In River Hills Ranch Ltd. (et al.) v. The Queen (2013 TCC 248), the Tax Court of Canada (Tax Court) examined the principles of contract interpretation and concluded that certain contractual payments made to the taxpayer were merely “dressed up” by the payer as an allowance for certain operating expenses; in fact, they were compensation for the destruction of the taxpayer’s business. Accordingly the payments were not taxable income (as contended by the Crown), but rather generated a capital gain for the taxpayer under the surrogatum principle. In reaching these conclusions, the Tax Court usefully clarified the principles of contract interpretation:

  • The starting proposition is that a contract is to be interpreted having regard to the words actually used (see paragraph 36, often called the parole evidence rule). The theory is that when parties reduce their agreement to writing, they intend what they actually say and the contract embodies their entire agreement. There are, however, two important qualifications.
  • The first applies where the words of the contract are ambiguous. Extrinsic evidence – i.e., material beyond the words of the contract – can be considered to dispel such ambiguities (see paragraph 37).
  • The second qualification does not require ambiguity. The “objective contextual scene” in which the contract was made can always be considered (see paragraph 42). The theory is that no contract is made in a vacuum: there is always an objective setting in which the contract must be placed. The latter consists of the background, the context, the market in which the parties were operating, the genesis and purpose of the transaction, and the parities’ subsequent actions (see paragraphs 42, 43, and 52).