tax treatment of damages and settlement amounts · pdf filetax treatment of damages and...

TAX TREATMENT OF

DAMAGES AND

SETTLEMENT AMOUNTS

JOHN SORENSENMarch 9, 2017

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Damages and Settlement Payments

Damages are money payable to a personas compensation for injury suffered

Chamberlain v. The North American Accident InsuranceCo., 1916 CanLII 334 (AB CA), at p. 301

In this presentation, I treat damages andsettlement payments synonymously

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Why tax matters

• Income Tax Act (Canada) (“ITA”) does not set outcode for taxation of damages: tax results aregoverned by general provisions and case law

• Tax treatment depends on characterization ofamount

• Receipt may be fully or partially taxed, or nottaxed at all

• A payment may be fully deductible or not• Tax treatment should be considered from outset

of civil action: to assess tax, revenue authoritymay rely on position taken in action by party

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Why tax matters

• Practice points• As a litigator, confirm in writing with

your client that you are not providingtax advice

• Connect client with tax counsel orobtain instructions to retain counsel foradvice

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Overview

1. Employment Law

2. Personal Injury

3. Commercial Litigation

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Employment Law & Dismissals

• Query whether worker was employee orcontractor in business on her ownaccount• General principles:

• was there an agreement;• control over the worker;• ownership of tools;• chance of profit; and• risk of loss

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• Key concept in this area: retiringallowance

• Taxable under ITA subpara. 56(1)(a)(ii)• not including an amount received

under an employee benefit plan, aretirement compensation arrangementor salary deferral arrangement

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• Retiring allowance defined in ITA ss.248(1): an amount received on or afterretirement from office or employmentrecognizing long service; or in respect ofloss of office or employment, whether ornot received as or on account ofdamages

• Not including pension/death benefit orcounseling service to employee

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• Inclusions:• Unpaid sick leave likely retiring

allowance• Unpaid accumulated vacation time

likely not

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• Planning opportunities• Retiring allowance taxed when

received, so spreading payments overtime could reduce tax at top marginalrate – may be bargaining chip insettlement

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• Rollover to RRSP/RPP• Transitional rules make this confusing,

but employees with years of servicebefore 1996 may transfer part ofretiring allowance directly to anRRSP/RPP (“eligible portion”)

• Non-eligible piece can be transferredto if there is contribution room

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• Consider also apportioning amongstheads of damage – amount may bepartially: retiring allowance, tortdamages, punitive

• T4A reporting and withholding to extentof any taxable amount (not transferredto RRSP/RPP)

• Withholding can waived if both payerand recipient agree and sign form

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• Speaking of tort damages andemployment

• Compensation for defamation or humanrights violation likely not taxable

• Challenge: will employer admit insettlement documents to bad acts?

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• Further challenge: how to benchmarkthe defamation or human rights amount?• Possible to use # of months of service• Using income as benchmark doesn’t

necessarily make compensation “income”

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• Apportionment of amounts determinedby the CRA or Tax Court in accordancewith their “true character”

• Apportionment must be reasonable andsupported – fact driven exercise

• Nonetheless, way pleadings orsettlement/release documents arewritten may be persuasive since draftingreflects parties’ intentions

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• Characterization of Amounts• Ahmad case as example• Sued Ontario Hydro for breach of employment

agreement• CRA called general damages retiring

allowance• Tax Court said “no” – general damages were

for Ontario Hydro ruining his career• Taxpayer stood his ground, lost his career and

consequently self-respect and dignity• General damages compensated for that

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• Characterization of Amounts• University dean who was passed over

for teaching position for whichqualified

• Sued and received damages• CRA called it retiring allowance• Tax Court held it was for loss of future

position and untethered from deanrole

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• Query also whether plaintiff was everemployed• Schwartz SCC• Accepted corporate job and quit law

practice• Company withdrew the offer and paid

$400k for release• SCC held not ss. 248(1) retiring

allowance

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• ITA subpara. 56(1)(a)(ii) did not providefor tax on settlements for loss ofintended employment

• General charging provision in s. 3 notapplicable, because general provisiontrumped by specific retiring allowanceprovision

• Taxpayer never employed so no nexusbetween settlement and employment

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• Legal fees incurred to obtain retiringallowance may be deductible (morespecifically, reimbursement of feestaxable under ITA ss. 56(1)(l.1) butdeductible under ss. 60(o.1)

• Any allocation of damages/settlement toreimbursement of legal fees must besupportable, not fanciful

• If you lose – see para. 8(1)(b) deduction

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• Pre-judgment interest• Tracks tax treatment of underlying

amounts• Interest non-taxable to extent award

not taxable

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Overview

1. Employment Law

2. Personal Injury


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Personal Injury

• General ITA rules and case lawprinciples apply to deduction/inclusion

• Special and general damages non-taxable

• Special - typically out of pocketexpenses (e.g. medical) or accrued andfuture lost earnings

• General – pain and suffering, loss ofamenities of life, loss of earning capacityetc.

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Personal Injury

• Whether damages based on accrued orlost future earnings could becharacterized as employment income isa question of fact

• But typically even if damages measuredby lost income, should not be taxed

• Again, accrued interest attributable tonon-taxable aware would be non-taxable

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Personal Injury

• Cirella case (FCTD 1978)• CRA determined compensation for

loss of earnings was taxable• Court held that commercial case law

not applicable – injured person not adamaged business asset

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Personal Injury

• Forest case (FCA 2007)• Sued employer for damages for

harassment ($100k “moral” damagesand $100k exemplary) for violating hisfundamental rights including tohonour, respect, dignity andreputation, by continuously harassinghim

• Received $152k to abandon his suit

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Personal Injury

• Forest case (FCA 2007)• CRA assessed based on retiring

allowance• TCC agreed• FCA held that only $23k was in

exchange for voluntarily leavingemployment, pursuant to employer’spolicy so the rest was non-taxable

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Personal Injury

• Forest case• Moral to the story – he lost at trial it

seems because he argued that all ofthe settlement was for harassmentand TCC judge could not agree

• Arguing apportionment would havebeen more advisable?

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Personal Injury

• Mathew (TCC 2012)• Allocation/characterization needs to

be supportable• Don’t want a court to describe a

settlement as “an attempt tocamouflage substantial amounts ofincome … received for work … as taxfree damages for pain and suffering.”

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Overview

1. Employment Law

2. Personal Injury


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Commercial Disputes - Recipient

• At high level/general rule: tax treatmentof an amount tracks treatment of thingthat was lost

• Compensation for lost income incommercial context typically taxed asincome

• Compensation for loss of, or damage to,capital property likely capital receipt

• Surrogatum principle

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• Can be confusing because againcompensation for loss of an incomeproducing asset could be calculatedusing lost income as benchmark, but stillbe capital receipt

• As very loose guideline, considertree/fruit analogy• Tree is capital asset producing fruit• Fruit is income

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• Is compensation for loss of tree orproduction from tree (i.e. income)

• As noted above, amounts in commercialcontext may be categorized as either:• Paid for purpose of gaining or producing

income (fully and currently deductible)• Paid on capital account (not deductible on a

current basis but capital cost allowance)• Eligible capital expenditure (deductible in

accordance with specific ITA provisions)

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• In reality, capital gain treatment is mostlikely

• Not surprisingly, punitive damages nottaxable as not tethered to either capitalasset or lost income

• Planning opportunity• As with other types of damages, in

commercial context considerallocation between heads of damage

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• Important that pleadings / court order /settlement document be explicit• As always, allocation needs to be

reasonable and supportable• Consider also symmetry between how

the payer and recipient would treatamount(s)• Inconsistent treatment may be

challenging to justify to CRA

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• Pre and post judgment interest taxable• Unless interest connected with a non-

taxable receipt

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Commercial Disputes - Payer

• Payer’s perspective• Outlays may be fully deductible or

capital expenditures• Key provisions s. 9 and paras.

18(1)(a) and (b)

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• Payer’s perspective• Subsection 9(1) first queries whether

claiming deduction was consistentwith “ordinary principles ofcommercial trading or well acceptedprinciples of business”

Symes SCC 1993

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• Beyond that general test:• 18(1)(a) limits deductibility of outlays

except to extent made or incurred forpurpose of gaining or producingincome from business or property

• 18(1)(b) limits deductibility of outlaysin respect of loss or replacement ofcapital, obsolescence or depletionexcept as expressly provided for in ITA

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• Payer’s perspective• Full deduction likely where damages

paid as result of event incidental tonormal course of business or whereconnected with inherent risk ofbusiness

• Where payment is capital in nature,deduction over time for capital costallowance

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• Assets from which income derives:enduring benefit concept

• Enduring benefit means more thanbenefit derived from a long-lived asset

• Could also mean a benefit arising froman expenditure associated with breakinga long-term lease or contract

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• Payer’s perspective• Punitive damages likely deductible if

incurred for purpose of earning incomefrom business or property

• Query whether public policy would barthis

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• McNeill (FCA) extended 65302 (SCC –deductibility of fines & penalties)

• Breach of contract was intentional anddamage deliberate, but bad acts werefor purpose of earning income frombusiness, thus deductible

• Still possible acts could be so repulsivethat they could be disconnected frompurpose of earning income

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The end

John SorensenPartnerNational Tax Practice Group Leader

[email protected]

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