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On February 25, 2005 a
divided Supreme Court of Canada released their reasons in Tsiaprailis v. Canada,
[2005] 1 S.C.R. 113, in a case involving whether a lump sum settlement of a
long term disability claim (“LTD”) is
subject to income tax. The Supreme Court ruled 4-3 that despite the fact the
sums were paid under a release of liability for a law suit, the sums paid were
in fact to replace lost income, both past and future and therefore subject to
income tax. The Court applied the surrogatum principle. The surrogatum principle made
replacement sums paid on account of past lost income taxable in the taxpayer’s
hands. Simply put, the surrogatum
principle says that the tax treatment of a transaction will depend on what the
amount was intended to replace. As a result of Tsiaprailis
any amount which can be attributed to arrears of past income or wage loss
replacement are taxable, and where it is not clearly delineated in a settlement
the Minister may reasonably allocate a sum to represent the wage loss
replacement or lost income. It is another in a series of decisions that have
taken a pragmatic approach to disentangling lump sum settlements or awards to
characterize their constituent parts for tax treatment.
In the workers’ compensation
context an award from a compensation board as a result of a worker’s illness,
injury or death in the performance of his duties of employment is not taxable
but must be claimed as income: IT202R2, Employees’
or Workers’ Compensation. The award is deducted from total income to
establish the taxpayer’s taxable income. This exception does not extent to
awards received from an arbitrator: see Vincent v. Canada, [1988] T.C.J. No. 503.
In the personal injury context,
however, it is generally understood in Canada that all amounts received by a
taxpayer or a taxpayer’s dependents for general or special damages for personal
injury or death are excluded from income even if the amount may have been
determined with reference to the loss of earnings of the taxpayer. However, an
amount that can reasonably be considered to be for past lost income from
employment rather than an award of damages will be included as income: see
IT-365R2, Damages, Settlements and
Similar Receipts.
Normally an
amount received as damages in a wrongful dismissal claim is not taxable as
income: Canada v. Atkins,
[1976] F.C.J. No. 411 (C.A.), Girouard v. Canada,
[1980] F.C.J. No. 137 (C.A.), Canada v. Pollock, [1984] C.T.C.353 (F.C.A.), and Buccini v. Canada,
[2000] F.C.J. No. 1892 (C.A.). Furthermore,
a sum paid to cancel an employment contract before the employee has even provided
services is not taxable as income: see Schwartz v. Canada, [1996] 1 S.C.R. 254.
However, sums paid under a LTD
insurance plan are specifically included under s. 6(1)(f)(ii)
of the Income Tax Act as taxable
benefits. Any amount received on a periodic basis by an employee as
compensation for loss of income that was payable under a sickness, accident,
disability or wage loss replacement plan to which an employer contributes, are
to be included as income except for a deduction for employee contributions: see
IT-428, Wage Loss Replacement Plans.
Sums previously paid by an employee for insurance premiums are deductible
against the wage loss replacement benefits received, but are restricted to
premiums paid by that employee to the particular plan from which the benefits
were received. However, any wage loss replacement benefits that are paid under
an “employee-pay-all plan” are not taxable. This is equally true where an
employer merely deducts from an employee’s salary the insurance premiums. In
both exemptions the insurance premiums are paid by the employee from “after
tax” money.
The rationale seems to be that an
employer’s disability insurance plan, to the extend of the employer’s
contribution on behalf of the employee, is in actuality a tax deferral vehicle
which becomes a taxable benefit in the employee’s hands once he or she draws
wage loss replacement benefits. Conversely, where the employee pays for the
whole of the disability insurance plan from “after-tax” funds, such funds are not
on account for income but in the nature of expenditures for personal or living
expenses or on account of capital.
Underlying the principle of
taxable benefits is the concept of horizontal equity. Of the principle of
horizontal equity Vern Krishna says: “ [T]he principle
of horizontal equity requires taxpayers in comparable financial and personal
circumstances to bear comparable burdens of tax. Thus, the tax treatment of
benefits is important to the principle of fairness in taxation. Unjustified
exclusions of benefit from income distort the tax system, undermine its
integrity, and erode taxpayer confidence in the self-assessment and voluntary
compliance system.”: Vern Krishna, Income Tax Law (1997), Chapter 4,
Employment Income, D. Benefits (QL). From the principle of horizontal equity it
follows that if the transaction does not improve the employee’s position it
should not be considered a taxable benefit.
Section 6(1)(f) of the Income Tax Act
Section 6
deals specifically with taxable benefits to be included in determining income
from office or employment. The relevant portions of the Income Tax Act read as follows:
6(1) there shall be included in
computing the income of a taxpayer for a taxation year as income from an office
or employment such of the following amounts as are applicable:
(a) value of benefits – the value of board, lodging and other
benefits of any kind whatsoever received or enjoyed by the taxpayer in the year
in respect of, in the course of, or by virtue of an office or employment …
(b) personal or living expenses …
(c) director’s or other fees …
(d) allocations, etc., under profit sharing plan …
(e) standby charge for automobile …
(f) employment
insurance benefits – the total of all amounts received by the taxpayer in the
year that were payable to the taxpayer on a periodic basis in respect of the
loss of all or any part of the taxpayer’s income from an office or employment
pursuant to
(i)
a sickness or accident insurance plan,
(ii) a
disability insurance plan, or
(iii) an
income maintenance insurance plan
to or under which the taxpayer’s employer has made a contribution …
(g)
employee
benefit plan benefits …
(h)
employee
trust …
(i)
salary
deferral arrangement payments …
(j)
reimbursements
and awards …
(k)
automobile
operating expense benefit …
The Facts and the Lower Courts
The facts
of Tsiaprailis are
straightforward. Vasiliki Tsiaprailis
worked for many years as a press machine operator for which she was entitled to
long term disability benefits through Manulife under a collective bargaining
agreement. The insurance premiums were paid solely by her employer. None of the
premiums were included as part of her income as a taxable benefit. The policy
provided long term disability benefits of 66 2/3% of her monthly earnings up to
a maximum of $1,100.00 less any Canada Pension Plan benefits she was entitled
to receive. Benefits were paid monthly up to her 65th birthday or
until she ceased to be totally disabled.
In November, 1984 Ms. Tsiaprailis was permanently disabled as a result of a motor
vehicle accident. She received benefits from May, 1985 to May, 1993 less her
CPP benefits. In July, 1993 Manulife terminated her benefits. She commenced
legal proceedings against Manulife for continuance of her benefits which were settled
in October, 1996 for a lump sum payment of $105,000.00. The sum represented
past benefits plus interest, 75% of the present value of future benefits, and legal
costs, GST and disbursements.
Upon review of Ms. Tsiaprailis’ income Revenue Canada
issued a notice of reassessment including the whole of the $105,000.00
settlement as income for the 1996 taxation year. Ms. Tsiaprailis
appealed the reassessment.
The Tax
Court of Canada reversed the reassessment. Bowman A.C.J.T.C. held that a lump
sum payment made as a result of a compromise in a law suit did not fit within
s. 6(1)(f) of the Act as it was not an amount payable to the taxpayer on a
periodic basis, nor could it be characterized as a payment in respect of Ms. Tsiaprailis’ employment. The Crown appealed.
At the
Federal Court of Appeal Pelletier J.A. (Strayer J.A.
concurring) overturned the decision of Bowman A.C.J.T.C. A payment is no less
payable on a periodic basis, Justice Pelletier reasoned, even if it is lumped
and paid late. With sufficient evidence it was possible to characterize
portions of a settlement as in respect of
income or capital. Characterization of an amount was a question of the whole of
the evidence even if a signed release characterized the whole of the payment as
damages. Therefore, the amounts paid to Ms. Tsiaprailis
in respect of arrears of disability benefits were taxable because, even though
they were paid as a lump sum under a compromise of a law suit, they were still
in respect of amounts payable on a periodic basis. Ms. Tsiaprailis
appealed.
The Supreme Court of Canada
Justice Charron for 4 of the 7 Justices of the Supreme Court of
Canada agreed with the majority of the Federal Court of Appeal. Both the
majority led by Charron J. (Bastarache,
Binnie and Deschamps JJ.
concurring) and the minority led by Abella J. (Major
and LeBell JJ. concurring) agree that payments made
to settle future benefits under a disability insurance plan are not made
“pursuant to” the plan as there is no obligation to make a lump sum payment for
future benefits under the plan, so such payments are in the nature of capital.
The difference between the two sides is as to characterization of the sums
allocated for arrears of wage loss replacement benefits. For the majority it is
not the characterization of the settlement that is the focus of the inquiry but
the tax liability of the insured, so the inquiry should look at what the sums
paid represent. In aid of such determinations Charron
J. applies the surrogatum
principle and puts forth two questions: (1)
what was the payment intended to replace?, and (2)
would the replaced amount have been taxable in the recipient’s hands? From
the evidence it was clear that a portion of the settlement was paid to Ms. Tsiaprailis for past lost income. Therefore, that portion
was taxable in Ms. Tsiaprailis’ hands.
In
rejecting the majority approach Abella J. for 3 of
the 7 Justices agreed with Evans J.A., dissenting, of the Federal Court of
Appeal in holding that the sums were paid to obtain a release from liability
and not “pursuant to” a disability insurance policy. The sum consisted of an amount to extinguish
the claim for accumulated arrears, an amount to extinguish the claim for future
benefits and an amount to extinguish the claim for costs. In the terms of settlement
Manulife denied liability under the insurance contract and throughout the law
suit and settlement process expressly disputed Ms. Tsiaprailis’
claim. Although the amounts paid under the claim related to sums that might
have been payable under the insurance policy as wage loss replacement, they
were in fact not paid under the insurance policy. The amounts that might have
been payable under the insurance policy were used only to gauge whether the
compromise settlement was reasonable. The sums were paid as a global settlement
of liability. In this case the surrogatum principle does not apply and the settlement sums
are not taxable.
The Surrogatum Principle and Damages in
Wrongful Dismissal Cases
The case
law has been overwhelmingly in support of characterizing damages in wrongful
dismissal cases as not taxable, however, the Tsiaprailis
characterization questions, based on the surrogatum principle, may give
rise to another attempt to reverse the current state of the law. Under the surrogatum
principle damages in wrongful dismissal cases can easily be characterized as
“replacement” sums for sums that would otherwise be taxable (i.e., lost income).
Currently, the view is that sums paid in lieu of proper notice of termination
are not salary, wages, remuneration or a benefit received in respect of, in the
course of or by virtue of his office or employment, and therefore such sums are
not taxable as income.
What about the Tax Treatment of the Amount Attributable for Future
Income?
Interestingly, one of the collateral
results of the Tsiaprailis case is that a
lump sum amount paid to discharge future obligations under a LTD
insurance plan is not taxable as income in the taxpayer’s hands, even though
the employer paid all the premiums. This creates a somewhat anomalous situation
as the premiums are now an unpaid taxable benefit to the taxpayer. Sums
received to replace past lost income are to be characterized differently than
sums received to extinguish future claims. In April, 2005 the Canada Revenue
Agency (“CRA”) accepted that such payments
are not taxable as income, but has decided to tax those amounts as capital
gains. The sums are characterized as the proceeds of the disposition of a
capital property, being the taxpayer’s rights under the LTD
insurance contract.
The
implication of the CRA’s approach is that sums, such as a settlement of liability
pursuant to a LTD insurance contract, to
compensate for lost income or for lost property may be taxed as on account of
income or on account for capital, even in personal injury cases where it is
possible, on the whole of the evidence, to allocate a portion to income or
capital. In the case of an allocation on account of capital, however, there
must be a disposition of property: see Ipsco Ltd.
v. Canada, [2002] T.C.J. 110.
For further
information please do not hesitate to contract the author of this
Article, Robert Omura
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