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Minimum Royalties Under Section 12(1)(g)
of the Income Tax Act
One of the judicial responses to the broad sweep of section
12(1)(g)’ of the Income Tax Act has been to distinguish between
dependent periodic payments and non-dependent lump sum pay-
ments.2 Such a distinction is a difficult one to make since all pay-
ments may be considered “.dependent upon use of property” if the
words are given a wide enough meaning. A lump sum payment de-
pendent only on the right to use property falls within such a broad
concept. For example, on this reasoning, a payment for the grant
of a leasehold interest which is coupled with periodic rentals or
production payments would not be considered a capital receipt but
rather income. At the other extreme, partial payments in satisfac-
tion of an obligation fixed as to amount could be viewed as “de-
pendent” as well.3
Canadian tax jurisprudence has failed to resolve satisfactorily
the issue of whether the phrase “payments dependent upon … use
of property” extends beyond production payments4 and refers to
those dependent on the mere fact of use of property rather than on
the extent of such use. The uncertainty arises out of a failure Vo
‘Income Tax Act, S.C. 1970-71-72, c.63; formerly R.S.C. 1952, c.148, s.6(1)(j);
formerly S.C. 1948, c.52, s.6(1); formerly R.S.C. 1927, c.97, s.3(f), added by S.C.
1934, c.55, s.l. The section creates an artificial “source” of income:
“12. (1) There shall be included in computing the income of a taxpayer
for a taxation year as income from a business or property…:
(g) any amount received by the taxpayer in the year that was de-
pendent upon the use of or production from property whether or not
that amount was an instalment of the sale price of the property (except
that an instalment of the sale price of agricultural land is not included
by virtue of this paragraph) [.J”
2 See, e.g., Ross v. M.N.R. (1950) 50 D.T.C. 775, [1950] C.T.C. 169 (Ex.) per
Cameron J. (lump sum plus dependent payments up to a fixed amount); Ade
v. M.N.R. (1963) 63 D.T.C. 23, 30 Tax A.B.C. 326 per Fisher (lump sum plus
dependent payments with no ceiling); cf. Gingras v. M.N.R. (1963) 63 D.T.C.
[1963] C.T.C. 194 (Ex.) per Noel J. (dependent payments which are
1142,
instalments of a fixed sale price).
3 E.g., instalments of a fixed amount or production payments which are cut
off when an agreed upon amount has been reached.
4 The expressions “production payments” and “dependent payments” are
used as shorthand references to receipts which are brought into income by
operation of s. 12(1)(g).
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COMMENTS – COMMENTAIRES
recognize what the word “dependent” refers to in section 12(1)(g).
If “dependent” modifies “an amount received by the taxpayer”,
then the phrase taken as a whole would bring into income only
those “amounts” that are calculated by reference to the extent of
use of, or production from, the taxpayer’s property. If “dependent”
modifies “received” then any payment which is obtained for a right
to use, or produce from, property would come into ordinary income.
Two recent Canadian decisions – Lackie v. The Queen5 and
adopted the broader
Porta-Test Manufacturing Ltd v. M.N.R.’ –
reading of section 12(1) (g) while ruling on novel issues of fact.
Both taxpayers entered into transactions which required that a
minimum royalty be paid, independent of the actual extent of use
of or production from the property owned by the taxpayer. In
Porta-Test, the corporation was granted an exclusive licence to ma-
nufacture and sell the taxpayer’s product over a specified geographic
territory in exchange for a five per cent royalty. However, the con-
tract also provided that if the royalties based on actual sales did
not amount to $150,000 in the first three years, the licensee was
required to remit the difference anyway. In Lackie, the contract
provided that the user would take out “the minimum quantity of
50,000 tons of gravel”7 each year, and if less was extracted in any
year the user had to remit “the difference in value between the
quantity actually removed and the quantity stipulated to be re-
moved”.”
Payment arrangements such as these have been the object of
litigation for some time. In Hoffman v. M.N.R.,9 the taxpayer had
sold all of his marketable standing timber for $8,400. The Minister
argued that the payment was for a profit & prendre and was there-
fore income by operation of section 12(1)(g). Mr Weldon rejected
the Minister’s interpretation of events only because a profit & pren-
dre denotes “a continuing activity –
one that goes on from year
to year”. 0 In Mr R. v. M.N.R.” a fixed amount of cash received for
the sale of a pharmaceutical invention was treated as a capital re-
ceipt while the percentage royalty was classified as income.’2
(1978) 78 D.T.C. 6128 (F.C.T.D.) per Dube J.
(1977) 77 D.T.C. 222, [1977] C.T.C. 2279 (T.R.B.) per St-Onge.
7Supra, note 5, 6129.
8 Ibid.
0 (1965) 65 D.T.C. 617, 39 Tax A.B.C. 220 per Weldon.
10 Ibid., 623.
11 (1950) 50 D.T.C. 398, 2 Tax A.B.C. 364 per Monet and Fisher.
12Income War Tax Act, R.S.C. 1927, c.97, s.3(f), added by S.C. 1934, c.55,
which is similar in language to the present s. 12(1)(g).
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The taxpayer in Pacific Pine Co. v. M.N.R. 13 also sold a right to
cut timber on land he owned, but the contract provided for a mi-
nimum payment which was subject to refund if less than the
amount of timber paid for had actually been cut. In Hazlett v.
M.N.R. 14 and Randle v. M.N.R. 15 the receipt of damages or com-
pensation for the removal of clay and injury to land was held to be
a capital transaction. 16 In contrast to the Pacific Pine Co., Hazlett
and Randle cases, Huffman v. M.N.R.’ 7 held that the sale of a mine
for the fixed sum of $25,000, to be computed out of the mine work-
ings on a percentage basis, gave rise to income under section 12(1)
(g). Mr Fisher reasoned that the use of a ceiling on production pay-
ments was not sufficient to bar the application of the section.’8
These decisions emphasize the form of payment and have not
provided an adequate basis upon which to predict the treatment of
minimum royalties. The issue has been obscured by an earlier line of
cases led by M.N.R. v. Lamon;’9 the Lamon decision suggests that the
mere transfer of a right to use property is itself a “use of property”,
as the phrase is employed in section 12(1) (g), and therefore any
payment in exchange for the “right to use” the property will be in-
come and not a capital receipt. Mouat v. M.N.R.20 expands this inter-
pretation, ruling that payments for even the “slightest use” of the
“right to use” will be income. Thus the logical extension of the
Lamon and Mouat decisions is that the extent of use of the property
‘3 (1961) 61 D.T.C. 95, 26 Tax A.B.C. 41 per Fisher.
14 (1965) 65 D.T.C. 511, 39 Tax A.B.C. 54 per St-Onge; see also Corrigan v.
M.N.R. (1965) 65 D.T.C. 513, 39 Tax A.B.C. 52 per St-Onge; Salt v. M.N.R. (1951)
51 D.T.C. 14, 3 Tax A.B.C. 180 per Fisher and Monet.
15 (1965) 65 D.T.C. 507, 39 Tax A.B.C. 46 per St-Onge.
16 Cf. Rebus v. M.N.R. (1953) 53 D.T.C. 1237, [1953] C.T.C. 452 (Ex.) per
Cameron J., who held that payment in compensation for royalty arrears
on a blown well that was put under government control fell within the then
s.6(1)(j).
17 (1954) 54 D.T.C. 383, 11 Tax A.B.C. 167 per Fisher.
18 Arrangements for participating royalties up to a fixed amount do have
tax avoidance overtones. For example, payments to a company president
for his copyright on a sales catalogue were to be equal to 3.5% of the cor-
poration’s gross sales therefrom until $200,000 (reduced from $1.5 million)
was reached. Noel J. held that s. 12(1)(g) would still apply because the
total sale price was fixed in an arbitrary manner and without any apparent
regard to the value of the asset (Gingras v. M.N.R., supra, note 2).
19 (1963) 63 D.T.C. 1039,
[1963] C.T.C. 68 (Ex.) per Cameron J.; see also
Mouat v. M.N.R. (1963) 63 D.T.C. 548, 32 Tax A.B.C. 269 per Fisher; Ladouceur
v. M.N.R. (1968) 68 D.T.C. 771, [1968] Tax A.B.C. 1057 per St-Onge.
2oSupra, note 19.
19781
COMMENTS – COMMENTAIRES
owned by the taxpayer is irrelevant so long as a “right to use” has
been granted.”
The simple fact that the purchaser will have acquired some right
of use over property – whether by itself or as an attribute of a
larger interest in the property –
should not transform payments
that would otherwise be capital receipts into ordinary income.
Unfortunately, the jurisprudence has left the issue unsettled, and
now the Porta-Test and Lackie decisions indicate that section 12(1)
(g) may be given a broader scope of application than was intended. 2
In both Porta-Test and Lackie, the crucial point was the lack of
an apparent intention to dispose of a capital asset for a lump sum
payment, although the parties evidently intended to do so for at
least an agreed amount in participating royalties. While the crucial
contract term is not set out in Porta-Test, it is apparent that Mr St-
to the parties’ charac-
Onge attached considerable
terization of all of the payments as “royalties”:
importance
Nowhere is mention made in the document of the lump sum payment
for an exclusive right. On the contrary, there are many mentions of
royalties and the document does not state a minimum payment but a
minimum royalty of $150,000.23
In addition, one of the corporation’s employees testified that the
purpose of the clause was to ensure that the licensee would actively
exploit the product..2 4 Mri’St-Onge interpreted the testimony as
supporting his conclusion that all of the payments were ordinary
income. This overlooks the fact that the character of the payment
was not important to the licensee and an obligation to pay $150,000
would provide an incentive to recover the investment. Viewing it as
a royalty rather than a payment would not affect that incentive.
In Lackie v. M.N.R.,25 clause 3 of the agreement characterized
the contract as a “lease” stipulating five annual payments of $10,000,
with an offset of $0.20 per ton of gravel removed. Clause 4 provided
that if the value of the gravel removed exceeded the amount of the
minimum sum payable, the value of the gravel removed would be
due. Under this arrangement the taxpayer received a total of $50,000
21 Apparently it does not matter whether the “right” which is transferred
is a proprietary or nonproprietary interest. See Jackson, Principles of Pro-
perty Law (1967), 28.
22 This would be especially true if the cases are viewed in light of the
form of the payments in question rather than the contractual terms giving
rise to them.
23 Supra, note 6, 224 [emphasis added].
24 Ibid., 223-24.
2: Supra, note 5.
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whereas only $28,000 worth of gravel was removed. The taxpayer
argued that receipt of an amount for granting a “right to use” the
property by removing gravel is not receipt of an amount which was
“dependent upon the use of or production from property”2 as re-
quired by section 12(1) (g).
In short, the case turns on the meaning of “dependent” as it is
used in section 12(1) (g). If “amount received …
that was dependent
upon the use of … property” encompasses any consideration for a
right of use, then the receipts should be treated as ordinary income.
If the language requires that the amount received be dependent
upon the extent or frequency or nature of the use of property, then
the payments in question should not be included in ordinary income
unless they fall within the common law concept of “income from
property”, such as rental income. The definition of the word “de-
pendent” in The Shorter Oxford English Dictionary indicates that
the meaning of the phrase is more consistent with the second in-
terpretation –
that the amount will be income only if it is de-
pendent on the extent, frequency or nature of use. “Dependent” is
defined as “having its existence contingent on, or conditioned by,
that of something else”. 7
This issue has never been fully appreciated in Canadian juris-
prudence, although obiter dicta in a few cases have touched upon it.
In the leading case of Orlando v. M.N.R., the majority of the Su-
preme Court held that amounts received for topsoil sold in small
lots and in one large lot were income from a “scheme of profit-
making”28 or an adventure in the nature of trade, thus obscuring
the section 12(1)(g) issue. However, Mr Justice Cartwright, in a
dissenting opinion, interpreted the section as catching payments
for profits ii prendre but not capital payments:
[T]he payments of $2 per cubic yard of top soil … were payments for
the granting to the company of a licence, analogous to a profit &i prendre,
permitting it to enter the lands of the appellant and take therefrom for
its use a portion of the soil subject to payment therefor at the price
agreed: from this it follows that the amounts so paid constituted taxable
income of the appellant as being amounts received by her from the use
of her property but not as profits from a business.2 9
Although this passage suggests that the consideration is for the
“right” of removal, the true character of the payment is described
2, Ibid., 6132.
27 The Shorter Oxford English Dictionary 3d ed. (1973), vol.1, 521.
28 (1962) 62 D.T.C. 1064, 1068, [1962] C.T.C. 108, 116 (S.C.C.) per Abbott J.,
Cartwright J. dissenting.
29 Ibid., 1069 [emphasis added].
1978]
COMMENTS – COMMENTAIRES
by contract as “payment [for the removal of soil] at the price
agreed” or as depending in quantum on the amount of soil taken.
Thus the further description of the amounts received as being “for
the use of her property” is overly broad and imprecise; the amount
is determined by the extent of use.
A similar understanding of the meaning of “dependent” is dis-
in which the taxpayer agreed to
played in Morrison v. M.N.R.,”
sell rock to a contractor for $0.025 a ton, but the parties later agreed
to an amount based on an approximation of the quantity taken.
in satisfaction of the
Thurlow J. held that the sum received,
taxpayer’s contractual rights, was paid in settlement and not as a
dependent amount. In addition, he was of the opinion that even if
the payments were for the material itself, the section still could not
apply:
[The amounts] were not dependent upon the quantity taken, since this
never was ascertained and … dependence upon the extent or quantity
of production or use and the application thereto of some rate or standard
appears to me to be an essential qualification of amounts which fall to
be taxed under section 6(1)(j).3 1
In the Lackie decision however, unlike Morrison, the amount
paid was determined by contract –
not settlement plus property
damages. Thurlow J. chose to infer that a substantial portion
of the settlement was attributable to the damage done to the tax-
payer’s property. However, he did express the view that even if the
remittance was based on an approximation, it might have been
“in lieu of payment of, or in satisfaction of” 32 dependent amounts
since it encompassed:
… the unknown quantity of rock in respect of which he was entitled to
payment at the rate of 2t1 cents per ton but had no way of knowing
what that would amount to or whether it would be more or less than
the losses which the removal of the rock entailed. 3
However, he pointed out that the words “in lieu of .. .” had not been
employed to extend the scope of section 12(1)(g). Since the tax-
payer had contracted for a minimum payment of $50,000 which
would be received whether or not any rock was actually extracted,
the parties must have contemplated that a large, though unknown,
quantity would be removed. Since the key feature of Morrison is
the indeterminate amount of material to be extracted, it is possible
30 (1966) 66 D.T.C. 5368, [1966] C.T.C. 558 (Ex.) per Thurlow J., rev’g (1965)
65 D.T.C. 25, 37 Tax A.B.C. 164.
3166 D.T.C. 5372; [1966] C.T.C. 564.
32 Ibid.
33 Ibid.
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to compare the two cases on that basis even though the legal
obligation to pay arose under a contract in Lackie and was based
on liability for damages in Morrison.
Lackie and Porta-Test should have been decided on the basis
that the extent or quantity of use under the contract was unknown,
and even though the minimum royalty may have been fixed in
anticipation of the approximate extent, the amount of the payment
was not contingent or dependent on that approximation. The scope
of section 12(1) (g) – which is broader than it need be in any event
should not be extended to cases in which it is not clearly applic-
–
able. Where the taxpayer is able to show that his or her characteriz-
ation of the source of the payment is consistent with the essence
of the transaction, that explanation should be sufficient to exclude
the application of the section. In both Lackie and Porta-Test, the
transactions in question involved the grant of an exclusive licence in
exchange for a fixed sum and a participating royalty, subject to
the fulfilment of certain specified conditions 4
The shortcoming of these two decisions, particularly Lackie, is
their reliance on the reasoning in Mouat v. M.N.R3 and M.N.R. v.
Lamon,36 even though the Lamon case was expressly rejected in the
later Morrison case. In defence of these two decisions, however, it
should be noted that there is no overriding principle to assist the
courts in their application of this particularly troublesome statutory
provision. Section 12(1)(g) was formulated
to reverse the tax
consequences of cases in which capital property was exchanged for
a participating interest 3 7 but the language employed was far broader
than was needed, with no discernible limit. Despite pleas to reform
the provision,38 the government has not responded. Thus decisions
such as these will undoubtedly become more frequent in the future.
Kathleen A. Lahey*
34The obvious weakness of this view is that some cases have held that a
fixed capital sum will be transformed into income when paid in the form of
participating payments. See, e.g., Ross v. M.N.R., supra, note 2.
s5 Supra, note 19.
36 Ibid.
37 See Spooner v. M.N.R. (1931) 1 D.T.C. 211, 213, [1928-34] C.T.C. 178 (S.C.C.),
aff’d (1933) 1 D.T.C. 258, [1928-34] C.T.C. 184 (P.C.).
38 See, e.g., Dickerson, “Tax Accounting v. Financial Accounting” in (1974)
25 Tax Conf. Rep. 343, 345: “Perhaps the most obvious candidate for deletion
from the Income Tax Act is paragraph 12(l)(g), the notorious ‘production or
use’ provision. This rule is so unconscionably harsh and unnecessary that it is
probably irrelevant that it is also out of accord with accounting principles.”
* Associate Professor, Faculty of Law, University of Windsor, Windsor,
Ontario.
