Contract or Option Cancellation

A bare trustee (“FSL”) for the taxpayer (an investment and real estate company) had received a ground lease of property in downtown Halifax (“Founders Square”) from the Province (until 2064 at $100,000 per year for the first 10 years) and with FSL leasing a building it had constructed on its leased interest to the Province. After FSL had subsequently sued the Province for reducing the space that was leased by it, the action was settled by the Province agreeing to pay FSL $2,056,250 in cash and, for $2,400,000, to grant an irrevocable assignable option (the “Option”) to FSL to purchase Founders Square (which was stated to have a fair market value of $2.4 million), together with an assignment of the Ground Lease in favour of FSL The $2.4 million consideration was to be funded by way of set-off against an additional amount of $2.4 million amount owing by the Province to FSL under the settlement agreement.

FSL assigned the Option to a wholly-owned subsidiary of the taxpayer (“ADL”) on condition that ADL grant FSL a new ground lease on the same terms as the previous one except for a nominal rent. FSL assigned $160,000 of the $2.4 million amount, that it was entitled to receive under the settlement agreement from the Province, to ADL in consideration for an ADL promissory note. FSL then surrendered the existing ground lease to the Province pursuant to a surrender agreement which stated that the consideration provided by FSL thereunder to the Province was “$10.00 and other good and valuable consideration,” the Province transferred the fee simple interest in Founders Square to ADL, and ADL and FSL entered into the new ground lease. The taxpayer (which had calculated that $2.24 million was the present value of the remaining lease payments under the terminated ground lease) treated $2.24 million of the amount paid on its behalf by FSL as a lease cancellation fee, and deducted this amount in full in computing its income.

Paris J noted that the agreements with the Province had not allocated the $2.24 million to the lease termination, and found (at para. 43) that “FSL paid the $2.24 million to the Province in order to permit ADL to acquire the fee simple interest in the Property, and that the payment was therefore on capital account.”

In this regard, he stated (at paras. 46, 50, 51, 53):

Regardless of the provision in the Surrender Agreement that “the delivery of this Surrender and the Conveyance shall in no way constitute a merger of the fee simple title and the leasehold title in the Lands”, the surrender of the Ground Lease to the Province caused it to merge with the fee simple title by operation of law.

…Since, under the Transfer Agreement, FSL transferred to ADL the option to acquire the fee simple interest to the Property, it appears to me that FSL paid the $2.4 million purchase price on ADL’s behalf.

In exchange, ADL gave FSL the right to enter into a new long-term ground lease of the Property with ADL at a minimal rent.

… [T]he leasehold interest that FSL obtained from ADL at a nominal rent under the New Ground Lease was a capital asset [having cited T Eaton, 99 DTC 5178, para. 36] and therefore that the payment made by FSL by offset on behalf of ADL was on capital account.

Various employees of the taxpayer had been granted stock options by the taxpayer's parent ("Imasco"), a public corporation, and the option plan had been amended to provide that the employees could surrender their options for a cash payment equal to the options' accrued value. After Imasco had agreed with another corporation to support a transaction under which the other corporation would acquire the common shares of Imasco held by the public and cause a going-private transaction to occur, Imasco accelerated the vesting of the options and agreed with the taxpayer that the taxpayer would reimburse Imasco for an amount equal to all cash payments made by Imasco to employees who surrendered their options.

In finding that the payment in excess of $54 million so made by the taxpayer was not a capital expenditure, Bowman C.J. stated (at para. 22) that:

"I start from the premise that in the ordinary course a payment made by an employer to an employee for the surrender of his or her option under a stock option plan to acquire shares of the company is a deductible expenses to the company."

and (at para. 31):

"The fact that a subsidiary reimburses its parent for compensation paid to the subsidiary's employees does not turn the payment into a capital expenditure just because the parent company is in the midst of a corporate reorganization."

Bowman C.J. noted (at para. 33) that the Kaiser case was distinguishable on the basis that in this case there was no "reshaping of the capital structure" of the taxpayer.

In finding that legal fees incurred by the taxpayer as a result of her cancellation of an agreement to purchase a building were capital expenditures, Paris J. stated (at para. 21):

"If the Appellant in the case at bar had completed the purchase of the building, its price would certainly have been a capital expenditure. The amount that she paid to get release from her obligation to purchase the building is therefore closely tied to what would have been a capital asset, and its character would be the same."

The taxpayer made a lump-sum payment to terminate an agreement under which an American company agreed to supply the taxpayer from time to time at its request with future know-how in consideration for an annual fee equal to 10% of the taxpayer's consolidated pre-tax profits for 15 years. After noting (at p. 250) the prima facie presumption that a lump sum commutation of recurring revenue payments is itself a revenue payment and (at p. 251) the exception from this presumption where "the liability to make recurring revenue payments is reduced or brought to an end by the modification or disposal of an identifiable capital asset", he then stated (at p. 253):

"Expenditure to acquire future know-how is paid to obtain a service; it is not made to acquire an enduring asset, but a commodity which is turned over or exploited in the course of trade at a comparatively early date."

The taxpayer, in order to sublet the portion of its Calgary office space which was excess to its needs, paid an inducement payment of $157,806 to the subtenant, a lease agent's commission of $23,325 and legal fees of $7,972. Taylor J. found that these payments were deductible because they were made "in order to reduce its ongoing obligation to the landlord to pay rent for the excess space" (p. 1043). On the other hand, a commission paid by the taxpayer to a real estate agent in order to locate Toronto leasehold premises for it was a capital expenditure.

The taxpayer, which had agreed to pay a royalty to an American company in consideration for the provision by the American company of technical knowledge and of plans on an on-going basis, was entitled to deduct a payment made by it in consideration for the cancellation of the agreement. The cancellation became desirable after the taxpayer's merger with another company which had its own technical assistance agreement with another overseas company.

Gresson J. found that the lump sum "was merely a commutation of a recurring annual expenditure, and thus was entitled to be treated as an ordinary business expense. It was approximately the actuarial equivalent in value of the residual annual royalty obligation, and it was identical in character" (p. 24) and that the elimination of the contract "left the capital structure of the appellant unaffected" (p. 25).

Payments made by a dealer in furniture and home furnishings to landlords for the termination of the leases for two of its unprofitable stores were fully deductible when paid by it.

The taxpayer paid $10,000 to a tenant for the agreement of the tenant to vacate the premises. As a result the taxpayer was able to lease the vacated space to another tenant at more than double the previous rent.

Mr. Fordham found that the payment was deductible notwithstanding s. 12(1)(a) of the pre-1972 Act given that "a lease is simply a particular form of contract" and, therefore, contract-cancellation cases such as Halifax Overseas Freighters Ltd. v. MNR, 59 DTC 1013 (Ex. Ct.) should be binding.

Among the liabilities assumed by the taxpayer on taking over the business of a predecessor was the obligation to continue making lease termination payments. Because this obligation was assumed in connection with the purchase of a business, the associated payments were non-deductible capital expenditures.

The taxpayer was obligated under the terms of its lease of premises that had been used by it for a pharmacy in Accra to continue paying the rent of £490 per year for the remaining 12 years of the lease even though those premises were entirely destroyed by an earthquake, and to rebuild the premises. In confirming a finding of the Commissioners that the taxpayer was not entitled to deduct the sum of £3,000 that it had paid for the cancellation of this lease, Atkinson J. stated (at p.146):

"The payment was made in order to get rid of a burdensome capital asset. It was not made merely in order to commute certain annual revenue payments."

In finding that instalments of a lump sum payment made by the taxpayer to a joint managing director in consideration of his cancelling his employment agreement with the company were expenditures of a capital nature, Dixon J. stated (at p.197) that the lump sum:

"... was made for the purpose of organising the staff and as part of the necessary expenses of conducting the business. It was not made for the purpose of acquiring any new plant or for any permanent improvement in the material or immaterial assets of the concern. The purpose was transient and, although not in itself recurrent, it was connected with the ever recurring question of personnel."

The taxpayer, which had entered into a long-term agreement with another company for it to act as the taxpayer's agent in managing its business in Persia and the East and to carry out sales of its petroleum products there, obtained the cancellation of this agreement on the payment of £300,000 to the agent. The payment was charged to revenue in five annual deductions of £60,000.

In finding that the agency contract did not form part of the fixed capital of the taxpayer, with the result that the amount paid was deductible notwithstanding contrary finding of the Commissioners, Lawrence L.J. noted that (p. 269):

"It is not open to doubt that under ordinary circumstances where a trader, in order to effect a saving in his working expenses, dispenses with the services of a particular agent or servant, and makes a payment for the cancellation of the agency or service agreement, such a payment is properly chargeable to revenue."

He also noted that the sum, although large, nonetheless was small in relation to the annual profits of the Company. In addition, as noted by Romer L.J., given that the effect of the arrangement was to replace one agent by others, the "business of the Company continued exactly as it was before the change" (p. 276).

In finding that lump sums paid by a colliery company in order to secure a reduction in the scope of (in one case) or the cancellation (in the other case) of two mining leases (and thereby release its liability to restore the surface) were on capital account, Lawrence L.J. first noted (at p. 787) that the company's trade did not consist of acquiring mining leases and selling those mining leases but, rather, of the winning and selling of coal, and then stated (at p. 788):

"... it cannot, in my opinion, reasonably be said that the consideration paid for and the acceptance of the surrender was a sum wholly and exclusively expended for the purpose of winning and selling the coal in which the Company traded. In substance and in fact it was a sum paid for the purpose of getting rid of the capital asset of the Company which had become burdensome to the Company."

Sargant L.J. characterized (at p. 786) one of the payments as "being made for the purpose of putting an end to the existence of a disadvantage or onerous asset for the enduring benefit of the trade" and the other payment as being "made for the purpose of modifying the conditions of an existing asset so as to make the resulting term more advantageous or less disadvantageous for the enduring benefit of the trade."

Although the taxpayer, which was an insurance and reinsurance broker, had cause to dismiss one of its directors, and to require him to transfer his valuable shares to the other directors for their nominal par value, the taxpayer did not dismiss him in order to avoid the possibility of public scandal. A substantial sum which the taxpayer agreed to pay to the director in five annual instalments in order to secure his retirement was found not to be a capital expenditure for purposes of Rule 3(f). The payments were made not to secure an actual asset but in order to avoid a detriment to the continued conduct of its existing trade, and they did not have a once-and-for-all character because they in no way ensured that a similar incident would not occur in the future.

The agreement for the sale of the business of The Queen Insurance Company ("Queen") to the taxpayer provided that the taxpayer was to retain the services of the current manager of Queen at a salary of £4,000 per annum subject to a right of the taxpayer to commute the salary. In the event, a commutation payment of £55,846 was made by the taxpayer to the manager shortly after the purchase of the business. This payment was characterized as part of the consideration which the taxpayer was required to pay for the business of Queen, with the result that it was found to be a capital expenditure.