21 November 1995 External T.I. 9520885 - DISABILITY REC'D AS DAMAGES FROM A BANKRUPT'S ESTATE

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

taxation of disability payments rec'd as damages from a receiver in bankrupty

Position:

taxable under 6(1)(f)

Reasons:

several issues covered but the characterization of the settlement remains the same

A. Humenuk
XXXXXXXXXX 952088

November 21, 1995

Dear Sir:

Re: Disability Benefits

We are replying to your letters of July 25 and August 31, 1995 concerning the tax consequences relating to a proposed settlement of your claim against XXXXXXXXXX in respect of disability benefits payable under a plan provided by your former employer. We apologize for the delay in our response.

The taxation of any particular amount is dependant on the facts. While you have been most helpful in providing many of the relevant facts pertaining to the issue at hand, we must caution you that the comments which follow do not constitute an advance income tax ruling as described in the attached Information Circular 70-6R2 "Advance Income Tax Rulings" and are, accordingly, not binding upon the Department with respect to any particular proposed transaction.

As we understand the facts, your former employer funded its wage loss replacement plan for employees with a disability policy from

XXXXXXXXXX

You raise several issues which may potentially impact on the taxation of any proposed settlement.

It was your understanding that amounts paid to an employee or former employee by a receiver in settlement of a proof of claim against a bankrupt for unpaid salary or wages was not required to be included in income. You asked if this position had changed and whether it would also apply to amounts received in respect of a breach of a disability insurance contract by the bankrupt.

As discussed in our telephone conversation of August 31, 1995 (XXXXXXXXXX/Humenuk), the requirement to withhold income tax from salary and wages paid by a trustee in bankruptcy forms a separate issue from the taxation of the payment in the hands of the recipient. An amount paid by a trustee-in-bankruptcy does not lose its characterization by reason of the fact it is paid out of the estate of a bankrupt. Accordingly, regardless of whether the amount received out of the estate of the bankrupt is on account of salary, wages or any other amount described in sections 5 to 7 of the Income Tax Act, the amount will be included in income as employment income in the year it is received. This includes amounts which were payable on a periodic basis in respect of the loss of all or any part of the recipient's employment income under an employer provided disability insurance plan.

Another issue which you would like us to address is that of the taxation of damages. In particular, you ask whether the taxation of any proposed settlement would be affected by the manner in which the amount of the settlement was calculated or by whether a court judgement was obtained. In particular, you ask whether a settlement would be taxable if the settlement is characterized as damages arising from a wrongful cancellation of the contract of insurance.

There is nothing in the statement of claim submitted to indicate that the insurance contract held by your employer was cancelled. The statement of claim indicates that you are seeking general and special damages arising from an alleged breach of contract, prejudgment interest and costs as well as a reinstatement of benefits effective December 31, 1993.

The Department's position on the taxation of damages and similar amounts is found in the enclosed Interpretation Bulletin IT-365R2 "Damages, Settlements and Similar Receipts". The characterization of an amount as damages does not itself determine the appropriate tax treatment of the payment. Where an amount can reasonably be considered to be income from employment (and this would typically include amounts received out of a wage loss replacement plan), the amount received is included in income as employment income notwithstanding that it was awarded by a court as damages. In the case of the Queen v Schwartz (94 DTC 6249), the Federal Court of Appeal affirmed that an award or settlement which replaces an amount of employment income that should have been received by a complainant by virtue of his or her employment retains its nature as employment income notwithstanding that it may also be described as damages.

Nevertheless, it is a question of fact as to whether an amount is received as compensation for disability payments which ought to have been received or as punitive damages for some other cause which can only be decided after a complete review of all the relevant circumstances. While the fact that the amount is received pursuant to a settlement agreement rather than a court judgement does not alter the characterization of the amount received, the onus of proof is on the parties to a settlement to show that the amount allocated for a particular purpose is reasonable in light of what a court would have awarded had the case proceeded to trial. Where the amount agreed upon or awarded by the court is equal to the payments which ought to have been made under the terms of the contract, there is a strong presumption that such an amount is in lieu of the amounts which ought to have been received under the terms of the policy and would therefore be taxable to the extent provided by paragraph 6(1)(f) of the Act.

While you did not raise the issue in your letter, the payment of benefits as a lump sum raises the issue of whether the payment in question can be considered to be "payable on a periodic basis". As stated in paragraph 11 of Interpretation Bulletin IT-428 "Wage Loss Replacement Plans", a lump sum payment made in lieu of amounts which were payable on a periodic basis out of an employer-paid disability insurance plan is taxable as employment income. This issue has been judicially considered in the case of Marchand v M.N.R. (87 DTC 630), in which the taxpayer received a lump sum payment in 1983 in respect of the loss of employment income for a prior period. The court determined that it was irrelevant that the taxpayer received the payments in question in a lump sum since the real issue was whether the payment in question was payable on a periodic basis under the terms of the policy.

If it is determined that the proposed settlement must be included in your income, you ask whether it could be included in income in the year to which it pertains rather than the year of receipt. Employment income is included in income in the year of receipt and there is no provision in the Act whereby the amount can be reallocated to previous taxation years. Since payments under an employer's disability insurance plan are considered employment income, a lump sum payment of disability payments paid in respect of a prior period must be included in the year of receipt.

Although it is your view that the settlement should not be included in your income in any event, you also asked us to address the question of whether it can be said that you made contributions to the disability insurance plan while you were actively working. Since 40% of your employment income earned prior to the accident was derived from a profit sharing plan, you suggest that some portion of the premium paid by the employer can be attributed to you. If the terms of the plan indicated that the employer is required to pay 100% of the premiums in respect of the plan, no portion of such premiums can be attributed to the employees by reason of their participation in a profit sharing plan. Under a typical profit sharing plan, an employer agrees to distribute to its employees a share of the profits as an incentive but does not require them to assume a share of the employer's liabilities.

With respect to the fairness issue raised in your letter of August 31, 1995, we understand that this concern was addressed in Mr. Gravelle's letter to you of July 25, 1994.

If you need additional assistance in determining the correct tax treatment of the proposed settlement, you may wish to obtain an advance income tax ruling (for which there is a charge) or you may contact your local tax service office once the settlement is finalized.

In the meantime, we trust our comments will be of assistance to you.

Yours truly,

P.D. Fuoco
for Director
Business and General Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch