2 February 2012 Internal T.I. 2011-0429691I7 - Out of court settlement

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.

Principal Issues: What should the proper income tax treatment be of the taxpayer's out of court settlement?

Position: General comments only.

Reasons: Unable to ascertain all relevant facts.

								February 2, 2012

	Toronto North TSO					HEADQUARTERS
	Joanne Grant, Team Leader			Income Tax Rulings
								  Directorate
	Attention : Erica Yan				Sandro D'Angelo
								(613) 952-5803

								2011-042969

Income Tax Treatment of Damage Settlement

This is in response to your correspondence of December 19, 2011 and our telephone conversation (D'Angelo/Yan) of January 3, 2012, concerning the treatment under the Income Tax Act (the "Act") of certain amounts received as a result of an out of court settlement pertaining to a claim for wrongful termination of a licence agreement.

Facts

While we have not been provided with a copy of the settlement agreement our understanding of the key facts is summarized as follows:

• XXXXXXXXXX (the "Taxpayer") entered into a technical assistance and licence agreement (the "Licence Agreement") with XXXXXXXXXX ("XXXXXXXXXX ") in 1988. XXXXXXXXXX. The Licence Agreement gave the Taxpayer the right to be the exclusive distributor of XXXXXXXXXX in Canada (the "XXXXXXXXXX Licence Business"). It also required XXXXXXXXXX to provide certain technical assistance to the Taxpayer.
• In 2006, XXXXXXXXXX unilaterally cancelled the Licence Agreement and the Taxpayer filed a $XXXXXXXXXX lawsuit against XXXXXXXXXX claiming compensation for the damages it sustained as result of XXXXXXXXXX 's breach of the Licence Agreement which included:

o Severance costs incurred on the termination of employees;

o Leasing/rental costs, travel plans previously arranged and advertising and marketing costs;

o Compensation paid to customers resulting from the Taxpayer's inability to fulfill their contracts on the supply of XXXXXXXXXX 's products; and

o Loss of income resulting from XXXXXXXXXX 's usurpation of the XXXXXXXXXX Licence Business.

• In 2008, an out of court agreement was reached in respect of the Taxpayer's damage claims under the lawsuit and the Taxpayer received $XXXXXXXXXX (the "Settlement Amount") from XXXXXXXXXX .
• Pursuant to the terms of the settlement agreement, the Settlement Amount was described as being in respect of the wrongful termination of the Licence Agreement and the usurpation of the XXXXXXXXXX Licence Business. You have indicated that it is not clear from the settlement agreement how much of the Settlement Amount should be attributed or allocated to each of these two items (i.e., no specific numerical allocation of the Settlement Amount has been made).
• The XXXXXXXXXX Licence Business represented approximately XXXXXXXXXX % of the Taxpayer's annual gross revenues. As such, XXXXXXXXXX 's cancellation of the Licence Agreement resulted in a significant reduction in the Taxpayer's annual gross revenue (from approximately $XXXXXXXXXX annually to $XXXXXXXXXX ) which resulted in the Taxpayer being forced to reduce staff and pay severance and other costs as described above.
• It is your view that the entire Settlement Amount should be included in the Taxpayer's income using the surrogatum principle on the basis that the Settlement Amount has been paid as compensation for lost revenue and additional expenses that are, or would have been, on income account. (footnote 1) However, the Taxpayer considered the Settlement Amount to be on account of capital and reported a taxable capital gain of $XXXXXXXXXX for its 2008 taxation year.

Issue

You have requested our views on how the Taxpayer's Settlement Amount should be treated for income tax purposes.

Our Comments

Generally speaking, and as indicated in paragraph 8 of Interpretation Bulletin IT-365R2, Damages, Settlements and Similar Receipts, an amount received by a taxpayer in lieu of the performance of the terms of a business contract by the other party (i.e., breach) may, depending on the facts, be either an income or a capital receipt. The courts have generally determined that if the amount received relates to the loss or disposition of a property, it will normally be considered to be a capital receipt and if the amount received is compensation for the loss of income, it will normally constitute business income under subsection 9(1) of the Act. (footnote 2)

As further explained in paragraph 9 of IT-365R2, where an amount is determined to be on account of capital, and it relates to a particular asset (tangible or intangible) which has been sold, destroyed or abandoned as a consequence of that breach, it will be considered proceeds of disposition of that asset (or a part thereof, as the case may be). However, if the amount is capital in nature but does not relate to the disposition of a particular asset (i.e., the amount is considered as compensation for the destruction of, or material crippling of, the whole profit-making apparatus of the taxpayer's business) the amount will be treated as an "eligible capital amount" for the purposes of determining the taxpayer's income inclusion under subsection 14(1) of the Act. (footnote 3)

In determining the correct tax treatment of a settlement payment the Canadian courts have relied on the common law concept referred to as the "surrogatum principle". This principle essentially determines the tax consequence of a settlement payment by looking to the real nature, character and purpose of the payment and not necessarily the name given to it by the parties. More simply stated, the income tax treatment of a settlement payment is determined by making reference to the income tax treatment that would have been accorded to the particular item or amount that the settlement payment is intended to replace.

In several instances, in determining whether a receipt of contractual damages is considered as compensation for the destruction of, or material crippling of, the whole profit-making apparatus of the taxpayer's business, or was compensation to fill a hole in the taxpayer's commercial profits, the courts have considered a variety of factors, including future events, that will help it establish the seriousness or degree of the impact or dislocation to the particular business. For instance, in Amaco Plumbing & Heating Co. Ltd. v MNR, 90 DTC 1381 (TCC), the court noted that the taxpayer did not suffer any permanent damage (within a period of two years its profits were back to normal). As such, it found that the particular payment was on account of income (i.e., the cancellation of the contract did not result in a material dislocation of the taxpayer's business structure). Accordingly, if the evidence more clearly suggests that the structure of the taxpayer's business could (or did) absorb the impact of the breach or termination of the particular contract or agreement the courts generally consider this to be a normal business risk and the amount of the compensation is more likely to be treated as income as opposed to capital.

The courts have also held that subsequent evidence of damage to the business, loss of revenue, or termination of employees may be unnecessary where the contract forms the basis of an entire business. For instance, in MNR v. Import Motors Ltd., 73 DTC 5530 (FCTD), the cancellation of an automobile distributorship arrangement was found to have seriously crippled the whole of the taxpayer's profit making structure as the wholesale division simply ceased to exist (i.e., it represented the loss in value of a capital asset with enduring value). As such, the court considered the amount received by the taxpayer to be compensation for the loss of a substantial portion of its business (i.e., a capital receipt) even though the court noted that there was some evidence that suggested that the payment could be considered as compensation for the loss of trading profits (i.e., an income receipt). This may also be the case where the taxpayer has identified a separate business that is seriously affected even though the overall income of the taxpayer may not be significantly affected. (footnote 4)

Similarly, in Valley Equipment Limited v The Queen, 2008 DTC 6200 (FCA), the court found that the rights of the taxpayer under a John Deere dealership agreement constituted property within the meaning of subsection 248(1) of the Act and that these rights were unlawfully taken when the dealership agreement was unilaterally cancelled by the franchisor. This action ultimately entitled the taxpayer to compensation for property unlawfully taken. In this case, the court found that damage award received by the taxpayer was taxable as a capital gain as it was consideration for the taxpayer abandoning its right to continue as a John Deere dealer such that there was a mutual exchange of property which brought the matter squarely within the parameters of paragraph 40(1)(a) of the Act. (footnote 5)

As indicated above, the Settlement Amount was described in the settlement agreement as being in respect of the wrongful termination of the Licence Agreement and the usurpation of the HG Licence Business. However, this really does not provide us with a clear indication as to the purpose or character of the Settlement Amount (i.e., what was it really paid for). It also appears that the unilateral termination of the Licence Agreement and the usurpation of the HG Licence Business may not be separate items. (footnote 6) However, the fact that a taxpayer's rights under a business contract (such as the Licence Agreement) or its right to sue for breach of those rights could be considered as property (footnote 7) for the purposes of the Act does not automatically mean that any damage award or settlement would always be on account of capital. In CNR v MNR, 88 DTC 6340 (FCTD), the court considered and rejected such a position in the following statement:

"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. In some cases the contract providing for compensation may be clear. The measure employed for calculating compensation is not always determinative: potential lost income may be taken into account in calculating the capital sum to be paid. 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. 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 the amount intended to replace?"

As indicated above, we understand that the XXXXXXXXXX Licence Business represented approximately XXXXXXXXXX % of the Taxpayer's gross revenue and the cancellation of the Licence Agreement resulted in a fairly significant decease in gross sales and the reduction of staff. Based on these facts, there appears to be a respectable argument that the Settlement Amount was paid as compensation for the destruction of an enduring asset or the crippling of a material portion of the Taxpayer's profit making apparatus which would support treating the Settlement Amount as a capital receipt. However, if there was no significant long-term damage to the Taxpayer's business it might also be argued that the Settlement Amount was simply paid as compensation for lost profits and additional expenses which would support treating the amount as an income receipt.

In our view, a more complete determination of the relevant facts is required before a definitive conclusion can be made on this issue and in this regard, it is our view that the TSO is in a better position to obtain the addition evidence that would be required to make such a determination. Obtaining answers to the following questions would assist you in making such a determination:

• Was the reduction in the Taxpayer's gross revenue/profit sufficient enough so as to destroy or materially to cripple its profit-making apparatus or has the Taxpayer's business sufficiently recovered?
• Did the Taxpayer have to significantly reduce staffing levels and was this reduction permanent?
• Were there any significant changes to the Taxpayer's business structure?
• Was the Taxpayer required to dispose of significant assets as a result of the termination of the Licence Agreement?
• Was this the end of the Taxpayer's business? What was the term of the Licence Agreement and was it near expiry? (footnote 8)

If the evidence suggests that the Settlement Amount is considered to be on account of capital, the amount may be considered as an "eligible capital amount". Older case law appears to suggest that it may be difficult to treat such amounts under the rules in subsection 14(1) of the Act. For instance, in Pe Ben the court considered and rejected such treatment. However, these older cases, including Pe Ben, had to consider the issue by applying the "mirror image test" which has been replaced with the 2006 amendments to "E" in the definition of "cumulative eligible capital" in subsection 14(5) of the Act. Under this new rule, it might be easier to establish that damages in respect of the unilateral cancellation of a business contract would be subject to the income inclusion under subsection 14(1) of the Act where such amount does not reduce the cost or capital cost of any property or result in a disposition of a specific capital property.

We trust our comments will be of assistance.

Yours truly

Michael Cooke
Manager
Business and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained
in the original document are shown below instead:

1 In your memorandum to us, we note that you have referred to several court cases and the comments in IT-365R2, Damages, settlements and other similar receipts. IT-365R discusses the CRA's general views, based on numerous court decisions, on whether certain payments arising as the result of the termination of a particular business agreement are on account of income or capital.

2 We have ignored whether a particular receipt in this particular situation could be considered as being a tax-free capital receipt or a windfall because the Taxpayer is not suggesting that this is the case. In the context of a settlement amount received in respect of a breach or termination of a business contract it would be unusual for a court to find that such an amount would be non-taxable. However, it should be noted that if one was to argue that a receipt of damages did not result in a disposition of a property in an effort to obtain tax-free or windfall treatment (i.e., a Fortino or Manrell type argument: The Queen v. Fortino et. al., 2000 DTC 6060 (FCA) and Tod T. Manrell v. The Queen, 2003 DTC 5225 (FCA)), the proposed restrictive covenant rules in section 56.4 of the Act might be applicable, which could result in a straight income inclusion instead of a capital gain or gain on a disposition of an eligible capital property.

3 The definition of "eligible capital amount" in subsection 248(1) of the Act refers to subsection 14(1) of the Act, such that it is an amount determined, in respect of a business of a taxpayer, as element "E" in the definition of "cumulative eligible capital" in subparagraph 14(5) of the Act.

4 For instance, in PE Ben Industries Company Limited v. The Queen, 88 DTC 6347, the court held that the termination of the contract was capital in nature which resulted in a capital gain (i.e., the payment was compensation for the loss of a distinct business even though the loss of that business had only a small effect on the company).

5 It appeared that the Minister initially considered whether the amount received by the taxpayer represented an "eligible capital amount" that was subject to inclusion in income pursuant to subsection 14(1) of the Act. However, this position was abandoned at trial.

6 This is more like a cause and effect (i.e., the termination of the Licence Agreement resulted in the loss of the XXXXXXXXXX Licence Business).

7 Refer to the definition of "property" in subsection 248(1) of the Act.

8 These factors were essentially adopted following the Parsons-Steiner Ltd v. MNR, 1962 DTC 1148 (Exch Court).