TaxMatters@EY - October 2014
Whether a settlement amount received is taxable
Bob Neale, Toronto
In a recent technical interpretation, the Canada Revenue Agency (CRA) addressed whether the amount received in an out-of-court settlement agreement would be taxable or non-taxable.
In this particular case, the taxpayer was involved in a dispute with an investment company for losses due to unsuitably invested accounts. The investment company made a payment to the taxpayer to end the dispute but did not acknowledge that there was any wrongdoing.
In its analysis, the CRA stated that based on the surrogatum principle, a settlement has the same tax treatment as the amount it is intended to replace.
Generally, an amount is taxable for income tax purposes if it constitutes income from a source or if a specific statutory provision applies to the type of payment. In other words, the underlying claim determines the tax treatment of amounts paid in settlement of the claim:
- A payment in settlement of a damages claim to avoid or terminate litigation may generally be accorded similar treatment for tax purposes as damages awarded in a judicial ruling, even though there may be no admission of wrongdoing.
- In reviewing the tax consequences of a settlement, the essential question is to determine what the settlement was intended to replace.
Canadian courts have used the surrogatum principle to determine whether compensation received as an award of damages or a settlement payment is an income or a capital receipt. A capital receipt must be further classified as proceeds from the disposition of a capital property, an eligible capital amount, a reduction in the cost base of a capital property or a tax-free windfall.
To apply the surrogatum principle, a court must first determine the nature of the amount that the compensation was intended to replace and then determine the tax treatment of the replaced amount in the recipient’s hands.
Ordinary income vs. capital receipt
A settlement payment will be treated as ordinary income and taxable if it compensates for the loss of an amount that would have been income, be it from business, property or employment sources. A settlement payment received as compensation for loss of, or damage to, a capital asset will generally be considered on account of capital and taxable as proceeds of disposition from property.
A settlement payment, or a portion thereof, may also represent damages in respect of personal injury, in which case the payment, or a portion of it, would be exempt from tax.
Paragraph 2(a)(ii) of CRA Interpretation Bulletin IT-365R2, Damages, settlements and similar receipts, describes an amount received on account of damages for accrued loss of earnings as special damages in respect of personal injury, regardless of the fact that the amount of such damages may have been determined with reference to the loss of earnings.
An amount is not taxable under the Act if it constitutes a windfall for the person receiving it. Factors indicating that a particular receipt is a windfall include the following:
- The taxpayer had no enforceable claim to the payment
- The taxpayer made no organized effort to receive the payment
- The taxpayer neither sought after nor solicited the payment
- The taxpayer had no customary or specific expectation to receive the payment
- The taxpayer had no reason to expect the payment would recur
Application of the surrogatum principle
The taxation of settlement payments is generally based on the nature and purpose of the payment, which is a question of fact. In most cases, the parties to the settlement agreement are in the best position to make this determination:
- Where it is determined that the payment, or a portion thereof, was compensation for actual financial losses resulting from bad investment advice (i.e., tort of negligence), the payment or a portion of it would likely be considered damages for personal injury and not taxable.
- Any part of the settlement payment that was intended to compensate for investment income, which would have been earned had there been no negligence, would be considered income from property and taxable.
In this particular interpretation, the CRA stated the settlement payment received by the taxpayer would not be considered a windfall, as the taxpayer pursued compensation for their investment loss.