Principal Issues: [TaxInterpretations translation]
Can the payor be considered to have a legal obligation to pay an amount at the time an agreement was signed if the agreement provides for the date of payments but the amount of payments will be determined as a percentage of the payor's operating revenues and no deadline for full payment of the debt has been set?
Position:
General comments only as this is a question of fact and the facts are not all available at this time.
Reasons:
For a genuine obligation to exist, there must be an enforceable claim by the creditor and it must appear reasonably probable that the debt will actually be paid by the debtor. In our view, there would be arguments for stating that the obligation to pay the amount provided for in the agreement is contingent only if it can be shown that there is uncertainty as to the payment of the obligation. If the facts show that it is only the time of payment that is not precisely established, but that there is no uncertainty as to the payment of the amount, we are of the view that it could then be a future obligation, and therefore an expense made or incurred for the purposes of paragraph 18(1)(a) of the Act, and not a contingent obligation.
July 10, 2000
Sherbrooke Tax Services Office Headquarters
Ghislaine Landry, CGA
(613) 957-8953
Attention: Mr. Christian Gravel
2000-002202Tax treatment of amounts to settle litigation
This is in response to your memo of April 18, 2000, in which you requested our opinion on the above subject.
You presented us with the situation of two taxpayers who signed an agreement to settle several existing disputes between them. The agreement provided that one of the taxpayers was to pay a specified amount to the other taxpayer. The agreement provided that the payer was required to make payments on specific dates, but the amount of the reimbursement to be made on those dates was to be determined as a percentage of the operating income for the period. In general, there was no minimum payment required and no deadline was set for repaying the debt in full. However, the agreement did provide for the possibility of discounts being granted to the payer if the debt was repaid quickly.
You asked whether the payer can deduct the total amount of the debt in the year the agreement was signed as an expense incurred for the purpose of earning income from his business under paragraph 18(1)(a) of the Income Tax Act (the “Act”). In other words, can the payer be considered to have a legal obligation to pay this debt at the end of the year in which the agreement was signed?
OUR COMMENTS
As discussed during the telephone conversation (Gravel/Landry) on July 4, 2000, it is not possible for us to take a precise position on the situation you have presented to us since it is a question of fact and, as you indicated, all the facts relating to this situation are not currently available. As agreed, however, we are providing you with some general comments that we hope you will find useful.
In computing a taxpayer's income from a business or property, paragraph 18(1)(a) denies the deduction of an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property. In addition, paragraph 18(1)(b) denies, among other things, the deduction of a capital expenditure and paragraph 18(1)(e) denies the deduction of an amount as, or on account of, a reserve, a contingent liability or amount or a sinking fund.
In a situation such as the one you have presented, we are of the view that it would first be necessary to determine the nature of the expense, whether it is a capital expenditure or an expense related to the operation of the taxpayer's business. It must also be determined whether the expense was made or incurred by the taxpayer for the purpose of earning income from the business.
Another important question that must be answered is the one you asked us, namely “Can the total amount payable be considered an expense made or incurred in the year or is it an amount in respect of a reserve or contingency? As provided in paragraph 15(e) of Interpretation Bulletin IT-109R2, Unpaid Amounts, in order for an expense that remains unpaid at the end of a taxation year to be deductible for tax purposes, it must constitute a genuine liability of the taxpayer. In The Queen v. Burnco Industries Ltd. 84 DTC 6348 (FCA), the Court commented:
an expense, within the meaning of paragraph 18(1)(a) of the Income Tax Act, is an obligation to pay a sum of money. An expense cannot be said to be incurred by a taxpayer who is under no obligation to pay money to anyone. ... an obligation to do something which may in the future entail the necessity of paying money is not an expense. (page 6348)
For a genuine obligation to exist, there must be a claim enforceable by the creditor. In addition, there must be a reasonable likelihood that the debt will actually be paid by the debtor. The Tax Court of Canada in Samuel F. Investments Ltd. v. MNR, 88 DTC 1106 (TCC), indicated that uncertainty as to the payment of an expense renders the expense contingent and therefore non-deductible under paragraph 18(1)(e) of the Act:
My understanding is that a liability to make a payment is contingent if the terms of its creation include uncertainty in respect of any of these three things: (1) whether the payment will be made; (2) the amount payable; or (3) the time by which payment shall be made. If there is certainty regarding the three matters just enumerated and time of payment is deferred it will still be a real liability, but in the nature of a future obligation. (page 1108)
In this case, the court was called upon to decide on the deductibility of a bonus that the taxpayer's board of directors had undertaken to pay to the corporation's president. The taxpayer claimed a deduction for the amount of the bonus. The Department disallowed the deduction on the grounds that it was for a contingency and had not been incurred for the purpose of earning income from a business. The court dismissed the taxpayer's appeal on the grounds that the expense was contingent, since it was uncertain when the bonus would be paid or even if it would be paid at all.
A similar issue was discussed in Mandel v. The Queen, 78 DTC 6518 (FCA), upheld by the Supreme Court of Canada, 80 DTC 6148, where the issue was whether the cost of a film included an amount payable out of film revenues. It was uncertain whether the film would generate revenues. The court limited the capital cost of the film to the amount actually disbursed because the balance of the purchase price depended on an uncertain event:
There is no doubt, ..., that, in contracting to buy the film on the agreed terms, the purchasers incurred a liability both in respect of the cash payment and the balance. It was not, however, as to the balance, a liability to pay merely on the expiration of a period of time or on the happening of an event that was certain, or even likely, to occur. It was a liability (from which the purchasers admittedly could not unilaterally withdraw) to become subject to an obligation to pay the balance if, but only if, an event occurred which was by no means certain to occur. The obligation was thus contingent on the happening of the uncertain event. (page 6521)
In your request, you referred to Barbican Properties Inc. v. The Queen, 97 DTC 122 (TCC), affirmed by the Federal Court of Appeal, 97 DTC 5008. In that case, the Court had to determine whether the taxpayer could deduct the interest payable on loans made to acquire properties, since payment of the interest could be deferred until the taxpayer realized operating income from the properties or a profit on the disposition of the properties. The Court determined that the obligation to pay the interest was not a future obligation but rather a contingent obligation since the possibility of the taxpayer realizing operating income or a profit on the disposition of the properties was unlikely:
In this case, the Court finds that there was uncertainty as to whether the payment would ever be made because it would only be paid upon the satisfaction of one of the conditions. There was uncertainty as to the amount of interest that would be paid because even though the repayment clause enabled the amount of interest that would normally be paid to be calculated, the only amount payable was to the extent of the net cash flow over the interest payable or the excess of the net sales value above the accrued amounts. There was uncertainty as to when the payment would be made because it would only be payable in any year when one of these conditions was met. That date was not certain at any time and indeed never arrived.
...
This Court is satisfied that what was involved here was not a future liability which was binding on the Appellant, but not payable until a future date. What was involved here was a "contingent liability". (page 129)
The Court therefore made a point of distinguishing between a future obligation and a contingent obligation. In the case of a future obligation, there is certainty as to the payment of the debt, but it is the time of payment that is deferred. The debt is real and enforceable in the form of a future obligation. In our view, in a situation such as the one you have presented to us, there would be arguments for saying that the obligation to pay the amount provided for in the agreement is contingent only if it can be shown that there is uncertainty as to the payment of the amount. If the facts show that it is only the time of payment that is not precisely established, but that there is no uncertainty as to the payment of the amount, we are of the view that it could then be a future obligation to pay and not a contingent obligation. However, it is not possible for us to make this determination at this time.
In your request, you indicated that you will consider the application of subsection 78(1) if the payer can deduct the total amount of the debt in the year in which the agreement is signed as an expense incurred for the purpose of earning income from its business under paragraph 18(1)(a). We agree with this possibility, but do not forget to consider the Agency's position in paragraph 15(a) of Interpretation Bulletin IT-109R2. There are, however, situations in which subsection 78(1) applies despite that position. See the Agency's position in Redclay Holdings Ltd. v. The Queen, 96 DTC 1207 (TCC).
We also wish to clarify a few points regarding the taxation of amounts received or receivable by the recipient under the agreement signed by the parties. First, it must be determined whether the amount is received or receivable on income or capital account. For example, is the amount related to the operation of the taxpayer's business? For this end, see paragraph 8 of Interpretation Bulletin IT-365R2, Damages, settlements, and similar receipts. If this is the case, we are of the view that the total amount received or receivable in the year in which the agreement was signed should be included in computing the recipient's income under subsection 9(1) and/or paragraph 12(1)(b) if it can be shown that the taxpayer had a clear right to receive the amount in question, could enforce payment of it, and the amount was determinable.
Establishing repayment terms is an indication that the recipient is in a position to demand payment. In this regard, see MNR v. Colford, 60 DTC 1131 (Exchequer Court), The Queen v. Imperial General Properties, 85 DTC 5045 (FCA), The Queen v. La Capitale, 98 DTC 6215 (FCA) and Maritime Telegraph and Telephone Company v. The Queen, 92 DTC 6191 (FCA).
In your request, you referred to the decision in The Queen v. Huang and Danczkay Ltd, 98 DTC 6393 (FCTD). This case has been appealed by the Agency to the Federal Court of Appeal and a hearing date is scheduled for August 23, 2000. In our view, the notes and mortgages in that case clearly constituted an amount receivable that were required to be included in the taxpayer's income under subsection 9(1) and paragraph 12(1)(b). If only amounts that the taxpayer is entitled to collect were considered receivable, very few amounts would be considered receivable at the end of a year, since the majority are due only in the future.
For your information, a copy of this memorandum will be severed using the Access to Information Act and will be available in the Legislative Access Database (LAD) located on the mainframe of the Canada Customs and Revenue Agency. 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 Legislative Access Bank 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 that has been severed in accordance with the Privacy Act will be sent to you for delivery to the client.
If you would like additional information on this subject, please do not hesitate to contact us.
Ghislain Martineau
Acting Manager
Individuals and Business Section
Business and Publications Division
Income Tax Rulings Directorate
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