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. Whether the proposed settlement is taxable and a qualifying amount. 2. Whether the legal fees are deductible under 8(1)(b).
Position: 1. Question of fact. However, based on the surrogatum principle the amount would be taxable as it is intended to replace an amount that would have been taxable had it been originally received, it would be a qualifying amount and income averaging would likely be available. 2. Yes.
Reasons: 1. The law and interpretation principles. 2. Proposed 8(1)(b) will allow a deduction for legal expenses incurred by a taxpayer to collect, or establish a right to collect, an amount that, if received, would be included in computing the taxpayer's employment income.
February 12, 2013
We are writing in response to your e-mail request of January 18, 2013, concerning whether certain amounts, if paid pursuant to a proposed order XXXXXXXXXX, would be considered to be taxable or non-taxable, and whether the amounts, if taxable, would be considered a "qualifying amount" as that term is defined in section 110.2 of the Income Tax Act ("Act"). Further, you enquired whether the legal fees incurred by XXXXXXXXXX ("Class") are deductible under paragraph 8(1)(b) of the Act.
It is our understanding that XXXXXXXXXX is a class proceeding brought by XXXXXXXXXX on behalf of the Class. The Class argued that their monthly long-term disability benefits received under the XXXXXXXXXX should not have been reduced by the monthly benefits they received under the Pension Act. XXXXXXXXXX.
It is the view of the Canada Revenue Agency ("CRA") that an amount received pursuant to a settlement agreement ("settlement amount") to avoid or terminate litigation may generally be accorded similar income tax treatment as an amount received pursuant to a judicial ruling. In determining the proper tax treatment of a settlement, the Canadian courts have relied on the common law concept referred to as the "surrogatum principle." The Supreme Court of Canada explained this principle in Tsiaprailis v Canada, 2005 DTC 5119 (SCC), as a principle that determines the tax consequence of a settlement based on the nature and purpose of the settlement. In other words, the tax treatment of a settlement amount should be the same as the amount it is intended to replace.
Disability Insurance Plan
Under paragraph 6(1)(f) of the Act, an amount received on a periodic basis from an employer funded disability insurance plan to replace all or any part of the individual's income from employment is required to be included in the individual's income as income from employment. Based on our understanding of the XXXXXXXXXX, it is an employer funded disability insurance plan and monthly amounts received by XXXXXXXXXX members are taxable and included in their income under paragraph 6(1)(f) of the Act.
In Tsiaprailis the Court concluded that payments made for past benefits were made pursuant to a disability insurance plan and were taxable under paragraph 6(1)(f) of the Act even though they were paid as a lump sum. It is our understanding that a portion of the proposed settlement amount will be a reimbursement of the monthly reductions that were made against the monthly XXXXXXXXXX payments ("Offset") and will be paid in a lump sum. Based on Tsiaprailis, the gross amount of the Offset would be taxable and included in the recipient's employment income in the year it is received under paragraph 6(1)(f) of the Act.
Qualifying Retroactive Lump-Sum Payment
In our opinion the Offset received by a particular Class member, which does not include any interest component, would be a "qualifying amount" under subsection 110.2(1) of the Act because it would be: awarded pursuant to a settlement of a lawsuit, included in the individual's employment income under paragraph 6(1)(f) of the Act, and the amount relating to prior years would likely be greater than $3,000. XXXXXXXXXX. In addition, the qualifying amount must be reduced to the extent that the individual may deduct an amount for legal fees paid under paragraph 8(1)(b), and/or disability insurance plan repayments under paragraph 8(1)(n) of the Act, in respect of the amount so included.
Under subsection 110.2(2) of the Act, individuals (other than a trust) may deduct a specified portion of the qualifying amount in computing their income. Further and pursuant to section 120.31 of the Act, an individual's tax payable in respect of the amount deducted under subsection 110.2(2) of the Act is the total of the additional taxes that would have been payable in each relevant preceding year had the amount been received in the preceding year to which it related. A notional amount of interest (using the rate of interest on tax refunds applicable to the relevant period) is added to the additional taxes. The CRA will apply this special calculation only when it is advantageous to the individual.
A completed form T1198, Statement of Qualifying Retroactive Lump-Sum Payment, should be provided to each payee, and each payee must attach the form to his or her personal tax return in which the deduction under subsection 110.2(2) of the Act is claimed.
Legal Fees Incurred
With respect to legal fees, paragraph 8(1)(b) of the Act is proposed to be amended (effective for amounts paid after 2000). The proposed amendment will allow a deduction for amounts paid by the taxpayer in the year as, or on account of, legal expenses incurred by the taxpayer to collect, or establish a right to collect, an amount that, if received, would be included in computing the taxpayer's employment income. Provided that paragraph 8(1)(b) of the Act is amended as proposed, it is our view that the legal fees paid in the year by a Class member could be deducted from the Class member's employment income in that year.
Disability Insurance Plan Repayments
Pursuant to paragraph 8(1)(n) of the Act, a taxpayer may generally claim a deduction against income from employment for any required reimbursement of amounts previously paid to the taxpayer for a period during which the taxpayer did not perform the duties of employment. This deduction is available for the taxation year in which the reimbursement is made and is limited to amounts which were included in computing the taxpayer's income from employment. In addition, the amount reimbursed cannot exceed the total amount received by the taxpayer over that period.
Under the proposed settlement, some Class members are required to reimburse XXXXXXXXXX for certain XXXXXXXXXX benefits received in previous years ("Overpayment Recovery"). In our view, it is likely that those Class members will be able to claim a deduction under paragraph 8(1)(n) of the Act in the year that the Overpayment Recovery is paid provided the Overpayment Recovery was previously included in the Class member's employment income and all of the requirements of paragraph 8(1)(n) are otherwise met.
It is the CRA's view that pre-judgment and post-judgment interest ("Interest Amount"), as described in the proposed order, are taxable to the Class member as interest income in the year received under paragraph 12(1)(c) of the Act.
Credit for Interest on Potential Tax Payable
Finally it is our view that the lump sum payment of tax referred to as the "Credit for Interest on Potential Tax Payable" in the proposed order, XXXXXXXXXX, would be included in the income of the Class member as a taxable employment benefit in the year received under paragraph 6(1)(a) of the Act.
We trust these comments will be of assistance to you.
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
cc. Lyne Levac
Trust Accounts Programs Division
Taxpayer Services and Debt Management Branch
395 Terminal Avenue
Canada Revenue Agency
Ottawa, ON K1A 0L5
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