21 February 2005 Internal T.I. 2005-0114991I7 - Contract Termination Payment

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: The taxable status of payments received in respect of the termination of a business contract to supply XXXXXXXXXX .

Position: Question of fact.

Reasons: The lion's share of the payments will be included in business income or reduce expenses since they relate to current revenue or expense items. A portion of the payment may be an eligible capital amount for purposes of determining the taxpayer's income inclusion under subsection 14(1) of the Act where it can be shown that the cancellation of the contract destroyed or materially crippled the whole structure of the profit-making apparatus of the taxpayer's business.

		February 21, 2005

	Noella Turcan	HEADQUARTERS
	V&E Division	Randy Hewlett, B.Comm.
	Winnipeg Tax Services Office	613-941-7239

		2005-011499

Contract Termination Payments

We are writing in response to your request for our opinion on the taxable status of payments received by several taxpayers (the "Taxpayer(s)") who deal with the Winnipeg TSO with respect to the termination of business contracts (the "Contract(s)") the Taxpayers had to supply a third party (the "Third Party") with XXXXXXXXXX.

Our understanding of the relevant facts is as follows:

1. Each of the Taxpayers operates their own business and had their own Contract with the Third Party to supply it with XXXXXXXXXX.

2. The Third Party recently began terminating the Contracts.

3. Enclosed with your request was a typical "Release And Agreement" relating to the termination of a Contract (the "Agreement").

4. The Agreement indicates that the Taxpayer and the Third Party mutually agree to terminate the Contract in exchange for the following payments which are set out in "Schedule A" to the Agreement:

XXXXXXXXXX.

Our Comments

The general position of the Canada Revenue Agency regarding the taxable status of amounts received in respect of the termination of a business contract is outlined in Interpretation Bulletin IT-365R, Damages, Settlements and Similar Receipts. This position is based on numerous court decisions rendered on this issue. The courts have generally determined that where the contract termination payment is intended to compensate the taxpayer for lost income, or expenses, the amount will be considered on account of income and must be included in the taxpayer's business income, or where appropriate reduce the applicable expense, pursuant to subsection 9(1) of the Income Tax Act (the "Act"). Where the contract termination payment relates to a particular asset that is sold, destroyed or abandoned, the amount will be considered proceeds of disposition for purposes of determining the gain on the asset. Where the amount received does not relate to a particular asset and is paid because there was a destruction or material crippling of the whole structure of the profit-making apparatus of the taxpayer's business, the amount will be considered an "eligible capital amount" for purposes of determining the taxpayer's income inclusion under subsection 14(1) of the Act. Another important principle coming out of jurisprudence on this issue is that, regardless of the description given to an amount or the process that gave rise to its payment, the underlying basis for the payment must be examined to determine its taxable status.

In our view, the payments under the Agreement that relate to the XXXXXXXXXX, are not contract termination payments. These payments clearly relate to the ongoing business relationship between the Taxpayer and the Third Party under the "XXXXXXXXXX", and as such, must be included in the Taxpayer's business income or reduce the particular expense where appropriate.

In terms of the status of the payment relating to the XXXXXXXXXX a determination must be made, for each Taxpayer, on whether the termination of the Contract resulted in a destruction or material crippling of the whole structure of the profit-making apparatus of the Taxpayer's business. Described below are two of the more relevant court decisions that may assist in making this determination:

(a) Canadian National Railway Company v. The Queen (1988 DTC 6340, FCTD)

In this case, the Northern Alberta Railways ("NAR"), which later amalgamated with Canadian National, received a damages payment from a customer in respect of the early termination of a railway transportation contract. NAR reported the amount as capital and was reassessed on the basis that the amount was business income. The FCTD determined that regardless of the characterization of the payment as damages or compensation for termination of a contract, "[t]he more relevant question is, what was the purpose of this payment: to compensate for loss of capital or for loss of income?" The FCTD concluded that the amount should be included in business income because the early termination of the contract did not destroy or materially cripple NAR's profit-making apparatus. The FCTD made this conclusion notwithstanding the fact that the contract was a long-term contract and that NAR made certain financial business decisions based on this premise. In the FCTD's view, the contract was "not a discrete operation separate from NAR's other railway activities", nor was its termination a "sterilization of a capital asset".

(b) Pe Ben Industries Company Ltd v. The Queen (1988 DTC 6347, FCTD)

This case was tried together with Canadian National and arises out of essentially similar facts and involves the same principles of law. Pe Ben was a subcontractor of NAR. Pe Ben received a payment from NAR is respect of the termination of their contract, which ultimately resulted from early termination of NAR's contract as described above. In this case, the FCTD concluded that the amount was received on account of capital and was an eligible capital amount for purposes of subsection 14(1) of the Act. The FCTD noted that "[t]he critical factual distinction between Pe Ben Industries and Canadian National is that, in the former case, the taxpayer's intermodal carrier business consisted of one substantial contract which had been prematurely terminated. However, the transportation contract in Canadian National was simply an ordinary trade contract and its termination was not of critical significance to the taxpayer's business operations. In summary, it is clear that in appropriate circumstances compensation paid for the cancellation or breach of a trade contract may be a capital receipt. Admittedly, the general rule is that such compensation is on income account."

In view of these decisions, we are of the view that where the Taxpayer's XXXXXXXXXX business only included the contract with the Third Party, the payment under the Contract for the XXXXXXXXXX is an eligible capital amount for purposes of determining the Taxpayer's income inclusion under subsection 14(1) of the Act. On the other hand, should the Taxpayer's XXXXXXXXXX business include contracts other than that with the Third Party, we are of the view that the payment for the XXXXXXXXXX is likely received on account of income and must be included in the Taxpayer's business income under subsection 9(1) of the Act. This determination will ultimately depend on whether the survival of the Taxpayer's XXXXXXXXXX business depends on the contract with the Third Party.

We trust our comments are of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. 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, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

John Oulton, CA
For Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Planning Branch