21 January 2010 Internal T.I. 2009-0345541I7 - Settlement of Future Benefits

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: What is the correct amount of income to report?

Position: Question of fact.

Reasons: Depends on whether the particular plan is an insured group plan described in subparagraph 6(1)(a)(i) and paragraph 6(1)(f).

								January 21, 2010

	Toronto North TSO					HEADQUARTERS
	Collections						Income Tax Rulings
			   					Directorate
	Attention: Ms. Sandra Osadec			Michael Cooke, C.A.

								2009-034554

Taxation of a Settlement Payment

We are writing in response to your letter of October 19, 2009, wherein we were asked to provide our views on the income tax consequences under the Income Tax Act (the "Act") of the settlement payment received by XXXXXXXXXX (the "Former Employee") from XXXXXXXXXX (the "Employer") in XXXXXXXXXX .

Our understanding of the facts is generally as follows.

Pursuant to the minutes of a court-approved settlement agreement dated XXXXXXXXXX (the "Agreement") between the Former Employee, the Employer and XXXXXXXXXX (the "Administrator") the parties agreed to settle a dispute relating to claims under XXXXXXXXXX employee benefit plans XXXXXXXXXX hereinafter referred to as the "Plans", and in respect of the Former Employee's termination of employment. Pursuant to the terms of the Agreement, the Former Employee was to receive $XXXXXXXXXX (the "Amount") to be allocated as follows:

• XXXXXXXXXX % in respect of past/present claims under the Plans ($XXXXXXXXXX );
• XXXXXXXXXX % in respect of any future entitlements under the Plans ($XXXXXXXXXX ); and
• XXXXXXXXXX % in respect of any claims relating to the Former Employee's termination of employment ($XXXXXXXXXX ).

The Administrator appears to provide administrative services to the Employer in respect of the Plans. The Plans are generally described as group self-insured sickness, accident or disability insurance plans for the purposes of subparagraph 6(1)(a)(i) and paragraph 6(1)(f) of the Act; however, we have not been provided with any specific factual details on either of these Plans.

Pursuant to the terms of the Agreement, the Amount was to be paid to the Former Employee's solicitor "in trust" on behalf of the Former Employee unless otherwise directed.

The Employer issued a T4A to the Former Employee for the XXXXXXXXXX taxation year reporting the net amount of $XXXXXXXXXX (i.e., $XXXXXXXXXX less $XXXXXXXXXX in legal fees that were incurred by the Former Employee in respect of this matter).

The net amount of $XXXXXXXXXX was reported in Box 27 of the T4A as a "non-eligible retiring allowance". Box 27 also included an additional amount of approximately $XXXXXXXXXX relating to a stock option benefit received by the Former Employee such that the entire amount actually reported in Box 27 of the T4A was $XXXXXXXXXX . The amount of the stock option benefit is not in dispute and we have not been requested to provide any comments on this particular amount.

Pursuant to the terms of the Agreement the Employer indicated that it would reduce the amount reported on the T4A in respect of the Amount by the Former Employee's legal fees of $XXXXXXXXXX .

The Employer's reporting method and treatment of the entire net amount of $XXXXXXXXXX as a non-eligible retiring allowance arguably appears to conflict with the above-described allocation of the Amount under the terms of the Agreement.

The Former Employee is requesting that the net amount of $XXXXXXXXXX that was reported by the Employer on his XXXXXXXXXX T4A be reduced by the portion (i.e., XXXXXXXXXX %) which relates to a lump-sum settlement in lieu of future entitlements under the Plans. The effect would be that the net taxable amount would be $XXXXXXXXXX . The Former Employee is relying on the SCC's decision in Tsiaprailis v The Queen, 2005 DTC 5119 as support for his position. (endnote 1)

Our Comments:

As noted above, we have no specific information as to whether the above-noted Plans are insured plans or self-insured plans that are otherwise based on insurance principles. While ultimately a question of fact, for the purposes of this response we will assume that these Plans are of the type described in subparagraph 6(1)(a)(i) and paragraph 6(1)(f) of the Act. (endnote 2)

In Rulings document 2006-019950, we indicated that where an employer's self-funded LTD plan was not an insurance plan; the SCC's comments in Tsiaprailis would have no direct relevance in determining the tax treatment of a lump-sum settlement received by an employee or former employee in respect of future LTD benefits under such a plan. We noted that while a plan must involve insurance, it is not necessary that there be a contract of insurance with an insurance company. However, if insurance is not provided by an insurance company, the plan must be one that is based on insurance principles (i.e., funds must be accumulated, normally in the hands of trustees or in a trust account, and calculated to be sufficient to meet anticipated claims). We also indicated that if the arrangement merely consists of an unfunded contingency reserve on the part of the employer, it would not be an insurance plan. Accordingly, we took the position that where an employee received a lump-sum amount for future benefits under an uninsured wage loss replacement plan the amount would be included in computing the taxpayer's income under subsection 5(1) or section 6, as income from an office or employment.

However, in Rulings documents 2006-021719, 2005-0141801M6 and 2005-016055, the CRA confirmed that amounts received from any settlement attributable to the disposition of the employee's entitlements to future benefits under a disability insurance plan described in paragraph 6(1)(f) of the Act would be excluded from taxation as a capital gain by virtue of subparagraph 39(1)(a)(iii) of the Act. Accordingly, based on the SCC's decision in Tsiaprailis lump-sum amounts for future entitlements under such a plan would not be taxable. We also noted that whether or not a particular employer's self-funded disability insurance plan would be considered as an insurance plan would require a finding of fact that could only be made on a case-by-case basis.

Therefore, based on the assumption that the Plans would each be an insured plan described in subparagraph 6(1)(a)(i) and paragraph 6(1)(f) of the Act, the portion of the Amount relating to the settlement of future benefits would not be taxable in accordance with the SCC's decision in Tsiaprailis. Accordingly, based on the terms of the Agreement, the following would appear to be the result:

• $XXXXXXXXXX would be included in the Former Employee's income under paragraph 6(1)(f) of the Act;
• $XXXXXXXXXX would be excluded from the Former Employee's income in accordance with the SCC's decision in Tsiaprailis; and
• $XXXXXXXXXX would be included in the Former Employee's income as a retiring allowance under paragraph 56(1)(a)(ii) of the Act.

In addition, the Former Employee's legal expenses of $XXXXXXXXXX appear to have been incurred to collect or establish a right to collect the Amount. As such, a portion of the legal expenses that were incurred to collect an amount that would be included in the Former Employee's income under section 6 or paragraph 56(1)(a) of the Act may be deductible under paragraph 8(1)(b) and/or 60(o.1) of the Act, respectively, while a portion of the legal expenses that were incurred by the Former Employee to collect an amount that would not be included in the Former Employee's income would not be deductible. (endnote 3)

For instance, if the same percentage that was used to determine the taxable portion of the Amount (i.e., XXXXXXXXXX %) was used for the purposes of determining the portion of legal expenses that would be deductible, in this situation, the amount of deductible legal fees would be $XXXXXXXXXX ($XXXXXXXXXX * XXXXXXXXXX %). (endnote 4) Accordingly, the net taxable amount would be $XXXXXXXXXX ($XXXXXXXXXX + $XXXXXXXXXX - $XXXXXXXXXX ), which is the same amount that the Former Employee argues should be taxable.

Conclusion/Recommendation:

On the assumption that the Plans are of the type described in subparagraph 6(1)(a)(i) and paragraph 6(1)(f) of the Act, it appears that the proper amount of total income to report by the Former Employee pursuant to the terms of the Agreement would be $XXXXXXXXXX .

Moreover, the Former Employee should also be able to deduct, based on the proposed amendment to paragraph 8(1)(b) of the Act, the portion of the legal fees (i.e., XXXXXXXXXX % of $XXXXXXXXXX ) that relates to the portion of the Amount that should have been included in his income under paragraph 6(1)(f) of the Act. (endnote 5) While paragraph 24 of IT-99R5 provides that paragraph 8(1)(b) does not permit a deduction for legal fees paid to obtain benefits under a "wage loss replacement plan" because the benefits under such a plan are generally not otherwise described as salary or wages owing by the employer or former employer there is a draft amendment that would permit such a deduction. (endnote 6)

The Former Employee should also be able to deduct, under paragraph 60(o.1) of the Act, the portion of the legal fees (i.e., XXXXXXXXXX % of $XXXXXXXXXX ) that relate to the portion of the Amount that should have been included in his income as a retiring allowance under subparagraph 56(1)(a)(ii) of the Act.

Lastly, if it is determined that the Plans are not insured plans, then it would appear that the net amount of $XXXXXXXXXX that was reported on the Former Employee's T4A slip for XXXXXXXXXX could ultimately be the proper amount of taxable income in respect of the Amount (even though the reporting of the net amount on the T4A might not be technically correct) since the Former Employee would likely have been entitled to a deduction of $XXXXXXXXXX under paragraph 8(1)(b) and/or paragraph 60(o.1) of the Act.

We trust the foregoing comments will be of assistance.

Yours truly,

Renée Shields
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
ENDNOTES

1 You have advised us that the Former Employee has not filed a T1 return for the XXXXXXXXXX taxation year in which he received the Amount from the Former Employer.

2 One should refer to paragraphs 6 and 7 of IT-428, Wage Loss Replacement Plans.

3 Please refer to paragraphs 22, 23 and 24 of IT-337R4 (Consolidated) Retiring Allowances for comments concerning the application of these provisions.

4 Refer to Rulings document 2008-027123.

5 See Rulings document 2006-017695.

6 Former Bill C-10 (2007; requires reintroduction) (Part 2 -- technical), subsection 50(1), will amend paragraph 8(1)(b) applicable to amounts paid in 2001 et seq.