TaxMatters@EY - October 2013

Characterization in question: income vs. capital

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River Hills Ranch Ltd., Bar M Stock Ranch Ltd., Avalon Ranch Ltd. v Her Majesty the Queen, 2013 TCC 248

Liza Mathew, Calgary and Al-Nawaz Nanji, Toronto

In this case, a pharmaceutical company terminated its contractual arrangement with the taxpayers and executed a release to pay each of the taxpayers an amount to cover their ongoing operating expenses. The Tax Court of Canada found that the payments were on capital account, as they were in fact intended to compensate for the loss of the taxpayers’ businesses.

The Court relied on extrinsic evidence to interpret the meaning of the terms and conditions of the release in light of the surrounding circumstances, and for purposes of determining the intended purpose of the payments, as the clauses in the release were ambiguous.

Facts

The taxpayers — River Hills Ranch Ltd., Avalon Ranch Ltd. and Bar M Stock Ranch Ltd. — were in the business of collecting pregnant mare urine (PMU). Wyeth Organics, a pharmaceutical corporation, acquired PMU from each of the taxpayers pursuant to a collection agreement, and used the PMU as an active ingredient in a drug used to treat symptoms of menopause.

Between October and December 2003, Wyeth terminated its collection agreements with each of the taxpayers and executed releases. This resulted in the complete cessation of the taxpayers’ PMU businesses.

Under the terms and conditions of the releases, Wyeth agreed to pay the taxpayers amounts labelled as “feed” and “herd health” payments (FHH payments). In respect of these payments, Wyeth agreed to pay each taxpayer a percentage of their total 2003-04 collection season payments to cover feed and herd health expenses. In order to receive the FHH payment, the taxpayers were required to satisfy a number of conditions.

The Canada Revenue Agency (CRA) assessed the taxpayers and treated the FHH payments as an allowance for anticipated expenses that were received on account of income. The taxpayers, however, argued that the payments were capital receipts that were meant to compensate for the loss of their PMU businesses.

Issues

The two issues before the Tax Court were:

  1. Whether the taxpayers received the FHH payments under the releases on capital account or on income account
  2. Under what circumstances could extrinsic evidence be considered for purposes of interpreting the releases?

Tax Court of Canada decision

Tax Court Justice Robert Hogan found that the FHH payments were capital receipts, and were intended to compensate the taxpayers for the loss of their PMU businesses.

The Court found that the surrogatum principle should be applied to characterize the nature of the payment (i.e., the payments should have the same character as what they’re compensating for). Justice Hogan found that the taxpayers’ businesses were destroyed by Wyeth’s actions, and the collection agreements represented all or substantially all of the taxpayers’ revenue. The cancellation of the agreements led to the “sterilization of a capital asset” (applying the reasoning in BP Canada Energy Resources Company v The Queen (2002 DTC 2110)), and the FHH payments were intended to compensate for the destruction of the taxpayers’ businesses.

On the issue of interpreting the releases, the Court reviewed a line of cases outlining the principles of contractual interpretation. In terms of determining whether extrinsic evidence could be used for purposes of interpreting the agreement, the Court referred to Kentucky Fried Chicken Canada, a Division of Pepsi-Cola Canada Ltd. v Scotts’ Food Services Inc. ([1998] O.J. No. 4368 (QL) (ON CA)). In that case, it was determined that where there is no ambiguity, the courts can use extrinsic evidence in taking into account the “factual matrix” of an agreement. The factual matrix of an agreement includes the purpose of the agreement and the commercial context in which it was made.

Surrogatum principle

Canadian courts have used the surrogatum principle to determine whether compensation received as an award of damages or a settlement payment is an income or a capital receipt. A capital receipt must be further classified as proceeds from the disposition of a capital property, an eligible capital amount, a reduction in the cost base of a capital property or a tax-free windfall.

To apply the surrogatum principle, a court must first determine the nature of the amount that the compensation was intended to replace and then determine the tax treatment of the replaced amount in the recipient’s hands.

The Court then noted, referring to the cases Dumbrell v Regional Group of Companies Inc. ([2007] O.J No. 298 (QL)) and KFC, that a distinction must be made between:

  • A case where extrinsic evidence is admissible for the purpose of resolving an ambiguity (as an exception to the parole evidence rule), and
  • A case (in which there is no ambiguity) where such evidence is considered for the purpose of giving meaning to the terms and conditions of an agreement in light of the “surrounding circumstances” or the factual matrix of the agreement.

In this case, Justice Hogan found that there were inconsistencies with the FHH payment clauses (e.g., there were no requirements for the taxpayers to use the FHH payments to cover feed expenses, or to even keep their PMU herd). The Court reviewed the evidence provided by the taxpayers and found that such extrinsic evidence was admissible because it pertained to the circumstances surrounding the releases and because the FHH payment clauses were ambiguous in light of the inconsistencies.
The Court found that the FHH payments were dressed up as compensation for feed and herd health expenses, but in reality were intended to compensate the taxpayers for the destruction of their businesses.

Conclusion

In this case, similar to other income versus capital cases, the appropriate characterization of the payment depended on all the surrounding facts and circumstances.

If there are inconsistencies in the applicable agreement, the courts can rely on extrinsic evidence in order to resolve or dispel ambiguities. However, even in cases where there is no ambiguity, the courts can rely on extrinsic evidence to give meaning to the terms and conditions of the agreement in light of the surrounding circumstances.