Judgments

[1994] 2 .F.C. 720

A-170-93

Her Majesty the Queen (Appellant)

v.

Alan M. Schwartz (Respondent)

Indexed as: Schwartz v. M.N.R. (C.A.)

Court of Appeal, Mahoney, Stone and McDonald JJ.A.—Ottawa, February 1 and 15, 1994.

Income tax — Income calculation — Appeal from Tax Court decision characterizing amount received by respondent upon breach of employment agreement not as income from employment but as compensation for loss of income for future services, embarrassment, anxiety — Tax Court Judge relying solely on respondent’s testimony — Finding no evidence of allocation of settlement amount between loss of income and embarrassment, anxiety, inconvenience — T.C.J.’s failure to weigh contradictory documentary evidence palpable and overriding error — Where, pursuant to legal right, person receiving compensation for failure to receive sum of money which, had it been received, would have been income from employment or office, compensation treated as if money received — Where right to compensation ensuing upon legal wrong, source of right and wrong activating it two different things — Employment contract source of respondent’s right — Source of income within Income Tax Act, s. 3(a).

This was an appeal from the Tax Court’s decision allowing the respondent’s appeal against the inclusion in his 1989 income of $360,000 paid to him by The Dynacare Health Group Inc. The respondent, a Toronto law firm partner, accepted an offer of offered employment by Dynacare at an annual salary of $250,000, and with an option to purchase equity shares. Respondent notified his partners of his withdrawal. Before the employment began, Dynacare unilaterally terminated the employment agreement. The respondent withdrew from the partnership, but began other employment the next day at an annual salary of $175,000. Following negotiations during which the value of the shares and lost income was raised, Dynacare paid the respondent $400,000, $40,000 of which was stipulated to be on account of costs. The respondent testified that the figure of $400,000 was picked from the air. He stated that he had suffered embarrassment, anxiety and inconvenience as a result of the breach of the agreement. The Minister had determined that the amount was a “retiring allowance” and to be included in the calculation of taxable income under Income Tax Act, subparagraph 56(1)(a)(ii). The Tax Court held that the amount was not a retiring allowance. Based on the respondent’s testimony, it further held there was no evidence to indicate any allocation of the settlement amount between losses of income from stock options and salary, and embarrassment, anxiety and inconvenience. It found that the sum was not income from employment, but was compensation for loss of income for future services and for embarrassment, anxiety and inconvenience.

Held, the appeal should be allowed.

The Tax Court’s finding must stand unless the Court was required to interfere with it under the criteria established by Stein et al v. Kathy K et al. (The Ship). An appellate court has a duty to review the evidence and can only interfere with a trial judge’s findings of fact if it finds some palpable and overriding error which affected the findings. If it finds such an error, the appellate court is duty bound to interfere.

The Tax Court Judge’s observation that “there was no evidence to indicate any allocation of the settlement amount between losses from stock options and salary … and embarrassment, anxiety and inconvenience” was wrong. Having reexamined the evidence, this Court was obliged to conclude that the Tax Court failed to weigh contradictory documentary evidence against the respondent’s viva voce evidence, and that failure was a palpable and overriding error which affected the assessment of the facts. The documentary evidence generated during the course of settlement negotiations was preferred to the respondent’s viva voce evidence given with the income tax consequences of the settlement very much on his mind. On a balance of probabilities, $75,000 was compensatory of lost wages; $267,000 compensatory of lost financial benefit under the option; and $18,000 was damages for embarrassment, anxiety and inconvenience and therefore not compensatory of lost income.

$342,000 was to be included in the calculation of the respondent’s taxable income. The $342,000 was not a windfall. An amount received in settlement of an asserted cause of action cannot be characterized as a windfall even to the extent that it may be gratuitously generous.

The rule applicable to damages compensating for loss of income by traders should apply to damages arising out of breach of a contract of employment. Thus where, pursuant to a legal right a person receives compensation for the failure to receive a sum of money or benefit which, if it had been received would have been income from an employment or office, the compensation is to be treated for income tax purposes in the same way as if the benefit or sum of money had been received instead of the compensation. Where a right to compensation ensues upon a legal wrong, the source of that right and the wrong that activates it are two different things. In a personal injury case, the source of the right to damages is that person’s right not to be injured by the tort of another. That is not a source of income within the Income Tax Act, paragraph 3(a). The source of the respondent’s right was the contract of employment, which was a source of income within the express contemplation of paragraph 3(a). Its breach, even if before performance was required, was the legal wrong that triggered the right to compensatory damages, but the breach was not its source.

STATUTES AND REGULATIONS JUDICIALLY CONSIDERED

Income Tax Act, S.C. 1970-71-72, c. 63, ss. 3(a), 56(1)(a)(ii) (as am. by S.C. 1980-81-82-83, c. 140, s. 26; 1987, c. 46, s. 15), 248(1) (as am. by S.C. 1980-81-82-83, c. 140, s. 128; 1990, c. 39, s. 54).

CASES JUDICIALLY CONSIDERED

APPLIED:

Stein et al. v. “Kathy K” et al. (The Ship), [1976] 2 S.C.R. 802; (1975), 62 D.L.R. (3d) 1; 6 N.R. 359; Mohawk Oil Co. v. Canada, [1992] 2 F.C. 485; [1992] 1 C.T.C. 195; (1992), 92 DTC 6135; 140 N.R. 225 (C.A.); leave to appeal refused, [1992] 2 S.C.R. viii; London and Thames Haven Oil Wharves, Ltd. v. Attwooll (Inspector of Taxes), [1967] 2 All E.R. 124 (C.A.); R. v. Manley, [1985] 2 F.C. 208; [1985] 1 CTC 186; (1985), 85 DTC 5150; 57 N.R. 364 (C.A.); leave to appeal to S.C.C. refused, [1986] 1 S.C.R. xi; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; [1984] CTC 294; (1984), 84 DTC 6305; 53 N.R. 241; leave to appeal to S.C.C. refused, [1986] 1 S.C.R. xi.

REFERRED TO:

R. v. Cranswick, [1982] 1 F.C. 813; [1982] CTC 69; (1982), 82 DTC 6073; 40 N.R. 296 (C.A.).

APPEAL from the Tax Court decision (Schwartz, A. M. v. The Queen (1993), 93 DTC 555) that an amount paid to the taxpayer for breach of an employment contract was for loss of income for future services and for embarrassment, anxiety and inconvenience and not to be included in taxable income. Appeal allowed.

COUNSEL:

Susan L. Van Der Hout and Elizabeth D. Chasson for appellant.

Benjamin Zarnett and Carrie B. E. Smit for respondent.

SOLICITORS:

Deputy Attorney General of Canada for appellant.

Goodman & Goodman, Toronto, for respondent.

The following are the reasons for judgment rendered in English by

Mahoney J.A.: This is an appeal from a reported decision of the Tax Court of Canada[1] which allowed the respondent’s appeal against the inclusion in his 1989 taxable income of $360,000 paid to him by The Dynacare Health Group Inc. in the circumstances set out below. The Minister had determined that the amount was a “retiring allowance” as defined by subsection 248(1) of the Income Tax Act [S.C. 1970-71-72, c. 63 (as am. by S.C. 1980-81-82-83, c. 140, s. 128; 1990, c. 39, s. 54)] and to be included in the calculation of taxable income by virtue of subparagraph 56(1)(a)(ii) [as am. by S.C. 1980-81-82-83, c. 140, s. 26; 1987, c. 46, s. 15]. On appeal, the learned Tax Court Judge held, correctly in my opinion, that the amount was not a retiring allowance. He also held that it was not income from employment within the contemplation of the Act. We did not hear the respondent on the retiring allowance issue and are in substantial agreement with the reasons for judgment below in that respect.

The Evidence

In April, 1988, the respondent received a verbal offer of employment as its senior executive vice-president from Albert J. Latner, Dynacare’s chairman. At the time he was a partner in a Toronto law firm on assignment to the Government of Ontario. He agreed to accept the employment upon completion of the assignment expected in November and, in May, wrote Latner a letter outlining the basic terms of their agreement which included the following relevant provisions as to compensation:

2. As compensation for my services I will receive the sum of $250,000 per annum, to be allocated in a mutually agreeable manner. I confirm that a portion of this amount will be allocated to a car allowance ….

3. In addition to my salary, I will receive an option to acquire equity shares totalling 1.25% of the existing shares of Dynacare (calculated as of the date of this agreement). The shares to be issued will be non-voting common shares and will be issued for the price of $.01 per share. The shares will vest in three equal amounts [on the date of commencement of the employment and on the first and second anniversary dates] …. The specific details of the option will be incorporated into a separate agreement ….

4. It is understood that every effort will be made to minimize taxes in connection with the above arrangements and that the implementation of the arrangements will be based on tax advice to maximize the tax advantages for both Dynacare and myself.

Latner endorsed his agreement on the letter. The respondent then notified his partners of his intention to withdraw upon completion of the Ontario assignment.

On September 29, he was advised by Dynacare that it was no longer in a position to employ him. That was confirmed by Dynacare’s solicitors by letter of October 6 which acknowledged that “Dynacare recognizes that it had a contractual obligation to you” and, noting his obligation to mitigate, offered him $75,000 for a full and final release. That was not accepted. The respondent retained counsel.

The Ontario assignment was completed during January, 1989. The respondent withdrew from the partnership January 31. He began other employment the next day at an annual salary of $175,000.

Discussions between counsel resulted in a letter from Dynacare’s solicitor to the respondent’s, dated June 13, 1989, analyzing, as of May 31, 1988, and in light of numerous subsequent transactions, the value of the shares which the respondent would have been entitled to take up had he commenced the employment. It concluded:

… on my calculation, your client’s entitlement at its highest is approximately $267,000 (being the value of one-third of 1.25 percent of the shares as at May 31, 1988).

In an effort to settle this litigation, my client is prepared to be flexible around the range of $267,000.

In fact, there was no litigation, whatever the threat of it. In any event, the respondent’s solicitor replied June 22, professing a large measure of ignorance as to the intervening transactions and continuing:

It does not seem reasonable to suggest that by rolling in additional properties and issuing additional shares the principals intended to dilute Alan’s interest.

3)   Your letter does not address the issue of lost income. In my letter of April 5, 1989 I confirmed to you that Alan’s salary is $175,000 per annum for two years. Therefore apart from the shares, he is entitled to $75,000 for lost income.

I am instructed to propose settlement of this claim in the sum of $400,000 plus costs provided we are able to resolve the matter quickly.

On August 21, 1989, the respondent and Dynacare entered into an agreement which acknowledged that Dynacare had unilaterally terminated the employment agreement in advance of the commencement of the respondent’s employment, provided a mutual release of claims arising out of the employment agreement and for the payment of $400,000 by Dynacare to the respondent. $40,000 of the $400,000 was stipulated to be on account of costs and is not in issue.

Only the respondent testified at trial. Starting from the initial $75,000 offer, his evidence as to the negotiations follows:[2]

Q.  In the colloquial sense, money that you lost, it was worth more than $75,000?

A.   In the broadest sense. I mean, I think when—I think I considered that the money was more. But there were many other factors involved. There was the pain and the humiliation. There was the inducement to leave my partnership. This was about many things. The money was one of them.

Q.  And you put in a counter-offer of $400,000?

A.   That’s correct.

Q.  And this was calculated—and I use `calculated’ in the very broad sense—based on, among other things, the loss of the stock option and the lost income?

A.   I would say that that’s true in the very broadest sense of the word. I know that my counsel and I and, in fact, counsel for Dynacare struggled to find some way of finding a number that could be rationalized because this involved a number of factors, as I mentioned earlier. My view is, in the end, we never did and we never could and the number was, in some sense, picked from the air.

Q.  I’d just like you to flip to Tab 9, please, Mr. Schwartz, pages 33 and 34. That is a copy of the letter from your lawyer?

A.   Yes.

Q.  At the top of page 34, there is a discussion there about “apart from the shares, he is entitled to $75,000 for lost income”.

A.   That’s all correct.

Q.  So that was part of the way in which the amount was calculated? That was taken into account?

A.   As I said, I think it was taken into account in the broadest sense. It was part of the hurly-burly of the discussions. But, ultimately, it didn’t seem to me that it became terribly relevant.

The Trial Judge’s Consideration of the Evidence

The Trial Judge did not, in his reasons, quote from or refer to either of the letters of June 13 or June 22. He referred only to the initial offer of $75,000 and the settlement agreement. The intervening negotiation was dealt with, at pages 556-557, as follows:

Schwartz did not accept Dynacare’s offer and retained counsel. At the time Schwartz was still practising law and continued to do so until he withdrew from the partnership at the partnership’s year-end on January 31, 1989. He had completed his work for the Ontario government prior to Christmas.

On February 1, 1989 Schwartz commenced employment with a firm of investment advisors.

In the meantime negotiations continued with Dynacare. On August 21, 1989, Schwartz and Dynacare executed mutual releases in consideration of Schwartz receiving $400,000, of which the sum of $40,000 was paid on account of costs and the sum of $108,000 was retained by Dynacare for remission to Revenue Canada.

Schwartz testified the amount of $400,000 was “more or less picked from the air” although losses on stock options and of salary were considered. He stated he suffered embarrassment, anxiety and inconvenience as a result of the breach of the agreement by Dynacare. There was no evidence to indicate any allocation of the settlement amount between losses of income from stock options and salary on one hand and embarrassment, anxiety and inconvenience on the other hand.

The respondent’s testimony recited above and summarized in the last quoted paragraph from his reasons is, so far as I have been able to ascertain, the only evidence upon which the learned Trial Judge could have based his critical finding of fact. It is certainly the only evidence to which we were referred that supports the finding.

The Critical Finding and the “Kathy K” Test

The critical finding of the Trial Judge is found, at page 562 of the reported judgment.

Schwartz suffered inconvenience and prejudice when he was informed his services would not be required. He had given notice of withdrawal to his law partnership. He had to begin to look for employment. Schwartz was never an employee or officer of the purported employer. The damages he received was in a small part, if any, for loss of income for future services and to a larger part, according to the evidence, for embarrassment, anxiety and inconvenience.

It seems to me that finding must stand unless this Court is required to interfere with it under the criteria established by the Kathy K ,[3] where, after an extensive review of the authorities, it was held:

These authorities are not to be taken as meaning that the findings of fact made at trial are immutable, but rather that they are not to be reversed unless it can be established that the learned trial judge made some palpable and overriding error which affected his assessment of the facts. While the Court of Appeal is seized with the duty of re-examining the evidence in order to be satisfied that no such error occurred, it is not, in my view, a part of its function to substitute its assessment of the balance of probability for the findings of the judge who presided at the trial.

In summary, an appellate court has the duty to review the evidence. It has no power to interfere with a trial judge’s findings of fact unless it finds some palpable and overriding error which affected the findings. If it finds such an error the appellate court is duty bound to interfere.

The Trial Judge’s observation that “there was no evidence to indicate any allocation of the settlement amount between losses from stock options and salary on one hand and embarrassment, anxiety and inconvenience on the other hand” seems to me clearly wrong. The failure of a trial judge to refer to all the contradictory evidence in finding a fact is not a ground for an appellate court to conclude that it was not taken into account and weighed but it is quite something else if the trial judge says that there was no contradictory evidence when there was. In my opinion, this is a case in which an appellate court, having re-examined the evidence, is obliged to conclude that the trial judge failed to weigh contradictory documentary evidence against the respondent’s viva voce evidence and that the failure was a palpable and overriding error which affected his assessment of the facts.

There are a number of reasons for preferring the documentary evidence generated during the course of the settlement negotiations to the respondent’s viva voce evidence given with the income tax consequences of the settlement being very much in his mind, the frailty of human memory perhaps among them. Paragraph 4 of the respondent’s letter to Latner outlining the basic terms of the proposed employment is recited above. It indicates clearly that the respondent was attuned to the idea of arranging transactions to minimize their tax consequences. There is no impropriety in that. Persons knowledgable of the tax system are as entitled as others to so arrange their affairs. The respondent’s evidence was self-serving. Again, there is no impropriety in that. It is simply a fact of life and, the rare saint or self-immolator excepted, to be expected of witnesses testifying when their own personal interests, financial or otherwise, are in issue. There being no issue of credibility calling for remission of the matter to the Tax Court, I am of the opinion that we are entitled to conclude that, on a balance of probabilities, of the total amount, $75,000 was compensatory of lost wages and $267,000 compensatory of lost financial benefit under the option. There is no reason to conclude otherwise than that the remaining $18,000 was damages for embarrassment, anxiety and inconvenience and, therefore, not compensatory of any sort of lost income.

Taxability of the $342,000

The relevant provision of the Income Tax Act follows:

3. The income of a taxpayer for a taxation year for the purposes of this Part is his income for the year determined by the following rules:

(a) determine the aggregate of amounts of each of which is the taxpayer’s income for the year (other than a taxable capital gain from the disposition of a property) from a source inside or outside Canada, including, without restricting the generality of the foregoing, his income for the year from each office, employment, business and property;

In my view, it is not necessary to go beyond that. The issue is whether, in light of the applicable jurisprudence, the $342,000 was income from an office or employment.

I do not think that any part of the settlement amount can be characterized as a “windfall” as argued by the respondent. Of the indicia accepted by this Court as relevant, but no one of which may be conclusive, only (e) seems clearly to apply.[4]

(a) The recipient had no enforceable claim to the payment.

(b) There was no organized effort on the part of the recipient to receive it.

(c) It was not sought after or solicited by the recipient in any manner.

(d) It was not expected by the recipient, either specifically or customarily.

(e) It had no foreseeable element of recurrence.

(f) The payer was not a customary source of income to the recipient.

(g) It was not in consideration of or in recognition of property, services or anything else provided by the recipient.

(h) It was not earned by the recipient, either as a result of any activity or pursuit of gain carried on by the recipient or otherwise.

The first four indicia, on their plain language, have no application here and the last three apply only if the recipient’s legal expectations, for the wrongful denial of which the settlement was made, are ignored.

In Mohawk Oil Co. v. Canada,[5] Stone J.A.,[6] for the Court, dealt with the settlement of a claim for damages where the amount paid exceeded the limitation of damages provided in the contract in the following terms:

No authority has been brought to the Court’s attention in which a payment that is not a “windfall” should nevertheless be treated for income tax purposes as “akin to a windfall.”

…

As I see it, the settlement amount, of necessity, included compensation for lost profits and expenditures thrown away. Such compensation cannot, in my view, be regarded as “akin to a windfall.”

In my view, an amount received in settlement of an asserted cause of action, whatever its nature, simply cannot be characterized as a windfall even to the extent that it may be gratuitously generous.

In London and Thames Haven Oil Wharves, Ltd. v. Attwooll (Inspector of Taxes),[7] a taxpayer had received, in settlement of a claim for negligence, an amount for loss of use of an income-earning asset. The legitimacy of referring to such an authority for the purpose of construing the Income Tax Act was expressly approved by the Supreme Court of Canada in Stubart Investments Ltd. v. The Queen.[8] After extensive reference to American, Australian, English and Canadian jurisprudence, it was noted:

 … there are certain broad characteristics of tax statute construction which can be discerned in the authorities here and in similar jurisdictions abroad.

In London and Thames, Diplock L.J., as he then was, proposed the following rule and the method for its application.

The question whether a sum of money received by a trader ought to be taken into account in computing the profits or gains arising in any year from his trade is one which ought to be susceptible of solution by applying rational criteria; and so, I think, it is. I see nothing in experience as enbalmed [sic] in the authorities to convince me that this question of law, even though it is fiscal law, cannot be solved by logic, and that, with some temerity, is what I propose to do.

I start by formulating what I believe to be the relevant rule. Where, pursuant to a legal right, a trader receives from another person compensation for the trader’s failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the time when the compensation is so received, the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received instead of the compensation. The rule is applicable whatever the source of the legal right of the trader to recover the compensation. It may arise from a primary obligation under a contract, such as a contract of insurance; from a secondary obligation arising out of non-performance of a contract, such as a right to damages, either liquidated, as under the demurrage clause in a charterparty, or unliquidated; from an obligation to pay damages for tort, as in the present case; from a statutory obligation; or in any other way in which legal obligations arise.

The source of a legal right is relevant, however, to the first problem involved in the application of the rule to the particular case, viz., to identify for what the compensation was paid. If the solution to the first problem is that the compensation was paid for the failure of the trader to receive a sum of money, the second problem involved is to decide whether, if that sum of money has been received by the trader, it would have been credited to the amount of profits (if any) arising in any year from the trade carried on by him at the date of receipt, i.e., would have been what I shall call for brevity an income receipt of that trade. The source of the legal right to the compensation is irrelevant to the second problem. The method by which the compensation has been assessed in the particular case does not identify for what it was paid; it is no more than a factor which may assist in the solution of the problem of identification.

That was expressly adopted, and indeed the reasoning characterized as compelling, by this Court in R. v. Manley.[9] Leave to appeal refused, [1986] 1 S.C.R. xi.

London and Thames and Manley dealt with damages compensating for loss of income by traders. I am not persuaded of any valid distinction in principle that would exclude application of the rule, with appropriate modification of its language, to damages arising out of a breach of a contract of employment, whether anticipatory or otherwise. I would state it thus:

Where, pursuant to a legal right, a person receives from another compensation for the failure to receive a sum of money or benefit which, if it had been received, would have been income from an employment or office, the compensation is to be treated for income tax purposes in the same way as if the benefit or sum of money had been received instead of the compensation.

The respondent’s submission was that since the employment had not begun, the amount paid is analogous to damages for personal injury which include an amount calculated with reference to loss of future employment income. The answer to that lies in the relevance of the source of the right to receive the money to the identification of what it was paid for.

Where a right to compensation ensues upon a legal wrong, the source of the right to compensation and the wrong that the law recognizes as activating that right are two different things. In the case of the personal injury victim, the source of the right to damages is that person’s right not to be injured by the tort of another. That is not a source of income within the contemplation of paragraph 3(a) of the Income Tax Act. On the other hand, the source of the respondent’s right was the contract of employment, which was a source of income within the express contemplation of paragraph 3(a). Its breach, even if before performance was required, was the legal wrong that triggered the right to compensatory damages but the breach was not its source.

Conclusion

In my opinion, $342,000 of the compensation received by the respondent from Dynacare in 1989 is subject to be included in the calculation of the respondent’s taxable income for that year. I would allow the appeal with costs of the appeal and below, set aside the judgment of the Tax Court of Canada and refer the respondent’s 1989 income tax return back to the Minister of National Revenue for re-assessment on a basis consistent with these reasons for judgment.

Stone J.A.: I agree.

McDonald J.A.: I agree.

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