2 April 2014 Internal T.I. 2014-0520921I7 - Compensation for damages to crops and lost profits

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: 1.) What is the treatment for income tax purposes of amounts received as compensation for damages to crops and for lost profits? 2.) What is the treatment of the expense to the payer?

Position: 1.) Question of fact, but given the same treatment as what it compensates for (surrogatum principle). 2.) See IT-467R2.

Reasons: 1.) Surrogatum principle. 2.) IT-467R2 provides a comprehensive review of the treatment of damage and settlement payments.

XXXXXXXXXX
2014-052092
Whitney Dunn

April 2, 2014

Dear XXXXXXXXXX:

RE: Compensation for damage to crops and lost income

We are writing in response to your email of February 13, 2014, where you requested our views on the income tax treatment of amounts received by a farmer under a settlement as compensation for damages.

In particular, in your email you briefly described two situations. In the first, the farm corporation received amounts under a legal settlement for damages to its planted seed crop. In the second, the farm corporation received compensation after having been sold crops not suitable for the climate. In both, the compensation was for the value of the damaged crops as well as for lost profits.

Our comments

This technical interpretation provides general comments about the provisions of the Income Tax Act (the "Act"). 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 70-6R5, Advance Income Tax Rulings.

Canadian courts have relied on the common law surrogatum principle to determine the tax treatment of a settlement or judgment. As the Supreme Court of Canada explained in Tsiaprailis v Canada, 2005 DTC 5119 (SCC), surrogatum requires examining the nature and purpose of a settlement and then according each amount the same tax treatment as what it is intended to replace. Generally speaking, amounts which compensate a taxpayer for lost business income (or profits) are treated as business income, and amounts which compensate for damage to or loss of capital assets are treated as on account of capital.

The determination of what an amount is intended to replace is a mixed question of fact and law which can only be made by examining all the relevant circumstances, including the court judgment or settlement agreement, if applicable. The parties' characterization of an amount is relevant but not always determinative. For example, an amount described as compensation for lost profits (which would be on account of income), might, on examination of all the facts, actually be compensation for loss of the business itself (which would be on account of capital).

A useful question to ask when classifying amounts paid as compensation for damage to physical goods is "how did the taxpayer originally treat the cost?" For example, where a farmer expensed crops, compensation for those is likely income; conversely, where they treated crops as a capital asset, compensation for those is likely on account of capital.

When amounts received as part of a settlement are recognized for tax purposes depends on whether the taxpayer uses the cash or accrual method of accounting. When using the cash method, amounts are included in the year received. When using the accrual method, amounts are included once the taxpayer has a right to them—not necessarily immediate—and they are ascertainable.

For additional information on the income tax treatment of damages, settlements and other similar amounts please refer to interpretation bulletin IT-365R2, Damages, Settlements and Similar Receipts. For information on the tax treatment to the payer, please see IT-467R2, Damages, Settlements and Similar Payments. Both publications are available on the Canada Revenue Agency's website.

Note that while the concerns and analysis are similar, the treatment of an amount to the payer and the recipient is not necessarily symmetrical.

We trust our comments will be of assistance.

Michael Cooke, C.P.A., C.A.
Manager
Business Income and Capital Transaction Section
Business and Employment Division
Income Tax Rulings Directorate