17 April 2012 External T.I. 2011-0415941E5 - Taxation of Damages

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 damages received in connection with a settlement
agreement are taxable. 2. Where legal costs are reimbursed as part of a settlement, are the receipts non-taxable?

Position: 1. & 2. Question of fact.

Reasons: 1. General damages received in respect of personal injuries sustained before or after the loss of employment (i.e., in situations of harassment during employment or defamation after dismissal) will be viewed as unrelated to the loss of employment and therefore are non-taxable. In most other cases, taxable as a retiring allowance. 2. Where settlement amounts received are taxable as employment income or a retiring allowance, any reimbursement of legal costs related to such an award would also be included in income but may qualify for deduction to the extent provided by paragraphs 8(1)(b) and 60(o.1) of the Act.

XXXXXXXXXX
									2011-041594
									T. Baltkois

April 17, 2012

Dear XXXXXXXXXX :

Re: Taxation of Damages

We are writing in response to your email of August 3, 2011, concerning whether certain amounts received pursuant to a settlement agreement would be considered to be taxable or non-taxable. In the situation you described, the amounts received are comprised of pay in lieu of notice of termination, mental distress damages and the reimbursement of legal costs.

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, even though there may be no explicit admission of wrongdoing. In assessing the tax consequences of a settlement amount, it is essential to determine what the receipt is intended to replace. This can only be determined after reviewing all of the relevant facts and circumstances of the particular case. Our Directorate only provides written confirmation of tax implications where the transactions are proposed and are the subject of an advance income tax ruling. Although we are unable to give you definitive comments relating to your particular situation, we hope the following comments will be of assistance to you. Please note that we have not commented on the amount received in lieu of termination as you have acknowledged that the amount is taxable.

Mental Distress Damages

Generally, any portion of a settlement amount that is determined to represent damages in respect of personal injury or death would be non-taxable. A settlement amount, which compensates for the loss of an amount that would have been income from business, property, or employment sources, will be taxable as income.

Paragraph 11 of Interpretation Bulletin IT-337R4, Retiring Allowances (Consolidated), dated February 1, 2006, notes that where an individual receives compensation on account of damages for a loss of employment, the amount received will be taxed as a retiring allowance under subparagraph 56(1)(a)(ii) of the Income Tax Act (“the Act”) . This applies to both special damages, as well as general damages received for loss of self-respect, humiliation, mental anguish, hurt feelings, etc.

However, as noted in paragraph 12 of IT-337R4, where general damages are received in respect of personal injuries sustained before or after the loss of employment (for example, in situations of harassment during employment or defamation after dismissal), or where a loss of employment involves a human rights violation and is settled out of court, these damages may be viewed as unrelated to the loss of employment and would therefore be non-taxable.

If it is determined that the mental distress damages awarded to you are in respect of harassment during and after employment, the damages would be viewed as unrelated to your loss of employment.

Reimbursement of Legal Costs

A settlement amount received as a reimbursement of legal costs incurred to collect or to ensure a right to collect a retiring allowance is required to be included in income under paragraph 56(1)(l.1) of the Act. A deduction for legal fees paid to collect or to ensure a right to collect a retiring allowance is available under paragraph 60(o.1) of the Act, but is limited to the amount of retiring allowance received in the year minus any of the retiring allowance that was transferred into your registered retirement savings plan or registered pension plan. You may refer to paragraph 26 of Interpretation Bulletin IT-99R5, Legal and Accounting Fees (Consolidated) for a more detailed discussion of this issue.

Conversely, a settlement amount received as a reimbursement of legal costs incurred to collect or to ensure a right to collect a non-taxable receipt is not required to be included in income. In such cases, the legal costs so incurred are not deductible as they would not have been incurred to earn income from business, property, or employment sources.

The determination of what portion of the reimbursement of legal costs would be taxable and/or deductible would require a review of all the facts and circumstances. In general, the taxpayer’s allocation of reimbursed legal costs between taxable and non-taxable would be acceptable where a reasonable basis of allocation was used.

We trust these comments will be of assistance to you.

Yours truly,

Nerill Thomas-Wilkinson
Manager
for Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch