7 January 1991 Income Tax Severed Letter - Indemnity Paid to Investors Caused by a Reduction of a Renunciation of Canadian Exploration Expenses

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.

Subject: Indemnity Paid to Investors Caused by a Reduction of a Renunciation Pursuant to Subsection 66(12.73) of the Act

We are writing in reply to your memorandum dated November 15, 1990, wherein you request our opinion concerning the appropriate tax treatment in the scenario described below.

In 1987, a flow-through share agreement was entered into between a principal-business corporation (“PBC”) and a limited partnership (the “ Partnership”), such that the shares issued thereunder to the Partnership qualified as flow-through shares, as defined in paragraph 66(15)(d.1) of the Act.

In this flow-through share agreement, at paragraph XXX

You have requested our opinion as to the treatment for tax purposes, firstly to the PBC and secondly to the partners, of the damages and interest payments to be made by the PBC to the partners under the following circumstances:

• (i) as explained above;
• (ii) the payments being made only after the PBC is sued by the partners, but prior to any Court order; and
• (iii) the payment being made according to a Court order.

Rulings Comments - Damages Paid by PBC

Generally speaking, in determining the tax treatment of damage payments/receipts, the purpose for which the payment is made or the capacity in respect of which it is received, dictates whether it is made or received on account of capital or on income account. If the payments are received to replace lost income the payments are taxable as income, but if they are received for loss of capacity to earn income, they are received on account of capital.

In our view the damages will receive the same tax treatment whether paid to the investors by the PBC as an out-of-court settlement, as a result of the PBC being sued, but being paid prior to any Court order, or if they are paid pursuant to a Court order.

This position is consistent with the broad definition of “damages” found in paragraph 3 of IT-467, wherein it states “A payment in settlement of a damages claim to avoid or terminate litigation will be considered “ damages” herin even through there was no admission of any wrongdoing.”

Paragraphs 4 and 5 of IT-467 set out factors to consider in order to determine whether or not the damages to be paid by the PBC would be deductible in computing income. Paragraph 5 thereof states that where damages are paid as the result of an event which is incidental to business operations, or where the potential liability to pay such damages is a risk normally inherent in those operations, the deduction of the expenditure will not be considered to be prohibited by paragraph 18(1)(a) of the Act.

Paragraph 7 of IT-467 and paragraph 16 of IT-143R2 state that in circumstances where the payment of damages is on account of capital and is made for the purpose of producing income from business, the payment may qualify as an eligible capital expenditure provided the other tests in paragraph 14(5)(b) of the Act are met.

Although not without doubt, it is our opinion that the better argument can be made that the damages paid by the PBC would be an eligible capital expenditure (“ECE”) for the following reasons:

• 1. The payment of the damages would be on account of capital (i.e. precluded by paragraph 18(1)(b) from being deducted as a current operating expense) as it relates to the raising of capital amounts for the business.

The position that costs incurred in raising funds to be used in a business are capital in nature was accepted in the case Federal Court-Trial Division of Reviera Hotel Co. Ltd. v. M.N.R. [[1972] C.T.C. 157] (72 DTC 6142). Therein, at page 6144 Cattanch, J. states:

“The leading authority for the proposition that the cost of financing a business is a capital expense is in Montreal Coke and Manufacturing Co. v. M.N.R. [1944] A.C. 126. In that case interest bearing bonds were converted into other securities carrying lower rates of interest. It was claimed that the expenses of conversion were incurred “for the purpose of earning income”. The Supreme Court of Canada held that the payments on that account were not for that purpose and that, in any event the expenses were outgoings of capital and accordingly were not deductible. This decision was followed by the Supreme Court of Canada in Bennett White Construction Co. Ltd. v. M.N.R., [1949] S.C.R. 287 [49 DTC 514], where it was held that commission payments were not allowable as deductible expenses since they were incurred in connection with the financing of the business and were not related to the income earning process.”

We looked to section 20 which in some circumstances overrides paragraph 18(1)(b) to allow current expense deductions in computing income for a taxation year. It appears that only paragraph 20(1)(b) or (e) could possibly apply in this instance and we eliminated paragraph (e) as discussed below.

The payments of the damages by the PBC would be for breaching its flow-through share contract obligations. Such a payment would not be incurred in the course of a specific issuance of shares of the capital stock of the PBC, as required by paragraph 20(1)(e). Therefore, such a payment would not be deductible under that provision.

In support of this position we referred to page 6183 in the Federal Court of Appeal case of M.N.R. v. Yonge-Eglinton Building Limited [[1974] C.T.C. 209] [74 DTC 6180], where Thurlow, J. states that:

“. . . the words “in the course of” . . . are not a reference to the time when the expenses are incurred but are used in the sense of “in connection with” or “incidental to” or “arising from” and refer to the process of carrying out or the things which must be undertaken to carry out the issuing or selling or borrowing for or in connection with which the expenses are incurred.”

In our view a payment for damages for breach of contract would be too far removed to be considered “in connection with” or “incidental to” or “ arising from” a specific issuance of shares and would thus not meet the requirements of paragraph 20(1)(e).

• 2. The damages will be paid by the PBC for the purpose of gaining or producing income from the PBC's business, in the broad sense of the meaning of the words. The payment of these damages will be somewhat of a goodwill gesture by the PBC (in order to maintain a good reputation with investors) which will help to facilitate the future raising of working capital through share issuances, which proceeds can be used to earn business income.

We considered and rejected the notion that the payment for damages would not be deductible at all by the PBC because the damage payments were not laid out for the purpose of earning income.

In this regard reference was made to the Exchequer Court case of Imperial v. M.N.R. [[1947] C.T.C. 353] [47 DTC 1090]. At page 1098, Thorson, P. rejected the Minister's contention that when Imperial paid damages in an out-of-court settlement to another company for destruction of its ship, resulting from collision with Imperial's oil tanker, that the expenditure was not laid out for the purpose of earning profit at all, but solely to satisfy a legal liability and thus keep the sheriff away from Imperial's door.

At page 1099 of the same case, Thorson, P. states:

“It is no answer to say that an item of expenditure is not deductible on the ground that it was not made primarily to earn the income but primarily to satisfy a legal liability. This was the kind of argument that was expressly rejected by the High Court of Australia in the Herald & Weekly Times, Ltd. case (supra), and it should be rejected here.”

• 3. The amount of damages to be paid (i.e. the additional tax and interest to be paid by the partners as a result of the PBC's failure to renounce eligible CEE to the Partnership) appears to be reasonable in that it merely puts the partners back into the tax position they would have otherwise been in had the PBC fulfilled its contractual obligations by renouncing the proper amount of CEE.
• 4. We also looked to subparagraphs 14(5)(b)(iv) to (vi) to see if any of the exclusions noted therein applied to deny ECE treatment. If such was the case and ECE treatment was denied, then the damage payments would not be deductible at all by the PBC.

In our view a weak argument can be made that subparagraph (iv) would apply to deny ECE treatment if we view the investors as being creditors of the PBC and if we view the amount of the damages to be a debt owed by the PBC to the partners.

In light of the reference to bond or debenture in subparagraph (iv), we believe that debt was meant to apply more to something in the nature of a loan, as opposed to the damages in our case.

Subparagraph (v) also does not appear to apply to deny ECE treatment since the scope of that provision is limited administratively by paragraph 3(d) of IT-143R2. Also there is an argument that subparagraph (v) does not apply because the damages are to be paid to the partners and not to the Partnership which is the shareholder of the PBC.

Subparagraph (vi) has no application to this case.

Damages Received by Partners

The damages are in respect of lost tax deductions which the partners will not have access to because the PBC failed to renounce the agreed amount of CEE to the Partnership.

Although this matter is not without doubt, it is our view that the partners' receipt of damages from the PBC would be on capital account to the partners and would be a non-taxable receipt.

These damages are not on income account, so would not be taxed as income to the partners. They are on account of capital but do not appear to be in respect of the loss of a capital asset, so would not be treated as proceeds of disposition for a capital asset.

Upon receipt of the damage payments the partners relinquish their rights to tax deductions that the PBC previously agreed to transfer to the partners, pursuant to the flow-through share agreement. Although, it is our position that these rights to tax deductions are part of the bundle of rights and privileges inherent in the flow-through shares, it is also our view that the shares are not being disposed of and the damages are merely being paid for breaching the flow-through share agreement and not as proceeds of disposition for the shares.

As illustrated by the following examples, the partners are merely being put back to where they expected to be when they invested in the PBC's flow-through share program.

Example A

If a partner in a 50% tax bracket invested $100 in the Partnership which funds were used to acquire flow-through shares under which the PBC agreed to and did renounce $100 of CEE to the Partnership (which CEE in turn is allocated to the partner at the end of the year in which the CEE is renounced to the Partnership and which CEE can be deducted by the partner in computing his taxable income for the year), the partner would expect to have a net cash outflow of $50 (i.e. $100 investment in the Partnership minus $50 tax refund in respect of his $100 CEE deduction = $50 net cash outflow).

Example B

If the facts in example A above are the same except that the PBC fails to renounce CEE to the Partnership and in respect of this failure to renounce, the PBC pays damages to the partner of $50 (calculated as the amount of the tax loss to the partner for not being able to deduct $100 of CEE), that partner will still have a net cash outflow of $50 (i.e. $100 investment minus $0 tax refund minus $50 damages payment received from PBC = $50 net cash outflow).

Since the partner has not gained any sort of advantage over what he was supposed to receive in the first place, it is reasonable in our view that the receipt of damages payments from the PBC, as described herein, should not be subject to tax.

XXX

Interest Paid by PBC

The interest to be paid by the PBC to the partners is to reimburse the partners for interest paid by them on any additional income tax they will pay because of the PBC's failure to renounce the agreed upon amount of CEE.

In our view, this interest payment by the PBC would constitute a component of the damages and would also be characterized as an ECE.

Arguably, this position is consistent with paragraph 11 of IT-467 which states:

“The interest element, if any, in an award for damages is considered to be a component of the damages. Such interest included with damages awarded will be deductible if the damages themselves are deductible. In a case where damages are partially deductible the interest element will be deductible in the same ratio.”

The above position is also supported in the Federal Court-Trial Division case of Sunshine Mining Company v. The Queen [[1975] C.T.C. 223] [75 DTC 5126], affirmed without written reasons [76 CTC xvi (FCA)], where it was accepted that the amount of interest paid in connection with a damages award would be characterized to be of the same nature as the damages to which it related. Reference is made to page 2129 therein where it states:

“At the trial, counsel for the defendant agreed that if the damage award . . . was deductible, then the items of interest, legal fees and costs . . . would also be deductible because of the deductible nature of the matter in respect of which they were paid. Thus, the sole issue to be determined . . . is the deductibility or non-deductibility of the award of damages . . .”

In that case, the payment of damages was found to be on account of capital and non-deductible by the payor. Presumably the same treatment was afforded interest expenses incurred thereon and legal fees in respect thereof.

In the present scenario, we considered and rejected the possibility that paragraph 20(1)(c) could apply to allow the PBC a deduction for the interest component of the damages paid.

In our view subparagraph 20(1)(c)(iii) and (iv) definitely did not apply. Also, there would not be a borrower/lender relationship between the PBC and the partners, as would be required to have “borrowed money”, in order to qualify for a deduction pursuant to subparagraph 20(1)(c)(i). In this regard reference was made to the Supreme Court of Canada case of M.N.R. v. T.E. McCool Limited [[1949] C.T.C. 395] [49 DTC 700].

In addition, we did not accept that the interest would constitute “an amount payable for property acquired” as required by subparagraph 20(1)(c)(ii).

We note that in the Sunshine Mining case (supra) no argument was presetted to allow a deduction for the interest expenditure under paragraph 11(1)(c) (predecessor of 20(1)(c)). We can only speculate that the argument was not made for the reasons we quote above for not allowing the PBC a paragraph 20(1)(c) deduction in this case.

Interest Received by Partners

In this instance the settlement calls for the PBC to pay damages calculated as being equal to the amount of any additional income tax paid by the partners as a result of the PBC's failure to renounce the agreed amount of CEE, plus any interest paid by the partners to the Government in respect of such additional tax paid.

It is our view subject to our comments below on the possible application of paragraph 12(1)(x), that these payments in respect of interest paid to the Government by the partners would constitute a component of the damages received by the partners and would also be characterized as a non-taxable receipt.

If there was an additional element of interest paid by the PBC to the partners computed on the total damages (i.e. interest computed on the total additional taxes plus interest paid to the Government), then the amount of such additional interest would be taxable as interest income in the partners' hands. This is in accordance with paragraph 12 of IT-396R, where it states in part:

“Consequently, it is the Department's position that where, after 1983, an award for damages is made either by a court or by means of an out-of-court settlement which includes, or is augmented by, an amount stated, either by the court or in the terms of the settlement, to be in fact interest on all or a portion of the award, such amount will constitute interest income in the hands of the recipient thereof for all purposes of the Act. This position arises from the fact that a liability for damages is considered to originate on the date on which an injury occurred and there is therefore an amount owing to, or belonging to, the injured party from that date.”

The fact that we are recommending ECE treatment of this interest payment to the PBC does not necessarily require the same characterization of the receipt of such interest in the partners' hands. This proposition is supported by paragraph 8 of IT-467 where it states:

“The tax treatment of the damages in the hands of the recipient, and the size of the payment generally are not relevant facts in determining whether or not the payor is entitled to a deduction.”

Possible Application of Paragraph 12(1)(x) of the Act

We considered whether paragraph 12(1)(x) would apply to the damages received by the partners and concluded as follows:

• 1. The amount of damages in respect of the additional tax paid by the partners would not be considered a payment subject to paragraph 12(1)(x) in that the payment of those damages would not be an inducement (for the purposes of subparagraph 12(1)(x)(iii)) and would not be “. . . in respect of the cost of property or in respect of an expense” (for the purpose of subparagraph 12(1)(x)(iv) as the provision read prior to December 17, 1990. Note that subparagraph 12(1)(x)(iv) was amended (Royal Assent December 17, 1990) such that the reference to “in respect of the cost of property or in respect of an expense” was changed to read “in respect of the cost of property or in respect of an outlay or expense” (underlining is ours). This amendment is effective with respect to amounts received after January, 1990).
• 2. The amount of interest paid as damages to the partners before February, 1990 would not be included as an amount that is subject to the provisions of paragraph 12(1)(x). There is an argument that the interest portion of the damages could be a reimbursement in respect of an expense (i.e. the expense incurred by the partners in paying interest on their income tax reassessments) as contemplated at subparagraph 12(1)(x)(iv). However, it is our position, which was adopted in 1990, pursuant to a legal opinion and supported by Finance's May 23, 1985 budget papers concerning subparagraph 12(1)(x)(iv), that “expense” referred to therein means “deductible expense” under the Act. Since the partners are not able to deduct the interest paid to the government on overdue taxes, the reimbursement of that interest by the PBC would not meet the requirements in subparagraph 12(1)(x)(iv).
• 3. The amount of damages (in respect of taxes and interest) received by the partners after January, 1990, would be included as an amount that is subject to the provisions of subparagraph 12(1)(x)(iv).

This is so because the subparagraph has been amended to refer to “an outlay or expense” rather than merely an “expense” as it did previously. In our view the overdue taxes and interest paid by the partners to the Government in respect of those overdue taxes is unquestionably an “ outlay”.

Note that new subsection 12(2.2) of the Act would provide relief to the partners from the taxation of these damage payments. Subsection 12(2.2) allows taxpayers to elect to net outlays and expenses, which are incurred within a given time period, with related reimbursements, in order to determine the income inclusion pursuant to paragraph 12(1)(x) in respect of the reimbursements.

Summary

Our position is as follows:

• 1. The damages and interest paid by the PBC would constitute ECE to the PBC.
• 2. The amount of “damages” received by the partners in respect of additional taxes and interest paid to the Government would be non-taxable capital receipts, subject to the possible application of subparagraph 12(1)(x)(iv) to the damages as discussed above.

If you have any queries on this matter please contact the writer.