Date: 19990401
Docket: 97-1251-IT-G
BETWEEN:
R. REUSSE CONSTRUCTION CO. LTD.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Delivered orally from the Bench at Toronto, Ontario on February 11, 1999.
Bonner, J.T.C.C.
[1] This is an appeal from an assessment of income tax for the Appellant's 1994 taxation year. The issue is whether the sum of $1,250,000, received by the Appellant, a landlord, from a tenant consequent upon the breach by the tenant of the terms of the lease constitutes a capital receipt or ordinary business income.
[2] The Appellant is owner of a number of commercial buildings which it lets to tenants. One of those buildings was an office tower located at 100 Allstate Parkway in Markham, Ontario. That building was encumbered by a first mortgage in favour of Manufacturers Life Insurance Company, which I will refer to hereafter as ("ML").
[3] On September 13, 1988 the Appellant leased a very substantial part of the space in the building to Family Trust Corporation, which I will refer to hereafter as ("FT"). The term of the lease was ten years; the annual rent was $414,616 for the first five years and $530,067 for the next five years.
[4] In April of 1993 FT terminated the lease, vacated the premises and ceased paying rent. The Appellant, pursuant to its obligations under the mortgage, informed ML that its lead or anchor tenant, FT, had advised that it would no longer abide by the terms of the lease.
[5] The Appellant, faced with a serious reduction in rental revenues from the building, reduced its monthly mortgage payments to ML. It noted in correspondence with ML that ML held a substantial block of the shares of FT. It sought to renegotiate the mortgage. ML explained that it was not its policy to waive payment of either interest or principal and asserted that there was no connection between its position as mortgagee and as investor in FT. After much negotiation an agreement was reached whereby arrears under the mortgage were capitalized, the term was extended and monthly payments were reduced to interest only. The interest rate was also reduced, thereby saving the Appellant approximately $1,000,000 over the life of the new mortgage. For the time being, at least, the cash flow problem caused by the cessation of payment of the FT rents was solved.
[6] Some time before the renegotiation of the mortgage the Appellant had commenced a lawsuit in the Ontario Court, General Division against FT and its president Thomas Shea. The relief sought in the Statement of Claim included:
1. Damages of $5,000,000.00 for rent due by the defendant to the plaintiff for the unexpired portion of the term of the lease.
2. Damages of $6,000,000.00 for reduction in the value of the building caused by the defendant's termination and breaches of the lease agreement. ML was not a defendant in the lawsuit but Reinhardt Reusse, the Appellant's president, threatened to sue ML on the basis of allegations of conspiracy with FT to injure the Appellant.
[7] When discoveries in the Reusse-FT lawsuit were underway a proposal for settlement was made by an official of ML. After offers and counter offers a settlement was reached calling for payment to the Appellant of $1.25 million. The payment was made and a formal mutual release was signed among the Appellant, FT, its president Thomas Shea, ML and Manulife Financial Holdings Limited of all claims arising out of the September 1988 lease between the Appellant and FT of the building, and out of issues raised or which could have been raised in the lawsuit. Very shortly after the settlement was reached, ML increased its stake in FT to 100 percent.
[8] In its income tax return the Appellant treated the $1.25 million payment as a reduction in the undepreciated capital cost of depreciable property described in Class 3 of Schedule II to the Income Tax Regulations, that is to say the building.
[9] The Minister of National Revenue included the payment in the computation of the Appellant's income for 1994. He did so on the basis that, and I quote from the Reply to the Notice of Appeal:
e) the compensation received by the Appellant for the premature cancellation of the lease by FT was in substitution for future profits which would have been earned from the leased premises;
The Appellant pleads that as a direct result, and here I quote:
As a direct result of the termination and breach of the lease by FT and ML's complicity therewith, the value of the Property has been significantly reduced. The amount by which the value of the Property has been so reduced, and consequently the value by which ML's mortgage investment in the Property has been reduced, is greater than the amount of the Payment.
[10] The Appellant originally sought to support the position taken in the tax return by relying on section 80 of the Income Tax Act. That position was abandoned at the hearing of the appeal.
[11] The position taken by the Appellant at the hearing is that the payment is to be characterized as capital because it is compensation for the reduction in the value of the building.
[12] There is an abundance of case law dealing with the tax treatment of compensation for the untimely termination of business contracts. A very useful summary of the basic principles applicable in such cases may be found in the Reasons for Judgment of Strayer, J., as he then was, in Canadian National Railway Co. v. The Queen, [1988] 2 C.T.C. 111. In that case the taxpayer carried on the business of the transportation of goods and entered into a contract with a client for the movement of goods by road and by rail. The client failed to meet minimum tonnage provisions of the contract. The taxpayer put pressure on the client which thereupon terminated the contract and paid damages to the taxpayer for the breach. It was held that the damages in issue were ordinary income. At page 114, Strayer, J. stated:
There is much jurisprudence on the question of whether compensation paid on the occasion of the termination of some business arrangement is capital or income. To a large extent each case turns on its own facts. It appears to me that there are two aspects which a court must consider in examining such a situation retrospectively: was the purpose of the payment to replace capital or income; and, whether or not the purpose can be reliably determined, was the effect of the payment to replace capital or income? It appears to me to be a dual test because the purpose may not be discernible, or it may not be reliably discernible in the sense that parties to settlements should not, by misstating the real purpose, determine the tax consequences of the receipt of such compensation. It is therefore necessary to look at both purpose and effect.
With respect to purpose, the essential question is to determine what the compensation - whether paid pursuant to a contract, a court award of damages, or otherwise - is intended to replace....
[13] In argument, counsel for the Appellant contended that the payment was made by ML not by the tenant FT. The factual situation in this area is rather murky. The formal release speaks of a payment by ML to the Appellant as does some of the correspondence. On the other hand, the cheque to the Appellant in payment of the amount now in issue was issued by FT. The payment may have been funded by ML but no one was called from either ML or FT to prove the fact. ML which, as I have noted, took over 100 percent ownership of the shares of FT within days of the settlement, may have been instrumental in bringing about the settlement. But the central fact remains that what was settled was a bundle of claims arising out of the breach by FT of its obligations under the lease.
[14] Reinhardt Reusse, the Chief Executive Officer of the Appellant, made it clear in his testimony that what he sought was compensation for the reduction in value of the building brought about by the loss of the anchor tenant FT. And I have no doubt that that was his claim on behalf of the Appellant or at least one of his claims.
[15] It is, I think, self-evident that the loss of the income stream resulting from the departure of the anchor tenant FT would, at least until reletting, have an adverse effect on the value of the building. That adverse effect might, I think, be prolonged if, during the period when the Appellant was forced to seek a new tenant for the space vacated by FT, adverse market conditions compelled the Appellant to lease at depressed rates for terms extending into the period following the expiry date of the FT leases. The main difficulty, however, in characterizing the payment in issue as compensation for such loss of value of the building is that such loss was only one of several heads of damage claimed in the lawsuit. There is no evidence at all which links the payment in issue to a decrease in building value as opposed to any of the other heads of damage claimed.
[16] It is hard to imagine that ML, as mortgagee, would feel compelled to compensate the Appellant as mortgagor for a decrease in the value of the mortgaged property, simply because the property had dropped in value. It is, in my view, more logical to conclude that the payment recognized the root cause of the loss in value, namely the failure of FT to pay the rent which it was obliged to pay by the lease. In short, the theory that the purpose of the payment was to compensate the Appellant for the loss in value of its building was improbable and not supported by the evidence.
[17] The onus was on the Appellant to prove the factual basis for its case and in my view it has failed to do so. I note that the Appellant failed, without any explanation, to call any official of either FT or ML to explain the motive or purpose which led to the payment. The Appellant called Dr. L. S. Rosen, an expert in forensic accounting, who testified that in his opinion the payment should be regarded as capital. This treatment, according to Dr. Rosen, is required by Generally Accepted Accounting Principles ("GAAP"). He stated that:
In my opinion, given the seriousness of what is at stake commercially, where much doubt exists as to the capital versus income nature of the cash receipt, prudence would call for erring on the side of not recording income. Choosing the alternative of crediting the entire $1,250,000 as income opens up significant consequences, which in my opinion are not desirable for Canadian business practice.
He stated further that:
Accounting has a long, well-justified history of 'erring' on the side of not classifying a receipt as income (or revenue) unless strong evidence exists, ...
And he concluded:
In my opinion, given that the facts that are known to me are not at all clear, GAAP accounting in particular would not favour the recording of income for the $1,250,000. Calling the entire $1,250,000 as income neglects the lowering impact on capital asset value of not having an ongoing tenant. More importantly, calling the $1,250,000 as income opens up Ponzi fraud dangers and contradicts the essence of GAAP's concerns about not mixing and confusing capital with income.
[18] I am not persuaded by this reasoning. Dr. Rosen did not point to any authoritative work on GAAP which supports his point of view. Moreover, GAAP is not relevant in deciding whether a receipt is on revenue or capital account and in this regard I refer to what is said in IKEA Limited v. The Queen, 98 DTC 6092 and Symes v. Canada [1993] 4 S.C.R. 695.
[19] Finally, on the subject of Dr. Rosen's evidence, I reiterate that the Appellant pleaded as a fact that the receipt was compensation for the loss of value of the building. The onus was therefore upon it to prove that fact on the balance of probabilities. It failed to do so and accounting principles cannot overturn the ordinary rules of evidence which govern the conduct of litigation. He who asserts must prove.
[20] In my view, the effect of the payment is fairly obvious. It compensated the Appellant in part for FT's failure to discharge its obligation to pay rent under the lease. That, in my view, is the hole which the payment filled. It was a loss of ordinary revenue from the Appellant's business.
[21] The appeal will therefore be dismissed with costs.
Signed at Ottawa, Canada this 1st day of April 1999.
"Michael J. Bonner"
J.T.C.C.