NO.: DATE: November 13, 2002 SUBJECT: REFERENCE: INCOME TAX ACT Damages, Settlements and Similar Payments Paragraphs 18(1)(a), (b), (c), (h) and (e) (also section 67, subsection 40(1), the definition of eligible capital expenditure in subsection 14(5), and paragraphs 20(1)(z) and 20(1)(z.1)) At the Canada Customs and Revenue Agency (CCRA), we issue income tax interpretation bulletins (ITs) in order to provide technical interpretations and positions regarding certain provisions contained in income tax law. Due to their technical nature, ITs are used primarily by our staff, tax specialists, and other individuals who have an interest in tax matters. For those readers who prefer a less technical explanation of the law, we offer other publications, such as tax guides and pamphlets. While the comments in a particular paragraph in an IT may relate to provisions of the law in force at the time they were made, such comments are not a substitute for the law. The reader should, therefore, consider such comments in light of the relevant provisions of the law in force for the particular taxation year being considered, taking into account the effect of any relevant amendments to those provisions or relevant court decisions occurring after the date on which the comments were made. Subject to the above, an interpretation or position contained in an IT generally applies as of the date on which it was published, unless otherwise specified. If there is a subsequent change in that interpretation or position and the change is beneficial to taxpayers, it is usually effective for future assessments and reassessments. If, on the other hand, the change is not favourable to taxpayers, it will normally be effective for the current and subsequent taxation years or for transactions entered into after the date on which the change is published. If you have any comments regarding matters discussed in an IT, please send them to: Manager, Technical Publications and Projects Section Income Tax Rulings Directorate Policy and Legislation Branch Canada Customs and Revenue Agency Ottawa ON K1A 0L5 Most of our publications are available on our Web site at: www.ccra.gc.ca This version is only available electronically. Contents Application Summary Discussion and Interpretation General ( s 1-2) The Robert McNeill Decision ( 3) The 65302 British Columbia Ltd. Decision ( 4) Requirements for Deductibility ( s 5-6) Payments on Account of Capital and Other Amounts ( s 7-8) Impact of Tax Treatment for Recipient ( 9) Contingent or Anticipated Damages ( 10) Damages Paid by Taxpayers Formerly on Cash Basis of Accounting ( 11) Interest Element in Damage Awards, and Legal Fees Pertaining to Damages ( 12) Wrongful Dismissal Awards ( 13) Reasonableness of Amounts ( 14) Payments (Other Than Damages) to Cancel or Terminate Obligations ( s 15-17) Non-Competition Agreements ( 18) Explanation of Changes Application This bulletin cancels and replaces IT-467R, Damages, Settlements and Similar Payments, dated February 19, 1992. Unless otherwise stated, all statutory references throughout the bulletin are to the Income Tax Act (the Act). Summary This bulletin discusses the income tax treatment of amounts paid or payable by a taxpayer 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. Comments in this bulletin also apply to amounts paid pursuant to a mutual termination of a present or future obligation of the taxpayer. The bulletin s discussion covers the Federal Court of Appeal s decision in Robert McNeill v. The Queen, which concerned the deductibility of court-imposed damages. As the McNeill decision was based on the Supreme Court of
Canada s decision in 65302 British Columbia Ltd. v. The Queen, which concerned the deductibility of fines and penalties, the latter case is also discussed in the bulletin. Finally, the bulletin explains general and specific provisions of the Act that could be relevant to the deductibility or capitalization of damages, settlements and similar payments. Discussion and Interpretation General 1. The income tax treatment of damages, settlements or similar payments can be conclusively determined in any particular case only after an examination of all the relevant facts. The following comments are intended to give general guidelines for determining the status of these payments in an arm s length situation. 2. Damages may result from an unlawful act, omission or negligence of a taxpayer, as determined by a court. Damages can pertain to a loss or injury to a person or to the person s business or property. The loss or injury can be physical or otherwise, in the form of pain, suffering, harm, financial loss, loss of reputation, disadvantage or inconvenience. A financial loss or injury to a business or property can result from various causes, such as a failure to comply with the terms of a contract, negligence, failure to comply with the law or safety rules, or some other wrongdoing. A payment in settlement of a damages claim to avoid or terminate litigation will be considered damages for the purposes of this bulletin, even where there was no admission of any wrongdoing. The Robert McNeill Decision 3. In Robert McNeill v. The Queen, [2000] 2 CTC 304, 2000 DTC 6211, the Federal Court of Appeal allowed a deduction for court-imposed damages. The taxpayer had deliberately breached his restrictive covenant obligations under the agreement whereby he had sold his accounting business. The reasons for the Federal Court of Appeal s decision may be summarized as follows: Although 65302 British Columbia Ltd. v. The Queen concerned the deductibility of fines and penalties, the reasoning of the Supreme Court of Canada in that decision also had application to the deductibility of damages. (See 4 and also 6 for further comments on the 65302 British Columbia Ltd. case.) Although in the case at bar, the learned Tax Court judge referred to the appellant s actions as reprehensible, he also found they were for the purpose of keeping his clients and his business. We are not satisfied that they are so egregious or repulsive that the damages subsequently awarded are not justified as being incurred for the purpose of producing income. The taxpayer s deduction of the damages (and costs) was, therefore, not prevented by paragraph 18(1)(a). The damages were not on account of capital because they were for lost profits. The expense was deductible in the year that the court determination was made. This was the point at which the absolute and unconditional obligation arose. The 65302 British Columbia Ltd. Decision 4. In 65302 British Columbia Ltd. v. The Queen, [2000] 1 CTC 57, 99 DTC 5799, the Supreme Court of Canada allowed as a deductible expense an over-quota levy incurred by the taxpayer in respect of its egg-producing hens. The following general principles are found in the reasons for this decision: The characterization of a levy as a fine or penalty is of no consequence (i.e., does not make it any less deductible), because the income tax system does not distinguish between levies (which are essentially compensatory in nature) and fines and penalties (which are punitive in nature). The deduction of a fine or penalty cannot be disallowed solely on the basis that to allow it would be considered contrary to public policy. Prohibiting the deductibility of fines and penalties is inconsistent with the practice of allowing the deduction of expenses incurred to earn illegal income. In order for a fine or penalty to be deductible in computing income from a business or property, paragraph 18(1)(a) of the Act requires that it be incurred for the purpose of gaining or producing income from that business or property. Paragraph 18(1)(a) contains no requirement that a fine or penalty must be unavoidable in order for it to be deductible. Notwithstanding that a fine or penalty may have been incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a), its deductibility can nevertheless be disallowed by another provision in the Act. Further discussion on the deductibility of fines and penalties may be found in the current version of IT-104, Deductibility of Fines or Penalties. Requirements for Deductibility 5. In order to be deductible as a current expense in computing income from a business or property, damages must meet at least the following tests: (a) the outlay must have been made for the purpose of gaining or producing income from the business or property (paragraph 18(1)(a) see further comments in 6), (b) the outlay must not be on account of capital (paragraph 18(1)(b) see further comments in s 7 and 8), 2
(c) the outlay must not be made for the purpose of gaining or producing exempt income (paragraph 18(1)(c)), (d) the outlay must not be a personal expense (paragraph 18(1)(h)), and (e) the outlay must be reasonable in the circumstances (section 67 see further comments in 14). 6. Paragraph 18(1)(a) of the Act provides that, in computing a taxpayer s income from a business or property, no deduction shall be made in respect 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. As stated by the Supreme Court of Canada in the 65302 British Columbia Ltd. decision with respect to the deductibility of a fine or penalty: if the taxpayer cannot establish that the fine was in fact incurred for the purpose of gaining or producing income, then the fine or penalty cannot be deducted. For purposes of establishing whether damages have been incurred for the purpose of gaining or producing income: the taxpayer need not have attempted to prevent the act or omission that resulted in the damages; and the taxpayer need only establish that there was an incomeearning purpose for the act or omission, regardless of whether that purpose was actually achieved. In the 65302 British Columbia Ltd. decision, the Supreme Court of Canada also stated: It is conceivable that a breach could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income. The court did not, however, give any guidelines with respect to this statement other than to indicate that such a situation would likely be rare. The same would apply in the case of damages: the situation would have to be one in which the egregiousness or repulsiveness of the act or omission giving rise to the damages is sufficient to refute any allegation that the purpose of the act or omission was to gain or produce income. Payments on Account of Capital and Other Amounts 7. A payment for damages will be on account of capital if it meets one of the accepted legal criteria for distinguishing a payment on account of capital from a payment on account of income: (a) the payment represents the acquisition cost (or part of the acquisition cost) of a capital asset, (b) the payment can be considered to have been made to preserve or protect a capital asset of the taxpayer, or (c) the payment creates an enduring benefit to the payer s business. 8. If damages are incurred in connection with the acquisition of an asset for which capital cost allowance may be claimed, the cost of the damages is included in the capital cost of that asset (or the CCA class to which the asset belongs). If damages are incurred in connection with the acquisition of an eligible capital property, the cost of the damages is an eligible capital expenditure provided all the other tests in the subsection 14(5) definition of eligible capital expenditure are met. If damages are incurred in connection with the acquisition or production of inventory, the cost of the damages is included in the cost of inventory. If damages are incurred in connection with the disposition of a capital property, the cost of the damages is taken into account under subsection 40(1) for the purposes of calculating any gain or loss on that disposition. Impact of Tax Treatment for Recipient 9. The tax treatment of damages in the hands of the recipient, and the size of the payment, generally are not relevant facts in determining whether or not the payer is entitled to a deduction. The tax consequences of receiving damage payments are discussed in the current version of IT-365, Damages, Settlements and Similar Receipts. Contingent or Anticipated Damages 10. An allowable deduction in respect of damages can only be claimed by a taxpayer when paid, or where there is a legal or contractual liability to pay the damages, and the amount thereof has been quantified. An amount as, or on account of, a reserve or contingent liability for anticipated damages is not deductible, by reason of paragraph 18(1)(e). Damages Paid by Taxpayers Formerly on Cash Basis of Accounting 11. A taxpayer who was, or is, permitted to compute his or her income on a cash basis (e.g., a taxpayer carrying on a farming or fishing business) is allowed to deduct damages paid in a year even if, in that year, the taxpayer is no longer carrying on the business in which the liability for damages was incurred. Of course, the damages must have all the attributes of an allowable deduction. The allowance of such a deduction should not be interpreted, however, as meaning that the taxpayer is still carrying on the business after having, in fact, ceased to carry it on. Interest Element in Damage Awards, and Legal Fees Pertaining to Damages 12. 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. The treatment of legal fees is discussed in the current version of IT-99, Legal and Accounting Fees. 3
Wrongful Dismissal Awards 13. Payments to dismissed employees as damages for wrongful dismissal will normally constitute a deductible expense to an employer. Reasonableness of Amounts 14. Where a court determines the amount of damages the payment of the amount is considered reasonable in the circumstances for the purposes of section 67. In the case of a settlement, whether the amount paid is reasonable in the circumstances is to be determined on the basis of the facts of the case. Payments (Other Than Damages) to Cancel or Terminate Obligations 15. The following comments apply to payments (other than court-awarded damages or payments to settle or avoid litigation) that are made to cancel or terminate obligations or commitments. For example, in some instances payments are made by mutual consent to cancel a lease, contract or an arrangement that is disadvantageous or onerous to the taxpayer s business. The tests discussed in s 5, 7 and 8 with respect to damages will generally apply in this context to determine whether the payment is on account of capital or a current expense. 16. Where amounts originally payable under a contract would have been eligible for deduction from income had they been paid, amounts paid to terminate and settle that contract will also generally be eligible for deduction from income. It is not material that the termination is by way of a lump sum payment as opposed to instalment payments. 17. Paragraphs 20(1)(z) and (z.1) set out specific rules for the deduction of payments made by a landlord to a tenant for the cancellation of a lease. These provisions are discussed in the current version of IT-359, Premiums and Other Amounts With Respect to Leases. Non-Competition Agreements 18. Generally, any payment made pursuant to an agreement by the recipient not to compete with the business of the payer is considered to be a payment on account of capital qualifying as an eligible capital expenditure for the purposes of section 14 of the Act. (See the current version of IT-143, Meaning of Eligible Capital Expenditure.) 4
Explanation of Changes Introduction The purpose of the Explanation of Changes is to give the reasons for the revisions to an interpretation bulletin. It outlines revisions that we have made as a result of changes to the law, as well as changes reflecting new or revised interpretations of the CCRA. Reasons for the Revision This bulletin updates the former IT-467R, Damages, Settlements and Similar Payments, which discussed the income tax treatment of amounts paid or payable as damages or similar amounts. This bulletin has been revised to reflect the decisions of the Federal Court of Appeal in Robert McNeill v. The Queen, [2000] 2 CTC 304, 2000 DTC 6211 and the Supreme Court of Canada in 65302 British Columbia Ltd. v. The Queen, [2000] 1 CTC 57, 99 DTC 5799. Legislative and Other Changes This bulletin has been rewritten because of the McNeill and 65302 British Columbia Ltd. decisions. For further particulars, see the Summary statement at the beginning of the bulletin. 5