Pe Ben Industries Co. Ltd. v. The Queen, 88 DTC 6347, [1988] 2 CTC 120 (FCTD)

Strayer, J.:

Introduction

This is an appeal by the plaintiff of a reassessment by the Minister of National Revenue in respect of its 1976 income tax by which the Minister included a certain sum of $1,152,354.60 as income. The plaintiff contends that such amount was received as capital, being compensation for the breach (i.e. loss) of a contract that constituted the profit-making apparatus of a separate business which formed “a significant part of the plaintiff's profit-making apparatus". In the alternative the plaintiff contends that this payment was an “eligible capital amount" taxable under section 14 of the Income Tax Act, or constituted proceeds of disposition of its contract and is thus taxable as a capital gain only.

This case was tried together with that of Canadian National Railway Company v. The Queen [reported at [1988] 2 C.T.C. 111]. It arises out of essentially the same facts and involves the same principles of law. The reader is therefore referred to those reasons except to the extent that I must deal with the particular issues in this case in the present reasons.

Basic Background Facts

It was ordered during the course of the hearing that the evidence of A.J. Dove, called as a witness by Canadian National Railway Company in T-98-85, would be incorporated in the evidence in the present case as well. It was also ordered that commission evidence of Merron Vanish taken before me on June 11, 1987 in the present case also become part of the record.

As indicated in the reasons in T-98-85 the plaintiff in the present case was selected by Northern Alberta Railway ("NAR") as its sub-contractor to transport by truck all goods and materials from an intermodal yard, to be provided by NAR near Fort McMurray, to Mildred Lake, the site of construction of the Syncrude tar sands plant. This was a distance by road of about 40 miles. Pe Ben was selected in May of 1974 and started hauling to the Syncrude site in June, 1974, first from NAR's Waterways yard at Fort McMurray and later from its new Lynton yard also near Fort McMurray. It would appear that hauling went on for some time before a written agreement was finalized between Pe Ben and NAR. This agreement (Exhibit 15) is dated June 17,1974. I do not believe the evidence discloses exactly when this agreement was signed, but it would appear from its contents that it was not finalized until the contract between Canadian Bechtel Limited (“Bechtel”) and NAR was signed, and the evidence indicates that that did not occur until November 17,1975.

Because of the failure of Bechtel to use the NAR-Pe Ben intermodal service to the extent to which it committed itself through the "Traffic Commitment" of 250,000 tons during the life of the contract, Pe Ben had complained to NAR commencing at least as early as July 1975. By November 25, 1976 Pe Ben's solicitors wrote to NAR threatening action against NAR for fundamental breach of contract because of the shortfall in tonnages. NAR conveyed this threat to Bechtel in the course of its discussions with the latter company in December 1976 about the serious problems caused by the tonnage shortfall. This resulted, as has been seen, in a letter from Bechtel of December 17,1976 terminating its contract with NAR effective December 20, 1976. On the same day NAR in turn wrote to Pe Ben to cancel its agreement with Pe Ben effective the same date, December 20, 1976, relying on

the provisions of subsection (4) of Section 7.09 of the Agreement in writing made as of 17 June 1974 between Northern Alberta Railways Company and Pe Ben Industries Company Limited. . . .

It subsequently paid to Pe Ben the sum of $1,152,354.60 which is in issue in the present case. This sum represented the net amount owing to Pe Ben in compensation payable under its contract, representing $10 per ton of shortfall from the Traffic Commitment of 250,000 tons during the life of the contract. Actual tonnage handled up to December 20, 1976, the date of termination was 85,025 tons, being far short of the 250,000 tons specified in the traffic commitment under both the Bechtel-NAR contract and the NAR- Pe Ben contract. (There was deducted from the shortfall payments otherwise owing to Pe Ben the sum of $517,157 representing advances previously paid to Pe Ben in accordance with the contract.)

Legal Principles

These are the same as discussed in the Canadian National Railway case and need not be repeated here.

Conclusions

I will consider first whether the purpose for which the compensation was paid to the plaintiff can be determined. As the compensation arose under the contract one must look primarily to that instrument and the body of law which governs it. As in the case of the Bechtel-NAR contract in T-98-85, the contract between NAR and the plaintiff is not clear on this question. Section 6.01 establishes NAR's Traffic Commitment of 250,000 tons to be hauled between Lynton or Fort McMurray and the plant site, using the trucking services of Pe Ben. Within this same section there is a provision in paragraph 6.01(4)(a) which provides that:

(4) (a) If the traffic commitment has not been met at the termination of this agreement for any reason other than that specified in sub-section (3) of section 7.09, NAR shall pay to Pe Ben, as liquidated damages and not as a penalty, $10.00 per ton on the difference between the number of tons of traffic credited and the traffic commitment.

Subsection 7.09(3) which is referred to in paragraph 6.01 (4)(a) quoted above, notes that in the event of termination of plant construction by Syncrude, then either Bechtel or NAR has the right “unilaterally to terminate” the Bechtel-NAR agreement. This subsection goes on to provide that if the Bechtel-NAR agreement is so terminated, since Bechtel's only obligation is to pay NAR fixed costs reasonably incurred by NAR and its contractors to establish this operation as yet unrecovered at termination date plus out-of- pocket costs attributable to the termination, NAR undertakes to reimburse Pe Ben as its "contractor" as contemplated in the Bechtel-NAR agreement. Further subsection 7.09(4) provides:

7.09 (4) Bechtel has the right to terminate the Bechtel traffic agreement unilaterally at any time and if it does so NAR shall have the right to cancel this agreement at the same date upon payment to Pe Ben of the liquidated damages established in clause (a) of sub-section (4) of section 6.01 of this agreement whereupon NAR shall be relieved of and have no further or other liability to Pe Ben save for the payment of any outstanding freight accounts which NAR might have incurred prior to termination.

As noted earlier, when NAR terminated its agreement with Pe Ben it invoked this subsection (Exhibit 33).

As noted in the Canadian National Railway case, the use of the term "liquidated damages" seems more appropriate in paragraph 6.01(4)(a) which deals simply with failure to meet the traffic commitment. In subsection 7.09(4) there is a right conferred on one party, the NAR, to cancel the agreement unilaterally at any time subject to payment of the same compensation as is provided for any other failure to meet the traffic commitment. It is more difficult to characterize a payment in this case as “liquidated damages" since the right to compensation would arise not out of breach of contract by NAR itself but out of its exercise of its clear right to terminate the contract. Nevertheless, as I indicated in the Canadian National Railway case, I do not consider that the question of whether the payment was simply "on termination”, or was "for termination” and thus liquidated damages, is determinative of whether that payment is capital or income in the hands of the recipient. One must look to see what loss was being compensated, that of capital or that of income. The remainder of the contract is not very helpful in this respect either. Again, subsection 7.09(3), the counterpart of 8.06(3) in the Bechtel-NAR contract, indicates a particular situation where there would be compensation for capital lost. It is open to debate whether this should be taken to exclude any other compensation for lost capital.

Turning to the effect of the payment in its total context, I am satisfied on balance that this payment was of a capital nature. It was compensation for the destruction of a distinct part of the business of the plaintiff. This was the first intermodal undertaking of the plaintiff. To engage in it the plaintiff had to establish a base of operations at the Lynton yard solely for the purposes of this contract. It established a trailer camp to house 60 persons at the yard. It specifically acquired for performance of this contract equipment to the value of $709,813.83, and leased other equipment for the same purpose. It employed an average of 25 persons on this project including one with specialized skills. When the contract was terminated the equipment was removed to Edmonton, including the trailers. Some of the employees at the Lynton site were relocated back to Edmonton and employed in other areas, while those employed locally were let go.

While the termination of the contract put an end to the plaintiff's inter- modal operations, it by no means put an end to the plaintiff as a viable business. According to the agreed statement of facts the plaintiff during the years in question operated, besides its transportation business, a brick making business and a pipe stringing business. As for transportation, the plaintiff says that this consisted of two businesses: general oil field transportation including some other forms of haulage; and intermodal transportation consisting of the operation in question here. The defendant characterizes both forms of transportation as "general oil field transportation" of which the NAR operation was simply a part. I am satisfied that the intermodal operation was sufficiently distinct to be considered a separate business for present purposes. It involved a relatively long-term commitment for a trucking company, some five years, tied to one route and one shipper with obligations to meet the schedule needs of both NAR and Bechtel. It required the establishment of a base on a site which it did not control and in respect of which it had rights only so long as the contract lasted. It appears that the termination of the contract did put an end to the plaintiff's intermodal activity. It is true that the intermodal operation never contributed a very large part of the gross revenue of the plaintiff during the years the contract was in operation : it provided only 3.8 per cent in 1974, 13.6 per cent in 1975, and 11.1 per cent in 1976 (the latter not including the payment in question here). Two observations can be made. First, the percentage would no doubt have been considerably higher had the traffic commitment been met. Also, while many of the cases which have found a destruction of a business have involved termination of a contract representing the vast majority of the taxpayer's business, I do not think that factor is determinative if the business in question is sufficiently distinct.

Considerable effort was made during the trial to demonstrate that the NAR had been guilty of fundamental breach of the contract, that the plaintiff seriously considered suing NAR accordingly, and that the payment made by NAR was in reality in lieu of damages for fundamental breach as a "settlement" of a potential law suit. It is true that Pe Ben signed a document entitled "Forbearance to Sue”, a kind of release document, upon payment of the $1,152,354.60 by NAR to Pe Ben (Exhibit D-34). But this does not prove the plaintiff had a good cause of action for fundamental breach: it only proves that NAR exercised normal prudence in getting a release from any possible further claims, whether warranted or not. I therefore do not find the evidence convincing on this point and, as in the Canadian National Railway case, it would require more evidence to satisfy me that the real nature of the payment was in lieu of damages for fundamental breach. Nor would that, I think, assist me in determining whether the amount was paid in compensation for loss of capital or of income. All that can be said with confidence is that the plaintiff in return for this payment gave up any right it had to have the contract performed by means of shipment of 250,000 tons.

Having regard to the effect on the plaintiff, however, I have concluded that the payment here was of a capital nature to compensate it for the loss of a distinct business.

There remains the question of whether if this was received as capital it should be regarded as a non-taxable capital receipt, or whether it should be considered an “eligible capital amount" taxable in accordance with section 14 of the Income Tax Act, or as proceeds of a disposition of property and thus potentially subject to treatment as a capital gain. As noted earlier, the plaintiff has raised all of these possibilities in this order of preference.

Looking at the most difficult issue first, whether this represented an “eligible capital amount”, I believe that I am bound by the decision of the Federal Court of Appeal in The Queen v. Goodwin Johnson, [1986] 1 C.T.C. 448; 86 D.T.C. 6185, to hold that it did not. Subsection 14(1) of the Act provided, at the relevant time, as follows:

14 (1) Where, as a result of a transaction occurring after 1971, an amount has become payable to a taxpayer in a taxation year in respect of a business carried on or formerly carried on by him and the consideration given by the taxpayer therefor was such that, if any payment had been made by the taxpayer after 1971 for that consideration, the payment would have been an eligible capital expenditure of the taxpayer in respect of the business, there shall be included in computing the taxpayer's income for the year from the business the amount, if any, by which '/2 of the amount so payable (which /2 is hereafter in this section referred to as an “eligible capital amount” in respect of the business) exceeds the taxpayer's cumulative eligible capital in respect of the business immediately before the amount so payable became payable to the taxpayer.

The consideration given by the plaintiff was its forbearance to insist on performance of the contract through shipping of the full traffic commitment. Because of the circumstances, that was of a capital nature because it involved the destruction of a significant part of the business of the plaintiff. However, I am obliged by subsection 14(1) to determine the nature of any payment that would have been made by the plaintiff for that consideration if it had been the payor. In the Goodwin Johnson case the Federal Court of Appeal had come to a similar conclusion that, having regard to the importance of the contract there in question, the payment made to the taxpayer to settle all claims under the contract was in his hands "on capital account”. But applying the requirements of subsection 14(1) it looked at the nature of the payment actually made by the payor. It concluded that the payor “acquired nothing but peace in the litigation and rid itself of a bothersome partner".* Such expenditure was made for the purpose of gaining or producing income

by getting rid of an operational contractual expense by paying damages for breach of that contract. The purpose could not remotely be described as being for the acquisition of a capital asset.+

That in my view is the nature of the payment made by NAR in this case. It was getting rid of its contractual arrangement with the plaintiff and avoiding all future litigation. It was getting rid of any further obligations to pay what would normally be operating expenses under the contract. In other words the payment made by NAR to the plaintiff was for it in the nature of an operating expense which would be deductible as a business expense. By virtue of subparagraph 14(5)(b)(i) of the Income Tax Act it could therefore not be "eligible capital expenditure" if it had been made by the plaintiff and therefore it cannot when received by the plaintiff be an “eligible capital amount”. This was the rationale of the Goodwin Johnson decision and it is directly applicable here.

The plaintiff argues that in applying the convoluted test of subsection 14(1) it is not permissible to characterize the payment which hypothetically

Ibid at 453 (D.T.C. 6189).

t/bid at 456 (D.T.C. 6190).

would have been made by the plaintiff by determining what the nature of the payment actually was as made by the real payor, in this case NAR. In support of this proposition the plaintiff relies on its own interpretation of Samoth Financial Corporation Ltd. v. Her Majesty the Queen, [1986] 2 C.T.C. 107; 86 D.T.C. 6335. I believe this involves a misinterpretation of the Samoth decision. What that case stands for is that before one can go through this metaphysical exercise required by subsection 14(1), it is necessary to determine first whether the amount as actually received by the taxpayer was on capital account or income account. According to Samoth, if it was received by the taxpayer on income account, then subsection 14(1) does not come into play. In Samoth the money was held to be received as income and therefore subsection 14(1) was inapplicable. In the present case, as I have already determined, the money was received by the taxpayer on capital account. Thus subsection 14(1) is potentially applicable. In applying it, one must then notionally put the plaintiff in the position of the payor who actually was paying this amount as an income matter, i.e., a deductible expense incurred in the process of earning income. That being the case the plaintiff notionally put in that position cannot claim the amount received by it as an “eligible capital amount" because of the provisions of paragraph 14(5)(b).

This leaves the question as to whether the amount in question was the proceeds of disposition of an asset thereby rendering it potentially subject to treatment as a capital gain. It may first be noted that both the plaintiff and the defendant contend as an alternative that the sum in question should be so treated. I am in agreement that it should in accordance with the various definitions in the Income Tax Act. Paragraph 39(1)(a) indicates that a capital gain arises "from the disposition of any property". Subsection 248(1) of the Act defines "property" as meaning "property of any kind whatever" including "(a) a right of any kind whatever, a share or a chose in action. . . .” I believe that the plaintiff's rights under the contract with NAR which it gave up in return for a final payment would constitute such a right or a chose in action. Further, a "disposition" of property is defined by subparagraph 54(c)(i) as including “any transaction or event entitling a taxpayer to proceeds of disposition of property". This would cover the payment made by NAR to the plaintiff, whether one regards it as payment pursuant to the contract or for termination of the contract. This view is reinforced by the definition in subparagraph 54(h)(iii) of "proceeds of disposition” to include "compensation for property destroyed. . . .” The money paid by NAR to the plaintiff was for termination of any claim which the plaintiff might have against NAR under the contract which claim was thus "destroyed".

As the evidence indicates that nothing was paid by the plaintiff with respect to the acquisition of this contract, the amount received by it from NAR upon its termination must be regarded as the proceeds of disposition.

The appeal is therefore allowed in part, and the Minister's reassessment for 1976 is referred back to him for further reassessment on the basis that the amount of $1,152,354.60 constituted the proceeds of disposition of the

plaintiff's contractual rights under its contract with NAR and that it therefore was a Capital gain.

Success being divided in this matter, no costs are awarded.

Appeal allowed in part.