Monday, 4 May 2015

Tax Rates, Timing and Damages

The deadline for most individuals in Canada to file their income taxes is today, so I thought I would post on the issue of damages and taxation.

In Canada, as a general rule, damages awards are subject to the same tax treatment as the monetary amounts they are meant to replace. For example, awards for lost profits are taxed as business income.[1] Litigation can often take a long time to resolve; some lawsuits span decades. What happens when the tax system undergoes significant changes between the year the lost profits would have been earned and the year in which the damages award is paid?

In Canada, corporate tax rates have fallen significantly in recent years. The following chart shows the combined corporate tax rate for income earned in Ontario for income not subject to the small business deduction. Rates have fallen from slightly over 50% in the 1960s to under 30%. This can have a significant impact on damages calculations:

Consider the case of Eli Lilly and Company v. Apotex Inc.,2014 FC 1254. Apotex was found to have infringed Eli Lilly’s patents for the drug cefaclor; after many years, in late 2014 the court awarded Eli Lilly approximately $31M in damages resulting from the infringement over the period 1997 to 2000.

There is no discussion of income taxes in the written decision, and it is not clear if the issue was raised at trial. I refer to this case simply to illustrate the concept, and impact, of differential tax rates.

Had Eli Lilly and its Canadian subsidiary not been deprived of their lost profits in the period 1997 to 2000, they would have paid an average income tax rate of roughly 35% for sales made in Ontario; rates were similar in most other provinces. By comparison, on receiving its damages award in 2014 or 2015, Lilly will pay taxes at a rate of around 26.5%, a differential of 8.5%.

Had Lilly earned the profits in question in the period 1997 - 2000, its after-tax profit would have been $31M x (1-35%) = $20.15M. Receiving the same profit in 2014, the after-tax value is$2.64M higher. This is a factor that should have been taken into consideration in assessing, (and reducing) Lilly's losses.

Stated otherwise, had the court wished to give Lilly an award in 2014 that would equate to $20.15M in after-tax dollars (the amount of after-tax profit it would have received in 1997-2000), the award should have been $27.4M, or $3.6M less than the actual award ($27.4M x (1-26.5%) = $20.15M).

Considering that prejudgment interest of $75M was also awarded on the damages assessed - and I will return to this spectacular prejudgment interest award in future posts - the issue of declining tax rates likely represented a $10M issue in this case.

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