Principal Issues: [TaxInterpretations translation]
1 Does the compensation received by a Taxpayer in the form of damages constitute income from its business for the purposes of section 9 of the Act or a capital payment?
2) Is the interest paid with the damages business income or property income?
Position:
1) Business income.
2) Business income
Reasons:
1) Due to a supplier's error, the Taxpayer had to incur additional costs for demolishing and redoing certain works under a contract for services, resulting in an economic loss to the Taxpayer. This event gave rise to an action by the Taxpayer who claimed reimbursement from the supplier of the costs of demolition and repair of the XXXXXXXXXX. The Taxpayer won the claim. There was no evidence that the profit-generating structure of the Taxpayer's business was crippled or destroyed as a result of the costs incurred in the demolition and repair work.
2) In our view, a parallel can be drawn between the facts of the present situation and those described in The Queen v. Irving Oil Ltd. The amount received as damages would otherwise have been used in the Taxpayer's business but for the undue bearing of demolition and repair costs. This amount was property for use in the Taxpayer's business and the interest income on it was business income.
January 27, 2005
XXXXXXXXXX TSO HEADQUARTERS Danielle Bouffard Attention: XXXXXXXXXX (613) 957-8953
2004-010353
Tax treatment of damages
This is further to your fax of November 16, 2004 in which you requested our opinion on the tax treatment of damages received by XXXXXXXXXX (the "Taxpayer") in its taxation year ending XXXXXXXXXX.
The Taxpayer's representatives sent you their comments on a draft adjustment that took into account the opinion rendered by our Directorate on September 30, 2004 (2004-008505) on the qualification of the interest and additional compensation received by the Taxpayer following a judgment awarding it damages arising from a failure attributable to the supplier.
Unless otherwise indicated, all statutory references herein are to the provisions of the Income Tax Act (the "Act").
Facts
We repeat the facts described in Opinion 2004-008505 which are relevant for the determination of the tax treatment of the amount received as damages.
The Taxpayer is a corporation that operates a construction business specifically in XXXXXXXXXX
XXXXXXXXXX.
The supplier of the XXXXXXXXXX was at fault through supplying the wrong product, which caused damage to the work. The Taxpayer was forced to redo part of the work, resulting in additional costs. It sued the supplier for the costs of $XXXXXXXXXX incurred in demolishing and redoing the XXXXXXXXXX as well as $XXXXXXXXXX for loss of earnings due to an undue limitation of his financial ability to enter into further contracts in the following months and years.
The Taxpayer was successful only by virtue of its action regarding the costs of repairing the work pursuant to a judgment of the Superior Court of Quebec rendered in XXXXXXXXXX awarding it the sum of $XXXXXXXXXX with interest and additional indemnity since the claim (XXXXXXXXXX) and expenses, including costs and fees fixed at $XXXXXXXXXX.
The taxpayer launched an appeal of that judgment, which was dismissed by the Quebec Court of Appeal in XXXXXXXXXX.
The parties admitted that the loss resulting from the demolition and repair of the XXXXXXXXXX was a contractual loss amounting to $XXXXXXXXXX. The Superior Court accepted that admission. The Taxpayer received a total amount of $XXXXXXXXXX of which $XXXXXXXXXX represents the interest and additional indemnity pursuant to Articles 1618 and 1619 of the Civil Code of Quebec, i.e. the difference between the total amount and $XXXXXXXXXX.
The Taxpayer applied $XXXXXXXXXX to its cumulative eligible capital, and treated the amount of interest and additional compensation, which according to it totaled $XXXXXXXXXX, as investment income.
In opinion 2004-008505, it was considered that the Taxpayer had characterized $XXXXXXXXXX of the $XXXXXXXXXX damages as business income and that you agreed. That position is being challenged by the representatives.
Comments from the Taxpayer's Representatives
With respect to the treatment of the $XXXXXXXXXX, the representatives are of the view that the amount received "is not intended to compensate the business for the loss of an identifiable tangible asset" and "is not intended to reimburse a specific, identified expense or to compensate for an amount of lost income but is an arbitrary lump sum agreed to by the parties. "They support the Taxpayer's position to treat the $XXXXXXXXXX as part of the "cumulative eligible capital" of the business.
As for the amount of interest and additional compensation, they consider that those amounts constitute interest which is investment income.
Our Comments
Tax treatment of damages
Compensation received for damages may be considered to be of a current or capital nature. The amount received will be treated as income under section 9 if it is received as compensation for loss of income unless such loss results from the destruction or crippling of the entire profit-making structure of the business. In such a case, it would be considered capital in nature.
The jurisprudence has provided some criteria for attempting to characterize damage payments. The one that is most commonly found is explained by the comments of Strayer J. in Canadian National Railway Company v. MNR, 88 DTC 6340 (F.C.T.D.), which is summarized as follows:
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 a 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 this amount intended to replace?
Furthermore, in Catherine Dumas v. The Queen (2000 DTC 2603), Justice Mogan of the Tax Court of Canada stated:
In income tax law, there is nothing magic about an amount recovered by a plaintiff in civil litigation whether it be the result of a favourable judgment or a negotiated settlement. The amount recovered is compensatory in nature. That alone will not determine its character for tax purposes as being income or capital or something else. The real question is to determine why the compensatory amount was paid. The answer is often found in the pleadings of the plaintiff and defendant in the civil litigation.
In the situation presented, in order to determine what the sum received as damage replaces, it is relevant to refer to the very basis of the recourse undertaken by the Taxpayer against the payer. Due to a supplier's error, the Taxpayer had to incur, in the framework of a business contract, additional costs to demolish and redo certain works causing it an economic loss. This event gave rise to an action by the Taxpayer claiming reimbursement from the supplier of the costs of demolition and repair of the XXXXXXXXXX (admitted by the parties involved to be $XXXXXXXXXX). Those facts are clearly indicated in the judgments rendered by the Quebec Court of Appeal and the Quebec Superior Court. Furthermore, although the Superior Court acknowledged that the Taxpayer experienced difficulties in obtaining security during XXXXXXXXXX, there is nothing in that judgment to show that the profit-generating structure of the Taxpayer's business was crippled or destroyed as a result of the costs arising from the demolition and repair work.
We are of the view that the amount of $XXXXXXXXXX received by the Taxpayer to reimburse it for its costs incurred in the course of its business in connection with the reconstruction work was income from its construction business under section 9.
Tax treatment of interest
As stated in the facts, the Taxpayer also received interest and an additional indemnity pursuant to Articles 1618 and 1619 of the Civil Code of Québec totalling $XXXXXXXXXX. In opinion 2004-008505, our Directorate concluded that such payments constituted interest for the purposes of the Act and were taxable pursuant to paragraph 12(1)(c), and constituted income from an active business.
We maintain this position. We remain of the view that a parallel can be drawn between the facts of the present situation and those described in The Queen v. Irving Oil Ltd, 2002 DTC 6716 (FCA). As noted above, the Taxpayer claimed costs from the supplier that it had incurred in the course of its construction business, which costs were reimbursed by the supplier in the amount of $XXXXXXXXXX (as damages) that would otherwise have been used in its business but for the undue bearing of the demolition and repair costs. The $XXXXXXXXXX received was property for use in the Taxpayer's business and we are of the view that the interest income on it was business income.
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope you find these comments of assistance. Should you require any additional information regarding the content of this document, please do not hesitate to contact us.
Ghislaine Landry, CGA
for the Director
Business and Partnerships Division
Income Tax Rulings Directorate