Principal Issues: What is the tax treatment of various amounts received as compensation resulting from a mutual agreement in the context of the construction XXXXXXXXXX?
Position: The tax treatment of each amount received as compensation depends on its nature.
Reasons: General comments. The nature of each amount received is a question of fact.
XXXXXXXXXX 2019-081727 M-Christine Torchio
July 16, 2020
Mr. XXXXXXXXXX,
Subject: Compensation received pursuant to a private negotiation
This letter is in response to your request received by email on July 23, 2019 regarding the tax treatment of sums which, as a result of private negotiations, may be paid by XXXXXXXXXX to a number of owners for the acquisition of their properties or as compensation for the completion of the XXXXXXXXXX construction project.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (footnote 1) (the "Act").
Our understanding of the situation from the information you have given us (request, sample contracts and emails) is as follows:
XXXXXXXXXX will acquire a number of properties as part of the XXXXXXXXXX construction project. The acquisition will be by private negotiation and will involve a number of owners whose properties have multiple uses (residential, commercial, forestry production, agricultural production, maple syrup production, woodlot or undeveloped land). The sale price of each property will correspond to its market value.
The compensation will be paid under a second contract between the parties. The contract specifies that they will be paid in addition to the sale price in order to compensate the owners for various losses suffered according to their particular situation. The contract also specifies that a seller is not be enriched by the compensation received and the seller’s loss must be real and calculable.
The potential compensation provided falls into five categories:
1. Compensation for loss of value of the remainder
This compensation, in summary, consists of compensation for a loss in value of the remaining portion of the property after the removal of a parcel.
2. Compensation for disturbance to use
These allowances will be used to compensate for, inter alia, the following:
- Loss of time spent negotiating (Where the farm or forestry operation is considered a business, costs for employees to search for alternative locations and costs for organizing relocation, if applicable, may be compensated including negotiation meetings)
- Loss of time XXXXXXXXXX to get to the remaining portion of the property
- Loss of access to a building (cost of replacing or moving the building)
- Loss of access to a water point (cost of acquiring an alternative source)
- Loss of rental income for hunting
- Loss of crops
- Loss of forest management plan
- Loss of business
- Pre-approved fees for an appraiser, forestry engineer, agronomist and legal counsel, if required
3. Compensation for construction-related disturbances XXXXXXXXXX
This compensation will be used, inter alia, to compensate for the following
- Damage to underground or surface drainage systems
- Disturbance of ditches
- Breakage caused by the construction (fences, soil compaction, damaged trees, etc.)
- Loss of agricultural land (could result in manure management or other problems)
- Relocation of a new access in the forest
- Loss of investment
- Loss of yield
4. Compensation for a building used as a residence
These allowances are related to the relocation of the owners and are intended to compensate or pay for the following
- Moving expenses
- Appraisal and inspection fees for a new house
- Costs of upgrading the replacement property
- Estimated discounted cost of property tax increases
- Additional acquisition costs
5. Compensation for early repayment of the seller's mortgage
YOUR QUESTIONS
1) Is the market value received by an owner for the sale of the owner’s property considered a capital gain?
2) What is the tax treatment of each of the above compensation payments?
OUR COMMENTS
The Income Tax Rulings Directorate ("ITRD") confirms the tax treatment of particular transactions of a particular taxpayer only in the context of an advance income tax ruling request made in the manner described in Information Circular IC70-6R9, Advance Income Tax Rulings and Technical Interpretations. However, we are prepared to provide general comments, which we hope you will find helpful.
Your request is unique in that it describes a situation involving several taxpayers who will receive different compensation depending on their particular circumstances, under contracts that, once concluded, will seal the legal relationship between the parties. Consequently, we caution that the comments in this letter will focus on provisions of the Act that may be applicable in the most common scenarios, but which may not be fully applicable in a particular situation. Indeed, the determination of the nature of the amounts to be paid (sale price or compensation) and the underlying tax implications are questions of fact that cannot be resolved without a thorough examination of the facts and particulars of each situation, including the agreements (written or oral) between the parties and the applicable private law.
Our comments are presented in three sections. First, we discuss the tax implications of the market value amount received by an owner for the sale of the owner’s property, which essentially answers your first question. Second, we examine the tax treatment of the compensation received for the loss in value of the remainder. Finally, we look at the tax treatment of other compensation received.
SECTION I - SALE OF PROPERTY AND CAPITAL GAIN
1.1 Capital gain or business income
The sale of property may give rise to a capital gain or loss or business income or loss, depending on the circumstances. However, there is no provision in the Act that specifies these circumstances. This is a question of fact.
Generally, the sale of a property that is a capital property (footnote 2) gives rise to a capital gain or loss while the sale of a property that is inventory gives rise to business income or loss.
See Interpretation Bulletin IT-459 ARCHIVED, Adventure or Concern in the Nature of Trade (footnote 3) and paragraphs 3 to 6 of Interpretation Bulletin Tt-218R Archived, Profits, Capital Gains and Losses from the Sale of Real Estate, Including Farmland and Inherited Land and Conversion of Real Estate from Capital Property to Inventory and Vice Versa (footnote 4), the main criteria considered by the courts in determining whether the sale of a property gives rise to a capital gain or business income, as well as the Canada Revenue Agency's ("CRA's") comments thereon. They may be helpful in making such a determination.
A capital gain or business income must be included in computing income.
However, if a loss were to result from the disposition of a property, it may not be deductible in certain circumstances. This is because a capital loss arising on the sale of a personal-use property, such as a principal residence, is nil under the restrictions of subparagraph 40(2)(g)(iii). This is also the case where a loss is sustained on the sale of a depreciable property. This loss is not considered a capital loss. However, such a disposition could result in a terminal loss that a taxpayer could claim pursuant to subsection 20(16).
Another consideration on the sale of a property, if it is depreciable property, is that its disposition may also give rise to an amount of recapture of capital cost allowance that will have to be included in computing income pursuant to subsection 13(1).
1.2 Computation of capital gain or loss
In summary, a capital gain or loss corresponds to the proceeds of disposition of a property less its adjusted cost base ("ACB") and any expenses made or incurred to make the disposition. If the result is positive, there is a capital gain; if the result is negative, there is a capital loss. The taxable capital gain is one-half of the capital gain, while the allowable capital loss is one-half of the capital loss.
Under the definition of "proceeds of disposition" in section 54, proceeds of disposition of property include the following amounts referred to in paragraphs (a), (c), (e) and (f) of that definition respectively:
(a) the sale price of property that has been sold,
[…];
(c) compensation for property destroyed …,
[…];
(e) compensation for property injuriously affected, whether lawfully or unlawfully or under statutory authority or otherwise,
(f) compensation for property damaged and any amount payable under a policy of insurance in respect of damage to property, except to the extent that such compensation or amount, as the case may be, has within a reasonable time after the damage been expended on repairing the damage,
[…]
Based on the information you have provided, the disposition of the property will be as a result of private contractual negotiations. Consequently, pursuant to paragraph (a) of the definition of proceeds of disposition in section 54, the proceeds of disposition of each property sold will include its sale price as stated in the contract of sale. If, however, the sale price were received as consideration for the disposition of a property that includes land and a building, the rules in paragraph 68(a) for the allocation of proceeds of disposition could apply.
The ACB of a property is defined in section 54 as its cost plus or minus certain adjustments.
For more information on computing the capital gain or loss, see Guide T4037, Capital Gains 2019.
If the property sold is depreciable property, the disposition of that property, in addition to being subject to the capital gains and losses provisions of the Act, could also result in a recapture of capital cost allowance or a terminal loss, as discussed above in Section 1.1. For more information on this topic, please refer to Income Tax Folio S3-F4-C1, General Discussion of Capital Cost Allowance (footnote 5).
1.3 Capital gains deductions, principal residence exemption and acquisition of a replacement property
Where a capital gain is realized, it may be reduced in part or in full or deferred by, for example, claiming a capital gains deduction, a principal residence exemption or by acquiring a replacement property.
1.3.1 Capital gains deductions - qualified farm or fishing property
An individual (footnote 6) who realizes a capital gain on the disposition of qualified farm or fishing property ("QFFP") may be able to claim a deduction in respect of that gain in computing taxable income for that year pursuant to subsection 110.6(2) or 110.6(2.2). For example, real property, such as land and a building, that was used in the course of carrying on a farming or fishing business in Canada may be QFFP if it satisfies certain conditions.
Further explanation of these deductions and QFFPs can be found in Guide T4037.
1.3.2 Principal residence exemption
The principal residence exemption may be claimed in respect of a capital gain realized on the disposition of a property that is considered as a principal residence. The term "principal residence" is defined in section 54. In order for a property to qualify as a principal residence, it must be designated as such by completing the relevant section of Schedule 3, Capital Gains (or Losses) of the income tax return and Form T2091(IND), Designation of a Property as a Principal Residence by an Individual (Other than a Personal Trust). The principal residence exemption is claimed pursuant to paragraph 40(2)(b) or paragraph 40(2)(c) in the case of land used in a farming business and containing a principal residence.
This exemption is explained in Income Tax Folio S1-F3-C2, Principal Residence (footnote 7) and in Interpretation Bulletin IT-218R ARCHIVED (footnote 8).
1.3.3 Acquisition of a replacement property
Elections may be made pursuant to subsections 44(1) and 13(4) to defer all or part of a capital gain or recapture of capital cost allowance realized on the disposition of a property to another year in certain circumstances. This is particularly the case where the property was, immediately before it was disposed of, a former business property, and a replacement property is acquired.
Further explanation of the replacement property rules can be found in Income Tax Folio S3-F3-C1, Replacement Property (footnote 9).
SECTION 2 – COMPENSATION RECEIVED FOR THE LOSS IN VALUE OF THE REMAINDER
According to the information you have given us, the remainder is the portion of the property remaining after the removal of the parcel. It is possible that this remainder may lose value as a result of the removal due to a number of factors, including accessibility, configuration, size or drainage. In such a situation, compensation will be received by the owners to offset this loss of value.
We are of the view that the compensation received for this loss of value could be compensation in respect of injuriously affected property. As noted above in section 1.2, this compensation could be the proceeds of disposition of the remainder pursuant to paragraph (e) of the definition of proceeds of disposition in section 54, if that remainder were capital property.
In such a case, for the purpose of computing the capital gain or loss on the disposition, a reasonable portion of the ACB of the remainder will be required to be allocated to the disposed of portion pursuant to subsection 43(1). There is no provision in the Act specifying the method to be used to make this allocation. However, paragraph 1.76 of Income Tax Folio S3-F4-C1 (footnote 10) provides an example of a reasonable allocation based on fair market value. This method is not the only one and other methods may be equally valid; reasonableness being a question of fact.
In addition, some or all of the capital gain or loss from this disposition may be reduced. In this regard, please refer to Section 1.3 above.
Finally, the amount computed pursuant to subsection 43(1) will be deducted in computing the ACB of the remainder pursuant to paragraph 53(2)(d).
SECTION 3 – OTHER COMPENSATION RECEIVED
According to the list of potential compensation attached to your request, compensation could also be received by the owners for various disturbances of enjoyment relating to the operation of their business, such as loss of income, expenses or the cost of goods. Owners may also receive compensation for various heads of damages to their depreciable and non-depreciable property.
In general, the application of generally accepted business principles for the purposes of computing profit or loss under section 9 will result in the compensation received being included in computing income from their business or being applied against expenses or the cost of property. In some cases, specific provisions of the Act may apply to dictate the tax treatment of that compensation, as discussed later in this document.
Finally, owners may also receive compensation for a building used as a residence. The tax treatment that may apply to those allowances is also referred to below.
Given the quantity and variety of compensation to be received, their tax treatment is presented according to the following groupings:
3.1 Compensation for income or expenses of a business or property;
3.2 Compensation for property;
3.3 Compensation in respect of a building used as a residence.
We wish to remind you, in order to underline the importance of the point, that the tax treatment of an amount in a particular situation can only be determined after examining all the facts and documentation relevant to that particular situation.
3.1 Compensation for income or expenses of a business or property
Compensation received for loss of inventory (e.g. crops) or for loss of profit will be considered income from carrying on the taxpayer's business, whereas compensation received for loss of rental income, for example, from hunting, could be considered income from property of the taxpayer.
Compensation received for expenses made or incurred for the purpose of earning income from the taxpayer's business or property must also be included in computing income pursuant to paragraph 12(1)(x). In our view, such expenses could include those incurred for the time it takes to restore the remainder or for clearing or levelling the land or installing a drainage system.
However, an election could be made pursuant to subsection 12(2.2). The effect of this election is to reduce the amount required by paragraph 12(1)(x) to be included in computing income for the year in which the assistance was received, and to reduce the amount of the related expenditure.
3.2 Property-related compensation
3.2.1 Compensation for loss or destruction of property
Compensation received in respect of the loss or destruction of a capital property will be considered proceeds of disposition of the property pursuant to paragraph (c) of the definition of that term in section 54. The above rules for computing capital gain or loss, recapture of capital cost allowance, or terminal loss will apply, as the case may be, while those for replacement properties may apply.
3.2.2 Compensation for damage to depreciable property
Compensation for damage to property that, within a reasonable time after the damage occurred, has been expended to repair the damage will not form part of the proceeds of disposition of the property by virtue of paragraph (f) of the definition of that term in section 54 or paragraph 13(21)(f).
Such compensation payable in respect of depreciable property could be included in income pursuant to paragraph 12(1)(f) and expenses made or incurred to repair damage to depreciable property would be deducted in computing income. In our view, this could be the case with respect to compensation received to repair damage to fences.
3.2.3 Other compensation for depreciable property
Compensation received in respect of depreciable property, such as compensation for the acquisition or relocation of a building or compensation for the acquisition of a water storage tank, may not be included in income under paragraph 12(1)(x) if it reduces the capital cost of that property pursuant to subsection 13(7.1) or 13(7.4).
3.3 Compensation for a building used as a residence
3.3.1 Residence
Compensation received in respect of expenses incurred in acquiring a residence or in respect of the residence is not included in income. However, such compensation reduces the ACB of the residence in question pursuant to 53(2)(k). This could be the case, for example, for compensation received for appraisal and inspection fees, upgrading fees and other acquisition costs such as legal fees and transfer taxes.
3.3.2 Personal losses
Compensation received for expenses incurred or losses suffered in a personal capacity is not included in computing income. Examples include mortgage prepayment penalties, moving expenses and property taxes.
In conclusion, while the CRA attempts to meet the needs of all taxpayers and their advisors, the mandate of the ITRD is to interpret the Act and not of providing tax advice. This document provides general information on the tax treatment of amounts received by owners either for the sale of their properties or as compensation for the completion of the XXXXXXXXXX construction project and does not constitute an advance income tax ruling and is not binding on the CRA with respect to any particular factual situation.
In closing, it should be noted that the Canadian tax system is based on self-assessment, as it is not possible to review the tax treatment arising from facts, transactions or events specific to each taxpayer's situation prior to the filing of the taxpayer’s tax return. In this context, the CRA appreciates and recognizes the important role that tax practitioners play in the proper functioning of the system and the assistance they provide to taxpayers, among others, when unusual situations arise that give rise to unexpected tax consequences.
We hope that these comments are of assistance.
Best regards,
Nancy Deslandes, CPA, CGA
Manager
Business and Employment Income Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 R.S.C. 1985, c. 1 (5th Supp.).
2 Guide T4037, Capital Gains 2019, states that capital property is generally property purchased for the purpose of making an investment or earning income. Examples of property that could qualify as capital property include a cottage, land or a building used in a business or rental operation.
3 CANADA REVENUE AGENCY, Interpretation Bulletin IT-459 ARCHIVED, "Adventure or Concern in the Nature of Trade", September 8, 1980.
4 CANADA REVENUE AGENCY, Interpretation Bulletin IT-218R ARCHIVED, "Profits, capital gains and losses from the sale of real estate, including farmland and inherited land and conversion of real estate from capital property to inventory and vice versa", September 16, 1986.
5 CANADA REVENUE AGENCY, Income Tax Folio S3-F4-C1, “General Discussion of Capital Cost Allowance”, February 27, 2019.
6 With the exception of a trust.
7 CANADA REVENUE AGENCY, Income Tax Folio S1-F3-C2, "Principal Residence", July 25. 2019.
8 Supra, note 4.
9 CANADA REVENUE AGENCY, Income Tax Folio S3-F3-C1, "Replacement Property", April 8, 2019.
10 Supra, note 5.