in its 1986 taxation year from the Mountainside joint venture's year end of December 31 ending in the plaintiff's 1986 taxation year;

— the plaintiff, in filing its returns of income for its 1985 and 1986 taxation years, did not include in income any amounts with respect to the $187,500 and $93,791 amounts allotted to the plaintiff as a result of the settlement of the actions of the general partners against their solicitors;

— by reassessments made August 30, 1988 the Minister of National Revenue included the sums of $187,500 and $93,791 in the plaintiff's income for its taxation years ending August 31, 1985 and 1986, respectively;

— the plaintiff calculated that it had realized non-capital losses in its 1985 and 1986 taxation years of $139,456 and $23,497 respectively which it deducted in computing its taxable income for its 1984 taxation year. As a consequence of the reassessments for the 1985 and 1986 taxation years, the Minister of National Revenue reassessed the plaintiff by notice of reassessment dated August 30, 1988 in respect of its 1984 taxation year to disallow the deduction of non-capital losses from the plaintiff's 1985 and 1986 taxation years in computing the plaintiff's taxable income for its 1984 taxation year;

— the Blackcomb Lodge Ltd. partnership agreement and the Mountainside Lodge Ltd. partnership agreement were not amended as a consequence of the settlement of the actions and still apply as they existed before the actions were commenced to generally the same general partners, including the plaintiff, who, at the present time continue to operate the Blackcomb Lodge and the Mountainside Lodge on behalf of the limited partners.

In addition to these facts, the defendant admits for the purpose of this appeal that the general partnership interest owned by the plaintiff in the Blackcomb Lodge Ltd. partnership and in the Mountainside Lodge Ltd. partnership constitutes capital property within the meaning of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

The plaintiff contends as a result of the negligence of the solicitors retained by the general partners to prepare the partnership agreements, the value of the general partnership interest was "permanently impaired”. The plaintiff further argues the amount received as damages for the harm done to such capital property is a capital receipt and not a part of business profit. The plaintiff submits, therefore, it correctly computed its income or loss and taxable income for the 1984, 1985 and 1986 taxation years, because the damages not being part of profit within the meaning of section 9 of the Income Tax Act, they are not income within the meaning of section 3 and constitute therefore a non-taxable capital receipt in the 1985 and 1986 taxation years.

By contrast, the defendant says that the Minister of National Revenue properly reassessed the plaintiff for its 1985 and 1986 taxation years. The defendant says the Minister correctly included the compensation paid to the plaintiff in those years as its share of the proceeds of the settlement of the actions between the general partners of the Blackcomb Lodge and Mountainside Lodge Ltd. partnerships against their solicitors as income. The defendant says the compensation was so paid in respect of management fee income lost to the general partners, including the plaintiff, and represented income of the plaintiff from business within the meaning of subsection 9(1) of the Income Tax Act in the amounts of $187,500 in the 1985 taxation year, and $93,791 in the 1986 taxation year. The defendant says consequently, the Minister of National Revenue properly reassessed the plaintiff for its 1984 taxation year, and correctly determined the plaintiff's taxable income, as the latter had no non-capital losses from its 1985 and 1986 taxation years to be applied in computing its taxable income for the 1984 taxation year.

At trial, counsel for both parties recognized the amounts of $187,500 and $93,791 were not received by the plaintiff as proceeds of disposition of capital property. Counsel for the plaintiff further agreed the appeal should be dismissed with respect to the allegations contained in paragraph 12 of the statement of claim concerning the capital cost allowance allowed by the Minister of National Revenue in the plaintiff's 1985 and 1986 taxation years.

As to whether the damages paid to the plaintiff are properly to be regarded as profit from business for purposes of section 3 and subsection 9(1) of the Income Tax Act, I am of the view that the rule stated by Diplock, L.J., in London & Thames Haven Oil Wharves Ltd. v. Attwooll, [1967] 2 All. E.R. 124 at 134, is applicable:

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.

And further on, Lord Diplock stated at pages 134-35:

If the solution to the first problem is that the compensation was paid for the failure of the trader to receive a sum of money, the second problem involved is to decide whether, if that sum of money had been received by the trader, it would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the date of receipt, that is, would have been what I shall call for brevity an income receipt of that trade.

Attwooll was followed by the Appeal Division of this Court in The Queen v. Manley, [1985] 1 C.T.C. 186, 85 D.T.C. 5150, at page 190 (D.T.C. 5151). In Manley the taxpayer received in damages, precisely what he would have realized in profit from his adventure in the nature of trade. Applying the rule stated by Diplock, L.J. in Attwooll, supra, Mahoney, J.A. concluded, at page 191 (D.T.C.

In the present case, the respondent was a trader, he had engaged in an adventure in the nature of trade. The damages for breach of warranty of authority, which he received from Benjamin Levy pursuant to a legal right, were compensation for his failure to receive the finder's fee from the Levy family shareholders. Had the respondent received that finder’s fee it would have been profit from a business required by the Income Tax Act, to be included in his income in the year of its receipt. The damages for breach of warranty are to be treated the same way for income tax purposes.

Also, Strayer, J. appeared to be guided by the same general principles in Canadian National Railway Co. v. M.N.R., [1988] 2 C.T.C. 111, 88 D.T.C. 6340, at pages 114-15 (D.T.C. 6342-43), wherein he provided the following formulation of the legal principles applicable to cases of this sort:

There is much jurisprudence on the question of whether compensation paid on the occasion of the termination of some business arrangement is capital or income. To a large extent each case turns on its own facts. It appears to me that there are two aspects which a court must consider in examining such a situation retrospectively: was the purpose of the payment to replace capital or income; and, whether or not the purpose can be reliably determined, was the effect of the payment to replace capital or income? It appears to me to be a dual test because the purpose may not be discernible, or it may not be reliably discernible in the sense that parties to settlements should not, by misstating the real purpose, determine the tax consequences of the receipt of such compensation. It is therefore necessary to look at both purpose and effect.

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. [1] In some cases the contract providing for compensation may be clear. [2] The measure employed for calculating compensation is not always determinative: potential lost income may be taken into account in calculating a capital sum to be paid. [3] Nor on the other hand does the fact that an amount is paid as damages for breach of a contract necessarily make it a capital sum and not income. [4] On the contrary 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? [5]

In the present case, the measure of the damages paid to the plaintiff has been determined by reference to the present value of the amount of the income lost as a result of the reduced management fee by reason of the improperly drawn limited partnership agreements. Furthermore, the plaintiff, together with the same general partners, still continues to provide management services in respect of the Blackcomb Lodge and the Mountainside Lodge under the improperly drawn limited partnership agreements. Under such circumstances, I cannot find that the solicitors’ errors did destroy, sterilize or materially cripple the whole of the profit-making structure of the business operations of the general partners with respect to the Blackcomb Lodge or the Mountainside Lodge Ltd. partnerships. Such general partnership interest was simply impaired, albeit permanently. The general partners did not lose their capital asset. (See Glenboig Union Fireclay Co. v. C.I.R., [1922] S.C. 112, 12 T.C. 427 (Ct. of Sess.) at 463-64 (T.C.), and Attwooll, supra, at pages 129-30.) Therefore, the compensation paid by the solicitors to the general partners, including the plaintiff, was not on account of capital. The amounts of $187,500 and $93,791 allotted to the plaintiff as a result of the settlement of the actions of the general partners against their solicitors were compensation paid in respect of management fee income lost to the general partners as a result of the solicitors' errors and represented income to the plaintiff from business in the 1985 and 1986 taxation years.

Consequently, the plaintiff's appeal will be dismissed with costs.

Appeal dismissed.