Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: 1) Do paragraphs 81(1)(g.1) and (g.2) of the Income Tax Act apply to the income earned on damage awards paid to a minor child in respect of the death of their parents?
2) Is there an income inclusion to the recipient of an annuity payment, where the annuity contract was purchased with the proceeds of a damage award paid to a minor child, in respect of the death of their parents?
Position: 1) It depends, question of fact.
2) Yes, except in certain circumstances.
Reasons: 1) If the amount received by the child was awarded as damages for mental injuries suffered by the child, then paragraphs 81(1)(g.1) and (g.2) of the Income Tax Act would apply. Where the amount received by the child, was not awarded as damages for mental injuries suffered by the child, paragraphs 81(1)(g.1) and (g.2) of the Income Tax Act would not apply and the investment income earned would be taxable.
2) An annuity contract purchased by a taxpayer or a taxpayer's representative with proceeds of a lump sum award received for damages for personal injury or death will be an annuity contract for purposes of the Income Tax Act and will, except where the lump-sum award is organized as a structured settlement or in circumstances where paragraphs 81(1)(g.1) and (g.2) of the Income Tax Act apply, give rise to income in the taxpayer's hands.
2023 STEP CRA Roundtable – June 20, 2023
QUESTION 16. Damages in Respect of Personal Injury or Death
It is well established that an amount received as an award for damages in respect of personal injury or death is not taxable to the recipient. Further, where the award is paid to a taxpayer who is under 21 years of age, and where certain conditions are met, income derived from the settlement amount may be exempt from taxation per paragraphs 81(1)(g.1) and (g.2).
Assume that the parents of a child die in an accident and the child receives an award as a consequence.
1. In these circumstances, is income on the award taxable?
2. If the proceeds of the award were used to purchase an annuity, is the annuity tax-free or does the income element of the annuity need to be reported as interest income?
CRA Response
Part A
In substance, Part A asks whether paragraphs 81(1)(g.1) and (g.2) apply to the income earned on damage awards paid to a minor child in respect of the death of their parents.
The CRA’s views on the income tax treatment for amounts received out of claims for damages for personal injury or death is set out within IT-365R2, Damages, Settlements and Similar Receipts (IT-365R2).
Paragraph 2 of IT 365-R2 states,“[a]ll amounts received by a taxpayer or the taxpayer’s dependant, as the case may be, that qualify as special or general damages for personal injury or death will be excluded from income regardless of the fact that the amount of such damages may have been determined with reference to the loss of earnings of the taxpayer in respect of whom the damages were awarded”.
Paragraph 4 of IT-365R2 sets out that where an amount awarded for damages is held on deposit or otherwise invested, the amount of interest earned or any taxable capital gains from the dispositions of such property will be included in the income of the injured taxpayer unless paragraphs 81(1)(g.1) or (g.2) apply.
Paragraphs 81(1)(g.1) and (g.2) provide that income earned from any property acquired by or on behalf of a person as an award of, or pursuant to an action for, damages in respect of physical or mental injury to that person, is exempt from computing the income of the injured person until the end of the year in which that person attains 21 years of age (exempt period). This exemption also applies, to any income earned from property substituted for such property, any taxable capital gains from the disposition of such property or substituted property, and any income earned on invested income that was, by virtue of paragraphs 81(1)(g.1) and (g.2) not required to be included in the injured person’s income, until the end of the exempt period.
In the current scenario the child is awarded and receives an amount in respect of the death of their parents. It is a question of fact whether the amount awarded is for damages in respect of the child’s mental injury. If the amount received by the child is awarded as damages in respect of mental injuries suffered by the child, then 81(1)(g.1) and (g.2) could apply. Where the amount received by the child, is not awarded as damages in respect of mental injuries suffered by child, 81(1)(g.1) and (g.2) would not apply and the investment income earned would be taxable.
Part B
In substance, Part B asks whether there is an income inclusion to the recipient of an annuity payment, where the annuity contract was purchased with the proceeds of a damage award paid to a minor child in respect of the death of their parents.
An annuity contract purchased by a taxpayer or a taxpayer’s representative with proceeds of a lump sum award received for damages for personal injury or death will be an annuity contract for all purposes of the Act and, except in certain circumstances, will give rise to income in the taxpayer's hands.
Depending on the terms and conditions of the annuity contract, annuity income would be included in the recipient’s income under paragraph 56(1)(d). Where the annuity income is included in the recipient’s income under paragraph 56(1)(d), a deduction under paragraph 60(a) is allowed in respect of the capital element of the payment. This generally means that only the interest element included in the annuity payments will be taxed in the taxpayer’s hands, and not the lump-sum award for damages for personal injury or death (capital portion), that is used to purchase the annuity.
The exceptions to the income inclusion described above are in circumstances where paragraphs 81(1)(g.1) and (g.2) apply or where the lump-sum award is organized as a structured settlement.
Paragraph 3 of IT-365R2 indicates that paragraph 6 of IT-365R2 provides an exception to the income inclusion of the interest element of the annuity payments. Paragraph 6 of IT-365R2 specifies that paragraphs 81(1)(g.1) and (g.2) provide that interest and other property income received from the investment of funds received as a result of certain personal injury awards is exempt from tax where the injured person is less than 21 years old. Paragraphs 81(1)(g.1) and (g.2) would apply to the interest element of the annuity payments in situations where the amounts received were awarded as damages for physical or mental injuries suffered by the recipient.
Paragraph 5 of IT-365R2 sets out the criteria which must be satisfied in order to ensure that the funding of the periodic payments provided for in structured settlement arrangements does not affect the tax free nature of the periodic payments in the hands of the recipient.
Paragraph 5 of IT-365R2 outlines that a structured settlement is a means of paying or settling a claim for damages, usually against a casualty insurer, in such a way that amounts paid to the claimant as a result of the settlement are free from tax in the claimant's hands. To create such a structured settlement the following conditions must be complied with:
(a) a claim for damages must have been made in respect of personal injury or death,
(b) the claimant and the casualty insurer must have reached an agreement under which the latter is committed to make at least periodic payments to the claimant for either a fixed term or the life of the claimant,
(c) the casualty insurer must
(i) purchase a single premium annuity contract which must be non-assignable, non-commutable, non-transferable and designed to produce payments equal to the amounts, and at the times, specified in the agreement referred to in (b),
(ii) make an irrevocable direction to the issuer of the annuity contract to make all payments thereunder directly to the claimant, and
(iii) remain liable to make the payments as required by the settlement agreement (i.e., the annuity contract payout).
As a consequence of compliance with the foregoing conditions, the casualty insurer is the owner of, and annuitant (beneficiary) under, the annuity contract and must report as income the interest element inherent in the annuity contract. While, in the CRA’s view, the payments received by the claimant represent non-taxable payments for damages.
Chris Brennan
2023-096132
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