Judgments

[2000] 4 F.C. 132

A-709-98

Robert McNeill (Appellant)

v.

Her Majesty the Queen (Respondent)

Indexed as: McNeill v. Canada (C.A.)

Court of Appeal, Richard C.J., Strayer and Rothstein JJ.A.—Vancouver, March 6 and 8, 2000.

Income tax — Income calculation — Deductions — Appeal from 1998 T.C.C. decision court ordered damages for breach of contract not deductible as expenses to earn income from business under ITA, s. 18(1)(a) — B.C.S.C. ordering appellant to pay damages for breach of restrictive covenant in agreement for sale of chartered accountancy practice — 1999 S.C.C. decision in 65302 British Columbia Ltd. v. Canada holding fines, penalties incurred to earn income from business deductible under s. 18(1)(a) applicable to court ordered damages — Analysis pertaining to tax neutrality, equity of taxation system, Parliament’s ability to expressly prohibit deductions equally apt herein — Damages awarded for lost profits — Damages deductible in 1994, when court ordering their payment.

This was an appeal from a Tax Court of Canada decision that court ordered damages for breach of contract were not deductible expenses for the purposes of gaining income from a business under Income Tax Act, paragraph 18(1)(a). Under the agreement of sale of his chartered accountancy practice, the appellant agreed not to practice in a certain area from 1991 to 1996. When, in 1991, the purchaser terminated the contract on the basis that appellant had failed to furnish certain services provided for in the agreement, the appellant set up practice outside the restrictive covenant area, but provided services to the client base within it. In 1994 the Supreme Court of British Columbia found him in breach of the restrictive covenant and ordered him to pay damages in the amount of $465,908. The appellant deducted that sum in his taxation year that ended in September 1994 pursuant to paragraph 18(1)(a), but the Minister disallowed the deduction. The Tax Court dismissed the appeal, holding that the damage award arose from the commission of reprehensible acts committed deliberately to cause damage, and were not deductible according to the 1996 Federal Court of Appeal decision in A.G. of Canada v. Poulin, J. In 1999 the Supreme Court of Canada held in 65302 British Columbia Ltd. v. Canada that fines and penalties incurred for the purpose of gaining or producing income were deductible under paragraph 18(1)(a).

The issues were: whether the court ordered damages for breach of contract were deductible as an expense to gain income from a business under Income Tax Act, paragraph 18(1)(a); whether the damage award was incurred on account of capital or income; and whether the damage award was deductible in the year in which it was made.

Held, the appeal should be allowed.

The reasoning in 65302 British Columbia Ltd. applied directly to a court judgment for damages for breach of contract. If a fine or penalty for breach of a law is deductible because nothing in paragraph 18(1)(a) precludes it, it follows that court ordered damages for breach of contract should also be deductible. The analysis of Iacobucci J. that disallowance of deduction of a fine or penalty would violate the objects of tax neutrality and equity of the taxation system, and that Parliament, should it choose to do so, can disallow the deductibility of specific categories of expenses, is equally applicable to court awards of damages.

It may be that in respect of a civil case, wrongful action may be so egregious or repulsive that deduction of the damages awarded could not be justified as having been incurred to gain or produce income. Although the Tax Court referred to the appellant’s actions as reprehensible, it found that they were carried out for the purpose of keeping his clients and business. Thus, they were incurred to produce income. While there may be policy reasons for disallowing the deductibility of damages as an expense when they arise from “reprehensible” conduct of a taxpayer, such policy questions must be left to Parliament.

The damages were awarded for lost profits. Each item of the damage award related to the business that the appellant carried on in breach of the agreement.

The right to deduct damages as an expense arises in the year the damage award is made, not in the year in which the events giving rise to the damages took place. At common law a taxpayer is entitled to deduct an expense when it is incurred, and an expense is incurred when a taxpayer has an absolute and unconditional obligation to pay an amount. The appellant’s liability to pay damages was ascertained and became an absolute and unconditional obligation when the judgment of the British Columbia Supreme Court was issued. The right to deduct damages as an expense under paragraph 18(1)(a) arose in 1994.

STATUTES AND REGULATIONS JUDICIALLY CONSIDERED

Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1, ss. 8(1)(a), 67.5 (as enacted by S.C. 1994, c. 7, Sch. II, s. 46).

CASES JUDICIALLY CONSIDERED

APPLIED:

65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804; (1999), 179 D.L.R. (4th) 577; [2000] 1 W.W.R. 195; 69 B.C.L.R. (3d) 201; 99 DTC 5799; 248 N.R. 216.

CONSIDERED:

A.G. of Canada v. Poulin, J. (1996), 96 DTC 6477; 204 N.R. 376 (F.C.A.); leave to appeal to S.C.C. refused, [1997] 1 S.C.R. x.

REFERRED TO:

Roe, McNeill & Co. v. McNeill, [1994] B.C.J. No. 1187 (S.C.) (QL); Roe, McNeill & Co. v. McNeill, [1998] 7 W.W.R. 175; (1998), 104 B.C.A.C. 20; 45 B.C.L.R. (3d) 35, 37 B.L.R. (2d) 184 (C.A.).

AUTHORS CITED

Krasa, Eva M. “The Deductibility of Fines, Penalties, Damages, and Contract Termination Payments” (1990), 38 Can. Tax J. 1399.

APPEAL from a T.C.C. decision that court ordered damages for breach of contract were not deductible expenses under Income Tax Act, paragraph 18(1)(a) (McNeill v. R., [1999] 1 C.T.C. 2197; (1998), 99 DTC 280 (T.C.C.)). Appeal allowed.

APPEARANCES:

Douglas C. Morley for appellant.

Patricia A. Babcock for respondent.

SOLICITORS OF RECORD:

Davis & Company, Vancouver, for appellant.

Deputy Attorney General of Canada for respondent.

The following are the reasons for judgment delivered orally in English by

Rothstein J.A.:

ISSUE

[1]        The issue in this appeal from an October 28, 1998 decision of the Tax Court of Canada[1] is whether court ordered damages for breach of contract are deductible as an expense for the purpose of gaining or producing income from a business under paragraph 18(1)(a) of the Income Tax Act [R.S.C., 1985 (5th Supp.), c. 1]. Paragraph 18(1)(a) provides:

18. (1) In computing the income of a taxpayer from a business or property, no deduction shall be made in respect of

(a) 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.

FACTS

[2]        The appellant was a chartered accountant. On September 1, 1988, he sold his chartered accountancy practice to Roe & Co. As part of the agreement, the appellant was to provide consulting and chartered accounting services for the benefit of Roe & Co. Further, during the three-year period from September 1, 1988 to August 31, 1991, the appellant was to act in the utmost good faith to introduce Roe & Co. representatives to clients of his practice and promote Roe & Co. to effect a smooth uninterrupted transition to Roe & Co. of his business. Finally, the appellant agreed that for a period of five years, from September 1, 1991 to August 31, 1996, he would not provide professional accounting services to the public within North Vancouver, West Vancouver, Burnaby and Vancouver.

[3]        On July 3, 1991 Roe & Co.[2] terminated the agreement on the basis that the appellant had failed to provide the services contemplated by the agreement. At or about that time, the appellant set up an accounting practice of his own outside the restrictive covenant area, but, to provide services to, amongst others in the restrictive covenant area, the client base dealt with in the agreement.

[4]        Legal proceedings were taken against the appellant by Roe & Co. in the Supreme Court of British Columbia. Following a 12-day trial in January and February 1994, on May 30, 1994 Madam Justice Boyd issued judgment[3] finding the appellant in breach of his obligations under the agreement to act in the utmost good faith to introduce Roe & Co. to his clients and that he was in breach of the restrictive covenant. As a result Boyd J. found the appellant liable for damages and costs in the sum of $465,908. On February 12, 1998 the British Columbia Court of Appeal upheld the judgment of Boyd J. and also determined that the appellant was subject to an independent fiduciary duty and was in breach of this duty to Roe & Co.[4]

[5]        The appellant sought to deduct the sum of $465,908 in his taxation year that ended September 29, 1994[5] pursuant to paragraph 18(1)(a) of the Income Tax Act.

[6]        On October 2, 1995 the Minister disallowed the deduction, stating:

Damages payable as the result of an event that is a normal risk or is incidental to the taxpayer’s business operations will be considered to meet the test of paragraph 18(1)(a) of the Income Tax Act. For the purposes of paragraph 18(1)(a), we will consider the relationship between the event and the business operations and the taxpayer’s inability to avoid the occurrence of the event.

Interpretation Bulletin 104 (Deductibility of Fines or Penalties) sets out tests and factors which must be satisfied in order for damages to be deductible. After due consideration of the information provided by you we have concluded that the expenses were not incurred to gain income from business and were beyond the normal risk of carrying on business. Furthermore, as stated by Madame Justice Boyd, “the damages are the result of blatant and continuous breach of the agreement.” [sic] The tests and factors outlined in the above-noted interpretation bulletin have not been met.

[7]        The appellant appealed to the Tax Court of Canada. The learned Tax Court Judge found that the appellant’s objective was to keep his clients and his business, notwithstanding the agreement he had entered into with Roe & Co.

His object was to receive the remuneration from the agreement and, at the same time, to keep the clients and their business.[6]

This finding of the Tax Court Judge was consistent with the finding of Boyd J. in the Supreme Court of British Columbia:

… McNeill … was determined to retain for himself a substantial portion of the client base so as to have some source of income. At trial McNeill admitted that he had not built up any separate client base of his own on Gabriola Island and that on leaving Roe, McNeill, his need for a continuing source of income could only be satisfied (at least until a new client base was established) if he continued to work for the Roe, McNeill clients.[7]

[8]        The Tax Court Judge dismissed the appeal. He relied exclusively on the decision of this Court in A.G. of Canada v. Poulin J. (1996), 96 DTC 6477, leave to appeal to the Supreme Court of Canada denied, [1997] 1 S.C.R. x, that damages payable arising from the commission of a reprehensible act committed deliberately with the aim of causing damage are not deductible expenses under paragraph 18(1)(a) of the Income Tax Act (as contrasted with damages arising from an act that was necessary to carry on a trade or profession that was performed improperly, which are deductible). The Tax Court Judge found that the damages the appellant was ordered to pay in this case were for the commission of reprehensible acts committed deliberately to cause damage to Roe & Co.

65302 British Columbia Ltd.

[9]        On November 25, 1999, the Supreme Court of Canada issued its decision in 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804. In that case, an over-quota levy by the British Columbia Egg Marketing Board was found to be a deductible expense under paragraph 18(1)(a) of the Income Tax Act. The decision to produce over-quota was a deliberate business decision made by the taxpayer in order to realize income. At paragraphs 39 and 40 [page 828], Iacobucci J., for the majority, stated:

To rephrase this language in the context of the present appeal, the question to ask is: did this appellant incur the over-quota levy for the purpose of gaining or producing or income from its business?

On its face, I would answer this question in the affirmative. I agree with Lamarre, J.T.C.C., in the Tax Court, that the levy was incurred as part of the appellant’s day-to-day operations. The decision to produce over-quota was a business decision made in order to realize income. The appellant deliberately produced over-quota in order to maintain its major customer, who was then expanding in the area, until it could purchase additional quota at what it thought was an affordable price.

[10]      Two arguments against deductibility of penalties and fines recognized in prior jurisprudence were rejected by Iacobucci J. The first was that a fine or penalty should not be deductible if the offence was avoidable. As the basis for this requirement was found to be language no longer in the Income Tax Act, Iacobucci J. stated at paragraph 45 [page 831]:

In the absence of similar language in the current Act, I find it difficult to endorse the requirement that expenses need be incidental, in the sense that they were unavoidable, in order to be deductible under s. 18(1)(a).

[11]      The second was that there was a public policy basis for not permitting the deduction of a fine or penalty. After a thorough analysis in which he found that the disallowance of deducting a fine or penalty would violate the objects of tax neutrality and equity of the taxation system and that Parliament has expressly prohibited deductions when it has chosen to do so, e.g. section 67.5 [as enacted by S.C. 1994, c. 7, Sch. II, s. 46], Iacobucci J. rejected the disallowance of deduction of a fine or penalty on public policy grounds. At paragraph 66 [page 841], he stated:

I therefore cannot agree with the argument that the deduction of fines and penalties should be disallowed as being contrary to public policy. First and foremost, on its face, fines and penalties are capable of falling within the broad and clear language of s. 18(1)(a). For courts to intervene in the name of public policy would only introduce uncertainty, as it would be unclear what public policy was to be followed, whether a particular fine or penalty was to be characterized as deterrent in nature, and whether the body imposing the fine intended it to be deductible. Moreover, allowing the deduction of fines and penalties is consistent with the tax policy goals of neutrality and equity. Although it may be said that the deduction of such fines and penalties “dilutes” the impact of the sanction, I do not view this effect as introducing a sufficient degree of disharmony so as to lead this Court to disregard the ordinary meaning of s. 18(1)(a) when that ordinary meaning is harmonious with the scheme and object of the Act. When Parliament has chosen to prohibit the deduction of otherwise allowable expenses on the grounds of public policy, then it has done so explicitly.

[12]      Iacobucci J. does acknowledge that if a taxpayer cannot establish that a fine was in fact incurred for the purpose of gaining or producing income, that it cannot be deducted. He also allows 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. At paragraph 69 [page 842] he stated:

It is true that s. 18(1)(a) expressly authorizes the deduction of expenses incurred for the purpose of gaining or producing income from that business. But it is equally true that 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 and the analysis stops here. 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. However, such a situation would likely be rare and requires no further consideration in the context of this case, especially given that Parliament itself may choose to delineate such fines and penalties, as it has with fines imposed by the Income Tax Act.

[13]      As a result of the Supreme Court decision in 65302 British Columbia Ltd., it is now established that fines and penalties incurred for the purpose of gaining or producing income are deductible expenses under paragraph 18(1)(a).

Application of 65302 British Columbia Ltd. to the Appeal at Bar

[14]      In the appeal at bar, the issue is not the deductibility of fines or penalties, but rather, the deduction of a court ordered award of damages for breach of contract. While the Supreme Court of Canada did not refer to Poulin in its decision in 65302 British Columbia Ltd., the basis for the denial of deductibility of damages as an expense in Poulin—avoidability and public policy—was rejected by the Supreme Court in 65302 British Columbia Ltd. In our opinion, the reasoning of Iacobucci J. in 65302 British Columbia Ltd. applies directly to a court judgment for damages for breach of contract. Counsel for the respondent suggested that while a fine or penalty may be deductible because it is payable to the government, a damage award in favour of an individual or a corporation is in a different category. We see no merit to this argument. If a fine or penalty for breach of a law is deductible because nothing in paragraph 18(1)(a) precludes it, it follows that court ordered damages for breach of a contract should also be deductible. The analysis of Iacobucci J. pertaining to tax neutrality and equity and the opportunity of Parliament, should it choose to do so, to disallow the deductibility of specific categories of expenses, is equally applicable to court awards of damages as to fines and penalties.

[15]      It may be that in respect of a civil damage award that the wrongful action may be so egregious or repulsive that the damages could not be justified as being incurred for the purpose of gaining or producing income and in such rare cases deductibility would properly be disallowed. 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 satisfied that they were incurred for the purpose of producing income.

[16]      Accordingly, we conclude that the finding of the Supreme Court of Canada in 65302 British Columbia Ltd. is determinative of the present appeal. In coming to this conclusion, we acknowledge that there may be policy reasons against allowing the deductibility of damages as an expense when they arise from “reprehensible” conduct of a taxpayer. Be that as it may, 65302 British Columbia Ltd. instructs that such policy questions are to be left to Parliament. If it so wishes, Parliament may legislate against the deductibility of damage awards in those circumstances.

Are Damages Income or Capital Related?

[17]      Two other issues need to be briefly addressed. The first is whether the damage award in this case could be considered to be incurred on capital as opposed to income account. In addition to the fact that the Minister did not assess on this basis, the finding of fact of the learned Tax Court Judge, that the appellant’s object in breaching the agreement was to keep his clients and business, is conclusive. The damages were awarded for lost profits. Appellant’s counsel explained how each item of the damage award for the losses incurred or that would be incurred by Roe & Co. related to the business that the appellant carried on or would carry on in breach of the agreement.

Year in which Damages are Deductible

[18]      The second is whether the damage award made in 1994 and sought to be deducted as an expense in that year was properly attributable to that taxation year. Appellant’s counsel explained that the damage award covered the period from July 3, 1991 to August 31, 1996, the period from termination of the agreement to the expiry of the restrictive covenant. The Court was not referred to any decided cases on the timing issue. However, appellant’s counsel did provide the Court with an extensive article by Eva M. Krasa entitled “The Deductibility of Fines, Penalties, Damages and Contract Termination Payments” (1990), 38 Can. Tax J. 1399, which provides a helpful analysis of this timing issue, explaining why the right to deduct damages as an expense arises in the year the damage award is made and not in the year in which the events giving rise to the damages took place. At pages 1431-1432 she states:

Lengthy delays between the occurrence of the event that gives rise to a liability for damages and the final ascertainment of that liability are extremely common. The issue therefore arises whether the damages are deductible in computing income for the year in which the event occurred or for the year in which the damages payment is finally determined.

…

For accrual basis taxpayers, such as the taxpayer in Imperial Oil, the appropriate timing of the deduction is more difficult. The basic common law rule is that a taxpayer is entitled to deduct an expense when it is incurred, and an expense is incurred when a taxpayer has an absolute and unconditional obligation to pay an amount. A contingent liability is not deductible. In the case of a damages claim against the taxpayer, it seems clear that the taxpayer’s liability to pay any amount is contingent until the taxpayer’s liability for damages and the quantum of damages have been finally ascertained either by the court or by binding settlement between the parties. At the time the damages are so ascertained (and not before), the taxpayer incurs an absolute and unconditional obligation to pay an amount and an expense is considered to be incurred for income tax purposes. It follows from this that the taxpayer’s right to deduct the amount arises in that later year and not in the year in which the event giving rise to the damages took place. The author has obtained a technical interpretation from the department in which the department has confirmed this position.

[19]      We agree with this logic and rationale. The appellant was an accrual basis taxpayer. His liability to pay damages was ascertained and became an absolute and unconditional obligation on May 30, 1994, when the judgment of the British Columbia Supreme Court was issued. It follows that the right to deduct the damages as an expense under paragraph 18(1)(a) arose in 1994.

CONCLUSION

[20]      The appeal will be allowed with costs both in this Court and in the Tax Court of Canada, the judgment of Tax Court of Canada will be quashed and the assessment will be remitted to the Minister of National Revenue for reassessment on the basis that the sum of $465,908 is deductible as an expense under paragraph 18(1)(a) of the Income Tax Act for the appellant’s taxation year ended September 29, 1994.

---