May 18, 2020
In one of our earlier alerts, we commented that the inevitable disruption to businesses begs the question of what the legal repercussion would entail to the failure of performing existing contractual obligations. Businesses may want to take a look at their force majeure clauses, which often exist to protect parties from the inability to fulfil contractual obligations due to supervening events.
Alternatively, businesses may wish to explore whether the doctrine of frustration applies to their contract, in which case pursuant to Section 57(2) of Contracts Act 1950, the contract is terminated.
Whichever route is taken including an amicable settlement, it is likely to involve some aspect of compensation. This alert discusses the tax treatment of compensation received.
Destruction Of Profit Making Apparatus
The Van Der Berghs Ltd case sheds light on the most fundamental position in determining whether the compensation sum is a capital receipt. An English company carried on a very extensive business as a manufacturer of margarine and other substitutes for butter. The company then entered into an agreement with its trade rival, a Dutch company to share profits and losses in the proportion which, on the average of five years, the profits of the rival’s tradings in margarine bore to each other.
Subsequently, a dispute arose, and the Dutch company had to pay the English company a sum of £450,000 as damages. It was ruled that the compensation sum was in the nature of a capital asset and not an income receipt to be included in computing the profits of the trade of the English company.
The court reached its conclusion by considering what exactly the taxpayers were giving up? In this regard, the following passage is instructive:
“Now what were the Appellants giving up? They gave up their whole rights under the agreements for thirteen years ahead. These agreements are called in the Stated Case ‘pooling agreements’, but that is a very inadequate description of them, for they did much more than merely embody a system of pooling and sharing profits. If the Appellants were merely receiving in one sum down the aggregate of profits which they would otherwise have received over a series of years, the lump sum might be regarded as of the same nature as the ingredients of which it was composed.”
In ruling that the compensation received by the taxpayer was a capital receipt and not a part of its trading income, the court added:
“The three agreements which the Appellants consented to cancel were not ordinary commercial contracts made in the course of carrying on their trade; they were not contracts for the disposal of their products… On the contrary, the cancelled agreements related to the whole structure of the Appellants’ profit-making apparatus. They regulated the Appellants’ activities, defined what they might and what they might not do, and affected the whole conduct of their business.”
“The agreements formed the fixed framework within which their circulating capital operated; they were not incidental to the working of their profit-making machine but were essential parts of the mechanism itself. They provided the means of making profits, but they themselves did not yield profits.”
Application In Malaysia
The Van Der Bergh principle has been adopted in Malaysia, including in the recent Toxicol Sdn Bhd case. Toxicol Sdn Bhd (Toxicol) was specifically incorporated for the purpose of executing a contract dated 1.10.1999 between Toxicol and Kualiti Alam Sdn Bhd (1999 Agreement).
Consequently, as a result of the takeover by Khazanah, a new management took over Kualiti Alam Sdn Bhd. The events which took place after the takeover by Khazanah caused Toxicol to be frustrated. Thus, Toxicol has no choice but to surrender the 1999 Agreement with Kualiti Alam Sdn Bhd. On 7.2.2005, Toxicol and UEM Environment Sdn Bhd entered into an agreement for the novation of contract (Novation Agreement), pursuant to which, Toxicol transferred all its rights and liabilities under the 1999 Agreement to UEM Environment Sdn Bhd. Toxicol received compensation of RM23,000,000.
The Inland Revenue Board disputed Toxicol’s claim that the RM23,000,000 received was capital in nature. The Special Commissioners of Income Tax (SCIT) held that the sum of RM23,000,000 was a revenue receipt and thus was subject to income tax. Consequently, Toxicol’s appeal to the High Court was successful, where it was held that the SCIT had committed an error of law and fact. The High Court’s decision was affirmed by the Court of Appeal. In arriving at the decision that the compensation received by Toxicol is capital in nature, the High Court found that Toxicol lost its business rights and its business structure was crippled and came to an end pursuant to the Novation Agreement. Accordingly, the compensation received could not be regarded as compensation for loss of income.
Filling The Hole Of Trading Profits
In the London & Thames Haven Oil Wharves Ltd case, the taxpayer, among others, received damages from the owners of the tanker who damaged the jetty owned by the taxpayer. The negligent act caused physical damage to the taxpayer’s jetty and prevented the taxpayer from using the jetty for the purposes of trade for 380 days. Consequently, the taxpayer suffered losses, including the amount that would have been received from customers for the use of the jetty, less expenses, during the 380 days while the jetty was out of use. The taxpayer received compensation amounting to approximately £21,000. The court held that this compensation was taxable as it was received for loss of income. It was held that:
“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 charter-party, 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.”
Summary
It appears that the compensation sum will only be treated as capital receipt based on the following contemplations:
The compensation is paid to the taxpayer for giving up its whole rights under the agreement.
The agreement did much more than merely embodying a system of pooling and sharing of profits.
The agreement is not an ordinary commercial contract made in the course of carrying on a trade or a contract for the disposal of products.
Termination of the agreement relates to the whole structure of the taxpayer’s profit-making apparatus and leads to the destruction of the taxpayer’s business apparatus.
The agreement is deemed to relate to the taxpayer’s “profit-making apparatus” when it regulates the taxpayer’s activities, defines the ‘dos’ and ‘don’ts’ by the taxpayer’s business and impacts the whole conduct of the taxpayer’s business. The agreement forms the fixed framework of the business – it is not merely incidental to the working of the profit-making machine but was an essential part of the mechanism itself.
The agreement provides the means of making profits but does not itself yield profits.
Proper documentation aspects will help taxpayers to identify the legal source for the compensation in the determination of the nature of the compensation.