If you run a business of any size, or work as an independent contractor, chances are contracts have been broken, altered or cancelled. In many cases, the parties to the contract agree to end the relationship, and fees are paid in recognition from one side to the other. This is what is known in Canadian income tax law as a “termination fee”.
The Canadian taxation of these termination fees is not always a simple matter. Various factors such as the amount of income that is given up by agreeing to terminate the ongoing business operation, and whether or not the loss of the contract effectively puts one party out of business all have a bearing on how a termination fee should be taxed.
There are essentially two ways that a termination fee will be taxed in Canada: as income or a payment on account of capital (capital gain). Depending on your circumstances it may be preferable to recognize a termination fee in one way rather than another. The advice of our experienced Canadian tax lawyers can help ensure that you don’t lose any of the tax benefits of that termination fee.
Definition of Termination Fee
A termination fee can be defined simply as the price one of the parties in a contract pays to the other in order to be released from their respective contractual obligations. Entering into a terminating fee arrangement is sometimes based on a cost benefit analysis.
One party determines that a large lump sum paid to the other now would actually cost less in the long run when considering the overall terms and life of the contract.
Another possibility is that a condition in another contract or transaction is that the current contract be cancelled. For example, a third party enters into negotiation to purchase a corporation. One of the conditions of the purchase is that all current supplier contracts be terminated before the sale will be completed. This requires the corporation that is being purchased to sever some or all of its existing contracts and leads to negotiations and normally a settlement between the parties.
In either of these scenarios, the Canadian income tax treatment is dependent oftentimes on how the parties go about the termination of the existing contract. Competent Canadian tax lawyer advice is this crucial in these situations.
Canadian Tax Law’s “Surrogatum Principle”
Practically speaking, the taxation of termination fees in Canada is a rather uncertain area. Canada’s Income Tax Act does not refer to termination fees directly, leaving it up to the interpretation of the courts.
Fortunately, judges have been sensitive to this issue for more than half a century. In order to ensure a level of certainty, the courts created the common law “Surrogatum Principle”. The Surrogatum Principle stands for the idea that an amount that is paid to replace – or act as a surrogate for – the original amount should be taxed in the same manner. A decision maker must examine all the facts and determine what a payment is made to replace or is in recognition of.
Two simple examples can serve to illustrate the Surrogatum Principle in action:
- A taxpayer purchases a truck to use in their business. The truck is considered a capital asset of the business. The truck is involved in an accident and is destroyed by the negligence of another driver. The business sues for the replacement of the truck. The settlement amount will thus be considered a capital payment.
- As a part of its business, a corporation has a contract with a small supplier for the supply of paperclips. A paperclip boom ensues, and the price drops significantly. The corporation pays a termination fee to the supplier in order to get out of the contract. In this case, the payment should be recognized as income for the supplier; this is because the payment is meant to replace the stream of income from the contract, one contract of many that the supplier is able to absorb the loss of easily.
One of the problems, and why you’ll want one of our experienced Canadian income tax lawyers on your side, is that a determination is based on all the surrounding factual circumstances. The difference between income and a capital payment can be incredibly large in some circumstances. Having said that, it is important to understand what types of situations and what the criteria are for having a termination fee recognized as a capital payment.
When a Termination Fee is a Capital Payment
Judges in Canada have been making decisions with respect to the tax treatment of termination fees using the Surrogatum Principle for decades. This allows an experienced tax lawyer to identify some of the most important characteristics of a termination fee and to therefore structure your affairs accordingly.
The most famous and important case in this area, Commissioners of Inland Revenue v Fleming & Co. (Machinery) Ltd. was decided over 50 years ago in the United Kingdom. Lord Russell’s words are mirrored in the CRA’s Interpretation Bulletin to this day:
“When the rights and advantages surrendered on cancellation are such as to destroy or materially to cripple the whole structure of the recipient’s profit-making apparatus, involving the serious dislocation of the normal commercial organization and resulting perhaps in the cutting down of the staff previously required, the recipient of the compensation may properly affirm that the compensation represents the price paid for the loss or sterilization of a capital asset and is therefore a capital and not a revenue receipt … On the other hand when the benefit surrendered on cancellation does not represent the loss of an enduring asset in circumstances such as those above mentioned — where for an example the structure of the recipient’s business is so fashioned as to absorb the shock as one of the normal incidents to be looked for and where it appears that the compensation received is no more than a surrogatum for the future profits surrendered — the compensation received is in use to be treated as a revenue receipt and not a capital receipt.”
In other words, when a termination fee is paid, the impact that it has upon the recipient is paramount. If the termination fee is paid to cancel a contract that comprises most or all of the party’s business operations it will be considered to be a capital receipt. This is because a contract of such importance is recognized as a “property” the destruction of which completely destroys the ability of the party to continue business operations.
On the other hand, if a business is large enough, or the stream of income flowing from the contract is small enough that the termination of the contract is foreseeable in the operation of the business, the termination fee will normally be considered to be a replacement for the income that otherwise would have flown from the contract. In these situations the termination fee will be taxable as income and should be included as such in the taxpayer’s return.
Termination Agreements Can Affect the Income Tax Treatment
Caution is also required in any situation where a termination agreement is drafted as a contract between the parties. The language used can have an unintended effect of classifying a termination payment as on account of income as opposed to capital.
Canada Revenue Agency and the courts have both held previously that contracts containing language that indicates that the payment is meant to replace a stream of income have the effect of categorizing the termination fee as on account of income despite the surrounding circumstances. Before you agree to any sort of termination agreement on your behalf or on behalf of your business, you’ll want expert advice from one of our expert Canadian tax lawyers.