QUESTIONS 8 & 47
Application of paragraph 18(1)(a) of the Act
Facts
An industrial business has been operating at the same location for 25 years. It discharges corrosive waste into the city's sewers. Over the years, the sewers deteriorated. Around 1983, the city gave the company formal notice to cease its practices and claimed damages. It sued the company for the costs incurred in repairing the sewers. In 1996, a final judgment was handed down against the company, ordering it to reimburse the City for the repairs it had carried out, as well as almost all of its costs, including legal fees, lawyers' fees, GST and QST on the repairs, interest on those amounts and exemplary damages.
Questions
- Does paragraph 18(1)(a) apply in this situation, permitting the outlays to be disallowed because they were not incurred for the purpose of earning income?
- Would it be possible to have guidelines that are easy to apply in such cases?
- Could criteria for environmental damage be added to Interpretation Bulletin IT-104R2?
- If the corporation itself repairs environmental damage on its property, is this a capital expenditure, a current expense or a non-deductible expense?
Our Comments
To answer this question, a distinction must be made between fines and penalties, compensation and reimbursement for costs incurred to repair the damage caused. Each situation is unique and, before deciding on the application of paragraph 18(1)(a) of the Act, all the facts and all the documents, including the judgment rendered by the court, should be analyzed.
Fines and Penalties
Interpretation Bulletin IT-104R2 deals with the deductibility of fines and penalties imposed by the courts on taxpayers by virtue of federal or provincial statutes and municipal by-laws, etc. A fine or penalty is generally imposed as a punishment of the offender and is intended to act as a deterrent. If an analysis of the facts reveals that there in actuality is a fine or penalty, we are of the view that the general principles of the Bulletin would help determine the tax treatment required. It would be difficult to anticipate all situations involving environmental fines and penalties in order to provide guidelines to be applied in all cases or to add specific environmental criteria to the Bulletin. Furthermore, according to this Bulletin, fines are generally non-deductible.
Compensation
In the process of analyzing a specific situation, it is also necessary to consult Interpretation Bulletin IT-467R, which explains how to treat amounts paid or payable as damages in respect of a loss or injury caused by the taxpayer to another person, or to a business or property of another person. If an analysis of the facts reveals that there really is compensation, we are of the view that the general principles of Interpretation Bulletin IT-467R would help determine the tax treatment required for that compensation. It would be difficult to anticipate all situations involving environmental compensation in order to provide guidelines to be applied in all cases or to add specific environmental criteria to the Bulletin.
Sewer repair costs
We are of the view that the reimbursement of costs incurred by the City to repair sewers should receive the same tax treatment as the cost of repairing environmental damage carried out by the company itself. To determine the tax treatment, a number of factors must be taken into account:
Are the expenses incurred voluntarily or with the intention of discharging a legal obligation made to restore a site or repair environmental damage that was caused directly by the company's operations? If so, those expenses would generally be considered a cost of doing business.
Is the need to incur expenses to repair environmental damage necessitated by an ongoing condition that is part of day-to-day operations?
Will similar expenses have to be incurred in the future if the company's operations continue?
Has the expenditure been incurred with a view to obtaining an enduring benefit? Consideration should be given to whether the sole purpose of the expenditure was to correct or repair damage caused by the company's operations.
Was the expenditure incurred to increase the value of a fixed asset held by the company, such as land? The condition of the land after restoration work has been carried out should be compared with the condition of the land when it is unpolluted.
Were the expenses incurred to acquire depreciable property?
See document E9413377 for an example of the analysis of a specific situation.
Other costs
With regard to legal fees and interest, the particular circumstances should also be analyzed to determine whether those expenses are incurred to earn income.
Paragraph 12 of Interpretation Bulletin IT-467R states the Department's position with respect to interest and legal fees incurred for the payment of compensation as follows:
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.
Similarly, reasonable legal fees incurred in the payment of damages will be deductible in accordance with the principle expressed for interest.
You may wish to consider this position of the Ministry when analyzing the treatment to be given to legal fees and interest in circumstances other than the receipt of compensation.
Sylvie Labarre
June 1999
7-991340
7-991347