You have recently been successful in litigating a complex commercial action on behalf of a client. Time passes and the facts of the case slowly fade from memory. After several months, your client unexpectedly calls you with an urgent matter – “Do I have to pay tax on the damage award? How should I report it on my tax return?” In the months (or years) leading up to the trial, your focus has been winning the case. The taxation of any damages ultimately awarded is a question that was viewed as largely academic in the face of trial preparation.
Now the thrill of victory has all but disappeared, and your client wants to know “what can you do for me now?” They would like the answer quickly, as they left their tax filing to the last minute, and they really want you to get back to them with the answer “Don’t worry, it’s tax free.”
This scenario is, unfortunately, fairly common. By understanding the principles behind the taxation of damage awards/settlements, one can be in a better position to address this issue proactively. By determining the likely tax treatment of a damage award, a litigant is better able to value the claim or determine whether a settlement offer is acceptable.
One ‘housekeeping’ item to note is that there is little differentiation between taxation of damages and taxation of settlement proceeds. The principles used to determine one are equally applicable to the other.
Surrogatum Principle The common law “Surrogatum Principle”, with a few statutory exceptions, governs the tax treatment of damage awards/settlements. This principle directs a taxpayer to consider what the payment was intended to replace and to then determine the tax treatment of the replaced amount. Unlike many other areas of tax law, the Surragatum Principle is not a detailed set of rules. Rather, it attempts to characterize the original loss and then tax the subsequent payment in a manner consistent with the Income Tax Act (the “Act”).
A recent development to the Surrogatum Principle is that one must also consider the relationship of the payor and payee. Tesainer v. R. [2009] 3 C.T.C. 109 (FCA) was a case dealing with the tax treatment of settlement proceeds that were paid to former partners of a limited partnership by a law firm to settle a negligence claim. The law firm had allegedly given negligent advice to the limited partnership resulting in its eventual financial collapse and dissolution. The Court found that the settlement did not attract capital gains tax, even though such payment was economically similar to a distribution of partnership capital. Despite the amount being paid to reflect a reduction in the value of the limited partnership, the Court found that to treat the receipt of settlement proceeds as a return of capital would be stretching the Surrogatum Principle too far. The settlement proceeds were received from a law firm that gave the limited partnership negligent advice, therefore such a payment cannot be characterized as a return of capital.
While the Surrogatum Principle continues to evolve, it has been sufficiently developed to allow for some generally accepted practices when dealing with certain types of damages:
A) Damages related to personal injury/death Generally such damage awards are not taxable, except to the extent that they are specifically related to income from an office or employment (i.e. an award to reflect unpaid time off from work resulting from the injury). Interest on such awards is only taxable to the extent that interest is earned on amounts held in trust. An award of interest in a personal injury/death case is not taxable.
There are statutory provisions (paragraphs 81(1)(g.1) and (g.2) of the Act) which provide a further tax exemption from tax on income earned from property received by an individual under 21 years of age as a result of personal injury. A taxpayer loses this exemption in the year following their 21st birthday. If such proceeds are invested until a child reaches the age of 21, the proceeds will grow tax-free.
B) Damages for breach of contract In breach of contract claims, the specific nature of the loss for which compensation is given determines the taxation consequences. If compensation is awarded with respect to a loss of a capital asset, such as a fishing boat, the award would be taxed as a capital receipt. Any amounts awarded, however, for loss of income arising from the loss of the fishing boat would be taxed as business income. Care should be taken to ensure the method of calculating damages is not mistaken for the basis upon which the damages were awarded. For example, the value of a capital loss may be determined by calculating the loss of future income resulting from such loss. Even though future income was considered in the determination of damages, it does not change the fact that damages were awarded on account of the loss of a capital asset.
A recent Federal Court of Appeal case, Goff Construction Ltd. v. R.[2009] 3 C.T.C. 101, has provided some clarification on the Surrogatum Principle. In Goff, the taxpayer made various expenditures of a capital nature which, by virtue of paragraph 20(1)(cc) of the Act, were deducted as current expenses. In the course of an action relating to such expenditures, the taxpayer received settlement proceeds, which were reported as receipts of capital. The position taken by CRA, and supported by the Court, was that notwithstanding the capital nature of the initial payment, as the taxpayer was entitled to deduct the payment as a current expense the reimbursement of the expense should be treated as income. It is therefore not sufficient to merely determine the nature of the loss and reimbursement, but one must also consider the impact of any specific taxing provisions.
Another illustrative example of this concept can be found in situations involving RRSPs. Typically such investments are of a capital nature, and therefore any amounts paid with respect to the wrongful devaluation of an RRSP could reasonably be considered to be on account of capital. The special tax status of RRSPs, however, requires that any damages paid in respect thereof be treated differently. If such an award is paid directly into the RRSP, the award would not be taxable until drawn from the RRSP. If the award is paid directly to the individual, the award would be taxable as income. The taxation of damages in this case mirror the taxation of an RRSP, as opposed to simply being based on an income/capital dichotomy.
C) Crime Compensation AwardsReceipts of this nature are generally not taxable. Some exceptions to this general rule involve situations where an employee receives compensation from his/her employer in an amount which exceeds a fair evaluation of the damages suffered by the employee, or if the amount relates to compensation for loss of earnings.
D) Termination of Employment As such payments are generally made pursuant to an employment contract, they are taxable under sections 5 and/ or 6 of the Act. Alternatively, such payments may fall within the definition of the expression “retiring allowance”, and as such would be taxable under subparagraph 56(1)(a)(ii) of the Act.
E) Punitive damages As these damages are intended to punish as opposed to compensate, the receipt thereof is viewed as being equivalent to receiving a gift, and therefore not taxable.
F) Aggravated/Exemplary DamagesUnlike punitive damages, aggravated and exemplary damages are intended to compensate a plaintiff. Such damages are typically taxed in a manner consistent with the underlying damages to which they relate.
Taxation of Damages on Account of CapitalIf an amount is determined to be on account of capital, the particular tax treatment of such payment still must be determined.
In some instances awards/settlements may be treated as proceeds of disposition if the receipt relates to a disposition of a capital property. In other situations however, a receipt on account of capital may reduce capital cost pool, or have no associated tax consequences.
Consider a situation where a plaintiff purchases a machine, which was not designed to specifications, and sues the supplier. The plaintiff proceeds to expend amounts to refurbish the machine, which amounts are capitalized. The plaintiff then settles the suit for $4,800,000.00. Notwithstanding CRA’s position on the matter (which is that the receipt should reduce the related CCA class) the Tax Court of Canada has found that such a receipt is without tax consequences (Ipsco Inc. v. R. [2002] 2 C.T.C. 2907 (T.C.C.)) on the basis that there are no specific provisions in the Act which require settlement proceeds to be deducted from a UCC account.
If an amount has been received on account of capital, a further analysis of case law will likely be necessary to determine the appropriate taxation
Harmonized Sales Tax (HST) ConsiderationsCare must be taken not to overlook potential GST/HST implications of a settlement. Section 182 of the Excise Tax Act, which generally applies in circumstances where a GST/HST-registered person receives compensation as a consequence of the breach, modification or termination of an agreement for making a GST/HST taxable supply, can have the effect of deeming the compensation payment to include a GST/HST component that must be remitted by the registrant. The party making the settlement payment may in turn be entitled to recover the GST/HST component by claiming an input tax credit. Accordingly, when structuring a settlement to which section 182 may apply care must be taken to ensure that the aggrieved party receives the intended compensation net of any GST/HST component.
ConclusionWhen framing an action, some consideration should be given to the eventual taxation of any amounts received. Amounts received on account of capital are taxed preferentially to amounts received on account of income, and awards of punitive damages or amounts received for personal injuries are not taxed at all. This is not to say that the tax characterization of a loss should dictate the framing of an action. Nevertheless, in certain circumstances careful framing may serve to reduce future taxation. At the very least, considering eventual taxation in the early days of litigation will assist in managing the expectations of your client.
This newsletter is a publication of Cox & Palmer and is prepared by our Taxation Practice Group. This publication is intended to provide information of a general nature only and not legal advice.
