12 November 1999 External T.I. 9917795 - LUMP-SUM PAYMENT-DISABILITY

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.

XXXXXXXXXX 991779
C. Tremblay
November 12, 1999

Dear XXXXXXXXXX:

This is in reply to your letter of June 23, 1999, wherein you seek our assistance in respect of an out of court settlement with an insurance company with regards to a long term disability claim.

In your letter, you state that an individual has received a proposal for the settlement of an action against a total disability insurer which had terminated payment some five years ago on the basis that the individual was not totally disabled. However, this was not the case. The insurer has offered to settle by a lump sum payment covering the past five years when no payments were received and the remaining two years of coverage to age 65. The actual amount to be paid to the individual is less than his salary over the total period of time. Had the individual received the payments in each year, income tax would have been paid for each past year and again in future years as the income was received. The individual is concerned that an immediate payment of such a large sum may not only attract income tax but will attract income tax at a significantly higher rate than would have been the case had payments been made in each year by the disability insurer. This would leave the individual with substantially less than he would have received had he paid taxes annually.

In order to avoid the impact of the higher tax burden, the following proposals have been raised:

(1) The insurance company will purchase a seven to ten year annuity out of the settlement. Interest payments will be taxable in each year and the entire sum will not be taxable on settlement. If this proposal is acceptable, does it matter whether the annuity is purchased in the Insurer's name or in the individual's name?

(2) The individual will refile income tax returns for the past five years and distribute payments in that manner. You are concerned that even if this is possible, such course may result in the individual being charged with penalties and interest arrears.

(3) Use of the fairness legislation. You question whether it is possible to prorate the settlement over the past and future years over which the monies are recovered and to pay the tax on the same basis that the individual would have paid if in fact payments had been received over that period of time.

(4) Allowing the recovery to be treated as the proceeds of litigation free of tax notwithstanding that premiums for the policy were paid by the individual's former employer.

Our Comments:

Written confirmation of the consequences inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an advance tax ruling request submitted in the manner set out in Information Circular 70-6R3. Where the particular transactions are partially completed or completed, the enquiry should be addressed to the relevant Tax Services Office. However, we are prepared to offer the following comments.

At the outset, it should be noted that subsequent to your letter of June 23, 1999, the Department of Finance introduced proposed legislation that would resolve some of the concerns you have raised. We have briefly described the proposals below under the heading "Proposed Legislation"

The different proposals raised in your letter are not attainable. In the first proposal, the payments of the annuity would give rise to an income inclusion in the hands of the annuitant (beneficiary) to the extent provided in respect of annuity contracts under paragraphs 56(1)(d) and 60(a) of the Income Tax Act (the "Act"). In addition, since the settlement identified a lump sum payment, that amount would be considered to be "received" by the individual at the time the amount was used to acquire an annuity contract for the benefit of the individual.

It is not possible to refile returns as suggested in your second proposal; the income is reported by the taxpayer in the year it is received in accordance with paragraph 6(1)(f) of the Act.

In answer to your third proposal, there is no provision in the fairness legislation that can be used to prorate the settlement over the past and future years over which the moneys are recovered.

In answer to your fourth and final proposal, the recovery cannot be treated as proceeds of litigation free of tax because paragraph 6(1)(f) of the Act provides for the inclusion of the amount received.

In our view, a lump sum payment received by a taxpayer in lieu of overdue periodic payments is taxable under paragraph 6(1)(f) of the Act. The lump sum payment represents a series of periodic payments which has not been paid in the past as required by the disability insurance plan. The mere fact of such payments being late, or being paid in the amount which includes several periodic payments in one cheque, does not alter their character. That view is also expressed in paragraph 11 of Interpretation Bulletin IT-428, Wage Loss Replacement Plans. With respect to the situation involving future disability benefits, we would require all relevant documentation before we could provide definitive comments on the appropriate tax implications. However, generally, a lump sum settlement in respect of future periodic payments payable pursuant to a wage loss replacement plan would also be taxable.

Proposed Legislation

If the draft legislation released by the Department of Finance on September 10, 1999, is enacted as proposed, new section 110.2 of the Act will provide relief for certain lump-sum payments received after 1994, and allow an individual to deduct in computing taxable income for a taxation year, the total of all amounts each of which is a specified portion of a qualifying amount received by the individual in the particular year if the total is $3,000 or more. A qualifying amount is the principal portion of certain amounts; lump-sum amounts received and otherwise described in paragraph 6(1)(f) of the Act are qualifying amounts. The specified portion is the portion of the qualifying amount that relates to a year that the individual's eligibility to receive that portion existed.

Under proposed section 120.31 of the Act, the individual will calculate his tax payable on that portion of the lump-sum payment that has been deducted under subsection 110.2(2) of the Act. This tax is the total of all additional taxes that would be triggered for each relevant preceding year if the portion of the lump-sum payment that relates to the preceding years were added to the individual's taxable income for those years. A notational amount of interest, which is not considered to be interest for any purpose of the Act, using the rate of interest on tax refunds applicable to the relevant periods will reflect not only the additional tax that would have been payable had the payment been received on an on-going basis, but also the fact that this additional tax was not paid during those preceding years.

It should be observed that the proposed legislation does not provide any form of relief with respect to lump sum settlements in lieu of future amounts receivable.

The above comments are only expressions of opinion on the application of the Act and as such should not be construed as advance income tax rulings, nor are they binding on the Canada Customs and Revenue Agency.

We trust our comments are of assistance

Your truly,

Jim Wilson
for Director
Business and Publications Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

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