Tax Court of Canada Judgments

Date: 20010704

Docket: 1999-1758-IT-G

BETWEEN:

TERENCE D. COUGHLAN,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Bowie J.

[1]            These appeals are brought from assessments under the Income Tax Act (the Act) for the taxation years 1993 and 1994. They raise issues as to the incidence of tax on certain amounts awarded to the Appellant by a Judgment of the Supreme Court of Nova Scotia, Trial Division, as amended by the Nova Scotia Court of Appeal.

[2]            The Appellant was president and chief executive officer of a resource company called Seabright Resources Inc. (Seabright) prior to 1988. In January of that year, he and the other shareholders of Seabright sold their shares to an Australian group which changed the name of the company to Westminer Canada Limited (Westminer). Revenue Canada considered the Appellant to be a trader in shares, and his gain from this sale was taxed as income from a business. In July 1988, Westminer began an action in the Supreme Court of Ontario against the Appellant and the other former directors of Seabright. The allegations against the Appellant in that action included fraud, deceit, conspiracy and insider trading.

[3]            The Appellant and the other former directors then brought actions in the Supreme Court of Nova Scotia against Westminer and its directors, in which they alleged conspiracy to injure and breach of fiduciary duty. These actions went to trial, and the Ontario actions were stayed pending their outcome. In the result, the Appellant and his fellow directors were successful in the Nova Scotia actions, and the actions against them in the Supreme Court of Ontario were then abandoned. Nunn J. of the Supreme Court of Nova Scotia, found that there had been a civil conspiracy among the defendants to injure the plaintiffs, and he awarded very substantial damages. He also held that the plaintiffs were entitled to be indemnified for the costs to them of defending the proceedings brought in Ontario under an indemnification clause in the by-laws of Seabright. By his judgment dated May 14, 1993, Nunn J. awarded to the Appellant:

                i)               general damages for the conspiracy in the amount of $1,000,000, together with prejudgment interest from August 25, 1988 to May 14, 1993;

                ii)              solicitor-client costs of the proceeding before him, which he later taxed at $2,992,668.39; and

                iii)             certain other amounts which are not in issue in these appeals.

He did not award prejudgment interest on the solicitor-client costs, presumably because the Judicature Act of Nova Scotia did not permit him to do so.[1]

[4]            Both sides appealed to the Nova Scotia Court of Appeal, largely without success. However, that Court held that Nunn J. should not have awarded solicitor-client costs, but rather damages for loss of indemnity under the Westminer by-law, and that when so characterized that amount qualified for the application of prejudgment interest. Paragraphs 5 and 6 of the Court's judgment read:

5.              The award of costs at trial is hereby affirmed as damages for the loss of indemnity, and the Appellant Westminer Canada Limited is liable to pay and shall pay to the Respondents the sum of $401,891.59 representing prejudgment interest on the award of damages for the loss of indemnity in respect of the expenses incurred by the Respondents in the trial of this proceeding, plus interest thereon in the amount of $12,497.18;

6.              The Appellants [Westminer et al.] are jointly and severally liable to pay to the Respondents as damages for the loss of insurance benefits, their reasonable expenses of this appeal, less a set-off in respect of a portion of the Appellants' costs of the cross-appeal on a party and party basis, in the net amount of $493,456.93 together with prejudgment interest in the amount of $7,117.06 provided that any payment under this paragraph 6 shall reduce pro tanto the liability of the Appellant Westminer Canada under paragraph 7 of this Order;

[5]            The Appellant therefore received the following amounts, among others, under the judgment of Nunn J., as varied by the Court of Appeal:

In 1993:                   $2,992,668 (the first amount) as damages for loss of indemnity; and

In 1994:                   $493,457 (the second amount) as damages for the loss of insurance benefits, and $401,892 (the third amount) as prejudgment interest on the amount of $2,992,668.

It is with these three amounts that these appeals are concerned. The Minister of National Revenue has included them in the Appellant's income in the years in which he received them.

[6]            The Appellant's position is that the first and second amounts are awards of damages, and are of a capital and not an income nature. Alternatively, if they are to be characterized as a reimbursement of legal costs they are nevertheless not included in income because they relate to a capital purpose, and the expenses of the litigation were not deductible when incurred. As to the third amount, the Appellant takes the position that it is not interest at all, but an additional award of damages of a capital nature. Finally, counsel for the Appellant submitted that

Alternatively, if it were found that the prejudgment interest was genuine interest on a debt and that the damages or indemnity award represented income from business, the amount of this business income should be considered to have been owing to the Appellant from the time when he incurred the related expenses. Under the accrual system of accounting for business income, the income in question would need to be recognized when it arose rather than when it was received.[2]

[7]            The Respondent's position is that the first two amounts are properly included in the Appellant's income for 1993 and 1994 respectively, either as income from a business, or in the alternative, under paragraph 12(1)(x) of the Act as "amounts previously expensed and deducted by the Appellant on account of income ...".[3] The third amount, the Respondent submits, is interest received in the year 1994, and is therefore taxable in that year pursuant to paragraph 12(1)(c) of the Act.

[8]            A number of additional facts need to be taken into account in the characterization of these payments. I accept the Appellant's evidence that his primary concern in this litigation was to protect his reputation as a businessman and a promoter in the financial community. It was essential to his future ability to raise capital and to earn a living that he should be vindicated of the serious allegations made against him in the Ontario actions. That this is so can also be seen from the Reasons for Judgment given in the two Courts in Nova Scotia. The Nova Scotia Court of Appeal was careful to point out, in varying the judgment at trial, that the first amount was payable to the Appellant not as costs, but as damages. Seabright had placed insurance to protect the directors from liability for wrongful acts and defaults alleged against them in connection with their duties as directors. Following the takeover, the new management permitted this insurance to lapse. In addition, the by-laws of Seabright, and subsequently Westminer, provided the directors with similar indemnification from the company. It was Westminer's breach of its obligation to indemnify the Appellant pursuant to the by-law, and its breach of the obligation to keep this insurance in force, which gave rise to the awards of the first and second amounts as damages. This is not altered by the fact that Nunn J. fixed the first amount by reference to the costs that would be awarded on a solicitor-client scale, and that the Court of Appeal fixed the second amount on the same basis. I accept the Appellant's evidence that these two amounts, although given as damages for breach of the indemnity and for the loss of insurance benefits, did not fully compensate him for the amounts he spent in connection with the litigation in Ontario and Nova Scotia.

[9]            Between the years 1989 and 1994, the Appellant spent some $4,725,635 in defence of the Ontario actions and in prosecuting the Nova Scotia actions, and he claimed to be entitled to deduct these amounts in computing his income. These deductions were initially disallowed by the Minister, but ultimately, after some negotiation, were allowed. Three of his fellow directors, Hansen, Amirault and Hemming, were not permitted these deductions, and they appealed to this Court from the assessments by which they were disallowed. Their appeals failed,[4] on the basis that their purpose in the litigation was to protect their accumulated assets, including their reputations. I have already found that protection of his reputation and the ability to earn his livelihood were the primary motivation for the Appellant's expenditures in this litigation, and I conclude that he would have fared no better on appeal than Hansen, Hemming and Amirault did. It may be surprising that the Minister allowed the deductions to the Appellant, but that fact cannot change the true legal character of the payments.

[10]          To determine whether these amounts were received on revenue account requires an examination of the true nature of the loss which they are meant to compensate.[5] The damages, whether for loss of indemnity or for loss of insurance benefits, must be considered in light of the purpose and the effect of the action in which they were awarded.[6] In this case the damages were awarded, as I have already found, in the context of the failure of the Westminer group to indemnify the Appellant in respect of the expense of litigation, and to maintain insurance that should have been available to him for that purpose. The evidence establishes that the purpose, and the effect, of that litigation was to protect and preserve the Appellant's reputation as a businessman and as a promoter of resource companies. The outlays made to conduct the litigation are therefor of a capital nature,[7] and so are the damages recovered for failure to indemnify and to insure against those outlays. The Respondent's main argument in support of this aspect of the assessment seems to be that the Appellant was permitted the deduction of amounts expended by him in the litigation in earlier taxation years. As I have already said, this fact cannot change the true character of the damage award that he received.[8]

[11]          Nor are the first and second amounts taxable under paragraph 12(1)(x) of the Act. In order to make it comprehensible, I reproduce here only the applicable words of that paragraph, omitting those which could not apply to the present case.

12(1)        There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

                ...

(x)            any particular amount ... received by the taxpayer in the year, in the course of earning income from a business or property, from

                                (i)             a person ... who pays the particular amount in the course of earning income from a business or property ...

                ...

                where the particular amount can reasonably be considered to have been received

                ...

                                (iv)           as a ..., reimbursement, ... allowance or as assistance, whether as a grant, ... in respect of

                                ...

                                (B) an outlay or expense,

                to the extent that the particular amount

                                (v)            was not otherwise included in computing the taxpayer's income, ..., for the year or a preceding taxation year,

As Teskey J. held in Hansen, supra, and as I have concluded earlier in these Reasons, the action in the Supreme Court of Nova Scotia was not brought by any of the plaintiffs "in the course of earning income from a business or property". For that reason alone, the first and second amounts do not come within paragraph 12(1)(x). Moreover, these amounts have been unequivocally characterized by the Nova Scotia Court of Appeal as damage awards, and as such they are not a reimbursement of the amounts laid out by the Appellant to fund his litigation: see Westcoast Energy Inc. v. Canada.[9]

[12]          This conclusion is also consistent with the judgment of the Supreme Court of Canada in Ikea Limited v. Canada,[10] where Iacobucci J., for the Court, said:

... Where a payment is made to a taxpayer as a reimbursement for the cost of capital property, it is to be treated as a capital receipt for tax purposes. On the other hand, a payment that is made as a reimbursement for an expense on revenue account is to be treated as income.

The second and third amounts are, as I have said, not reimbursements of expenses. They are damages for failure to maintain insurance and to indemnify. That is the characterization given to them by the Nova Scotia Court of Appeal, which is the Court having jurisdiction to make that determination.

[13]          I turn now to the third amount, which the Court of Appeal awarded as prejudgment interest. The Minister has assessed tax on the third amount, relying on paragraph 12(1)(c) of the Act.

12(1)        There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable:

                ...

(c)            subject to subsections (3) and (5), any amount received or receivable by the taxpayer in the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) as, on account of, in lieu of payment of or in satisfaction of, interest to the extent that the interest was not included in computing the taxpayer's income for a preceding taxation year;

Counsel for the Minister simply took the position in argument that the third amount is interest received in the year, and is therefore within this paragraph. For the Appellant, Mr. Harris drew a distinction between prejudgment interest awarded in a judgment for a sum owing on a contract, on the one hand, and a case, such as the present, where the prejudgment interest is on an award of damages.

[14]          The definition of interest most frequently referred to is found in the judgment of Rand J. in the Farm Security Act[11] case:

                Interest is, in general terms, the return or consideration or compensation for the use or retention by one person of a sum of money, belonging to, in a colloquial sense, or owed to, another. There may be other essential characteristics but they are not material here. The relation of the obligation to pay interest to that of the principal sum has been dealt with in a number of cases including: Economic Life Assur. Society v. Usborne (1) and of Duff J. in Union Investment Co. v. Wells (2); from which it is clear that the former, depending on its terms, may be independent of the latter, or that both may be integral parts of a single obligation or that interest may be merely accessory to principal.

                But the definition, as well as the obligation, assumes that interest is referrable to a principal in money or an obligation to pay money. Without that relational structure in fact and whatever the basis of calculating or determining the amount, no obligation to pay money or property can be deemed an obligation to pay interest.

Several cases were referred to in argument which demonstrate that an amount is not truly interest, and therefore within paragraph 12(1)(c), simply because it is called interest by the legislature.

[15]          In Huston, Whitehead and Whitehead v. M.N.R.,[12] Thurlow J. had to consider whether "interest" paid under the War Claims Regulations fell within the provisions of paragraph 6(1)(b), the predecessor to the present paragraph 12(1)(c). Those Regulations made provision for the payment of compensation to persons for loss of property as a result of World War II. The Regulations specifically provided that they conferred no right of payment; they simply gave authority to make a discretionary payment from the War Claims Fund. They also provided that "interest ... may be paid ...". After considering Riches v. Westminster Bank,[13] Glenboig Union Fireclay Ltd. v. C.I.R.,[14]C.I.R. v. Ballantyne[15] and Simpson v. Executors of Bonner Maurice,[16] Thurlow J. concluded that the real question to be decided is "... whether the amounts in question are of an income or a capital nature". He concluded that in the case before him, the amounts awarded as interest, along with the compensation, were not of an income nature and, therefore, were not interest within the meaning of section 6 of the Income Tax Act. This was so because no principal sum was owing to the Appellants at any time. They had no right to compensation, and they sustained no loss of revenue for which they could be entitled to either damages or compensation. Bellingham v. The Queen[17] is another case which demonstrates that not all statutory interest payments are received on income account. Under subsection 66(4) of the Alberta Expropriation Act,[18] the Land Compensation Board may award "additional interest" along with the compensation and interest otherwise payable, if the expropriating authority's proposed payment to an expropriated owner is less than 80% of the amount the Board awards for compensation. The Federal Court of Appeal held that this "additional interest", being in the nature of a penalty imposed on the authority, does not assume the character of income in the hands of the owner.

[16]          The Riches and Ballantyne cases illustrate that prejudgment interest may fall into either of two categories, depending on the circumstances of the case in which it is awarded. In Riches, the plaintiff contracted with Ridsdel to introduce him to a transaction whereby he could profit from a purchase and sale of shares, on consideration that Ridsdel would pay one-half of his profit to Riches. Ridsdel purchased the shares and resold them at a profit, but paid Riches less than one-quarter of his share of the profit. Riches sued for the balance once he discovered the fraud, and recovered judgment for the amount withheld by Ridsdel, together with a further £ 10,028 awarded as prejudgment interest. The House of Lords held that the interest was income subject to tax, essentially because it was given for the wrongful withholding of a debt.

[17]          In Ballantyne, an award of damages by an arbitrator included the words "with interest thereon at the rate of 5% per annum from the 4th day of November 1918, until payment". The award was made as damages arising out of the breach of a construction contract. The Scottish Court of Sessions held that the interest component, running from an arbitrary date some two years prior to the award, was in reality an additional amount of damages. It did not relate to any specific amount wrongly withheld by the defendant in the action, or a specific period during which a capital sum had been withheld.

[18]          The third amount is prejudgment interest on the first amount. It was awarded for the first time by paragraph 5 of the Order of the Court of Appeal, and it appears from paragraphs 211, 213 and 214 of the Reasons for Judgment of the Court of Appeal that the Court computed the amount of $401,891.59 on the basis of 11% interest on each of the component amounts making up the solicitor-client costs assessment[19] which was transformed by the Court of Appeal into damages for loss of indemnity, from the date each component was paid by the Appellant to August 4, 1993, the date of the final judgment of Nunn J. As to the amounts which together make up the first amount, the Court of Appeal said:[20]

[211]        In this case the right to be indemnified pursuant to the bylaw arose on the date the respondents were sued in Ontario. From that date on, the respondents were entitled to be indemnified for each expense and cost incurred as the payment was made. Although there was no way of knowing on that date the quantification of the indemnity award, it was an obligation to pay as of that date. The concept of indemnity as debt is strengthened by the following passage from Halsbury's (4th Ed.):

                "In law an action on a contract of indemnity does not normally lie until the promisee has paid the third person's claim. Where he has paid, the amount so paid constitutes a debt due to him from the promisor which save in certain circumstances, he may recover with interest in an action." (vol. 20, p. 173)

[213]       The indemnity award is a debt that is subject to the provisions of s. 41 of the Judicature Act. There is no valid reason for denying prejudgment interest on the award. ...

[214]       In this case it is necessary to award prejudgment interest on the indemnity award in order to fully compensate the respondents. Accordingly, the decision and order of the trial judge is varied to provide that interest shall be payable at the rate of 11% per annum from the date of each payment of costs and expenses included in the indemnity award to the date of the Order for Judgment, May 14, 1993. The matter of prejudgment interest on amounts assessed after that date is dealt with below in section VIII C.

These passages make it clear to me that the third amount was awarded as interest on liquidated amounts wrongfully withheld, rather than as incremental damages. It therefore has the character of income, and so falls to be taxed under paragraph 12(1)(c).

[19]          Counsel for the Appellant relied in argument upon a document published by Revenue Canada in 1998 which indicated that prejudgment interest on awards of damages for wrongful dismissal will not be considered taxable. That document refers to Interpretation Bulletin IT-365R2, which indicates that the Minister does not consider prejudgment interest on an award of damages for personal injury or death (or an equivalent amount included in a settlement agreement) to be taxable. This, however, is simply a reflection of the difference between prejudgment interest on a debt or other liquidated amount wrongly withheld, and on an award of damages assessed, as established by such cases as Riches and Ballantyne.

[20]          Paragraph 12(1)(c) of the Act taxes interest "received or receivable by the taxpayer in the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) ...". The prejudgment interest was taxed in 1994, the year of receipt. As I understood Mr. Harris in argument, he suggested that it should be taxed, if at all, in the year of accrual and not the year of receipt. As the entitlement to interest arose only upon the variation by the Court of Appeal of the judgment at trial, which occurred in April 1994, it is difficult to see how the interest could possibly have accrued before that date. The interest is computed with reference to prior years, but the right to receive it did not arise until the Court of Appeal pronounced its judgment. This is not a case such as The Queen v. Johnson & Johnson Inc.,[21] where an amount received in the year should properly be included in computing the income of prior years. Mr. Coughlan, in those prior years, had no more than a hope that when the litigation ended he would recover his expenditures, with prejudgment interest.

[21]          In any event, the Appellant has neither pleaded nor proved that he has regularly computed his income on the accrual basis for the years prior to 1994.

[22]          In the result, the appeals are allowed and the assessments are referred back to the Minister for reconsideration and reassessment on the basis that the amount of $2,992,668 received by the Appellant as damages for loss of indemnity in 1993, and the amount of $493,457 received by him as damages for loss of insurance benefits in 1994, are not subject to tax. The Appellant is entitled to his costs.

Signed at Ottawa, Canada, this 4th day of July, 2001.

"E.A. Bowie"

J.T.C.C.

COURT FILE NO.:                                                 1999-1758(IT)G

STYLE OF CAUSE:                                               Terence D. Coughlan and

                                                                                                Her Majesty the Queen

PLACE OF HEARING:                                         Halifax, Nova Scotia

DATE OF HEARING:                                           August 25, 2000

REASONS FOR JUDGMENT BY:      The Honourable Judge E.A. Bowie

DATE OF JUDGMENT:                                       July 4, 2001

APPEARANCES:

Counsel for the Appellant: E. C. Harris, Q.C. and Charles W. Demond

Counsel for the Respondent:              John Bodurtha and Marcel Prevost

COUNSEL OF RECORD:

For the Appellant:                

Name:                      E.C. Harris, Q.C. and Charles W. Demond

Firm:                        Daley, Black & Moreira

For the Respondent:                             Morris Rosenberg

                                                                                Deputy Attorney General of Canada

                                                                                                Ottawa, Canada

1999-1758(IT)G

BETWEEN:

TERENCE D. COUGHLAN,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Appeals heard on August 25, 2000, at Halifax, Nova Scotia, by

the Honourable Judge E.A. Bowie

Appearances

Counsel for the Appellant:          E.C. Harris, Q.C. and Charles W. Demond

Counsel for the Respondent:      John Bodurtha and Marcel Prevost

JUDGMENT

          The appeals from assessments of tax made under the Income Tax Act for the 1993 and 1994 taxation years are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the amount of $2,992,668 received by the Appellant as damages for loss of indemnity in 1993, and the amount of $493,457 received by him as damages for loss of insurance benefits in 1994, are not subject to tax.

The Appellant is entitled to his costs.

Signed at Ottawa, Canada, this 4th day of July, 2001.

"E.A. Bowie"

J.T.C.C.

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