Principal Issues: 1. What is the tax treatment of court awarded costs received by a taxpayer in a year subsequent to deducting legal fees in computing business income?
2. In what taxation year would the court awarded costs be included in income?
Position: 1. The tax treatment of court awarded costs received in a taxation year would depend on what the amount received was intended to replace. Where court awarded costs are to replace legal fees previously deducted in computing business income, the amount received will be included in income pursuant to subsection 9(1) of the Act.
2. The amount would be included in income in the year the amount is received or realized.
Reasons: 1. Based on the surrogatum principle, the tax treatment of an amount received depends on what the amount is intended to replace.
2. Generally, amounts have to be included in income under subsection 9(1) if such amounts have the quality of income. Generally, an amount has the quality of income if the recipient's right to such an amount is absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment.
XXXXXXXXXX Income Tax Rulings Directorate Ryan Wallace, CPA 2022-095354
March 8, 2024
Dear XXXXXXXXXX:
Re: Tax treatment of court awarded costs
We are writing in response to your email of October 24, 2022, wherein you requested our views on whether court awarded costs received by a taxpayer would be included in computing business income, under subsection 9(1) of the Income Tax Act (“Act”), in the year the award was received.
You describe a hypothetical situation where a taxpayer sues a customer that did not pay for goods and/or services under a business contract. In Year 1, the taxpayer deducts legal fees related to the lawsuit. In Year 3, the taxpayer wins the lawsuit and receives court awarded costs in respect of the taxpayer’s legal fees incurred throughout the duration of the lawsuit. You are asking whether the amount of court awarded costs are to be included in income in the year the court awarded costs were received.
Our Comments
This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R12, Advance Income Tax Rulings and Technical Interpretations. However, we can provide the following comments.
The CRA’s general views on the deductibility of legal expenses can be found in Interpretation Bulletin IT-99R5 (Consolidated) - Legal and Accounting Fees (“IT-99R5”).
As noted in paragraph 1 of IT-99R5, except where there is a specific provision in the Act dealing with legal and accounting fees, legal and accounting fees are deductible only to the extent that they are incurred for the purpose of gaining or producing income from a business or property and are not outlays of a capital nature. Also, as indicated in paragraph 4 of IT-99R5, legal costs to prosecute or to defend most tort, contract or other civil claims arising in the ordinary course of business will generally be deductible. Generally speaking, if the taxpayer is successful in a legal proceeding the gross amount of the legal fees which are otherwise deductible must be reduced by any legal costs awarded by the court which are received by the taxpayer.
The Supreme Court of Canada, in Ikea Ltd v The Queen [98 DTC 6092], confirmed the importance of the realization principle when considering the timing of income inclusion. Based on the realization principle, an amount will be included in income in the year in which that amount has the quality of income. An amount will have the quality of income when the amount is received, or realized, in the year where taxpayer's right to that amount is absolute and under no restriction, contractually or otherwise, as to its disposition, use, or enjoyment. Whether an amount received in respect of court awarded costs has the quality of income is a question of fact.
Therefore, in the situation provided, where a taxpayer has deducted legal fees in respect of a civil lawsuit in computing business income for a particular taxation year, it is our view that any court awarded costs received in a subsequent taxation year, in respect of that lawsuit, would be included in computing business income under subsection 9(1) of the Act in that subsequent year, provided the amount received has the quality of income.
We trust our comments will be of assistance.
Yours truly,
Sandro D'Angelo CPA, CMA
Acting Manager
Business and Capital Transaction Section
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch