Tsiaprailis: The Taxation of Settlements
On February 25, 2005, Tsiaprailis v. Canada,  1 S.C.R. 113 was released by the SCC. This appeal involves an income tax case that considers whether a portion of a lump sum payment based on an amount owing for past disability benefits is made “pursuant to a disability insurance plan”, and hence taxable under s. 6(1)(f) of the Income Tax Act.
Vasiliki Tsiaprailis received long-term disability benefits from her employer’s insurance policy after being seriously injured in a car accident. Eight years later, the insurer terminated her benefits and Tsiaprailis brought suit against the insurer seeking a declaration stating her entitlement to a continuation of the benefits. Tsiaprailis received a total of $105,000 from a settlement of her claim against the insurer, which included 75 percent of the present value of her future benefits, costs, disbursements, GST, and her entitlement to past benefits under the insurance plan. In return, Tsiaprailis signed a release exculpating the insurer from any liability.
In 1996, the Minister of National Revenue included the entire $105,000 as income in a reassessment. This was set aside by the Tax Court of Canada, however, on the basis that the lump sum was not an amount payable on a periodic basis pursuant to a disability insurance plan within the meaning of s. 6(1)(f) of the Income Tax Act, leaving it non-taxable. The Minister’s appeal was allowed by the Federal Court of Appeal as the majority found that monies payable on a periodic basis under the insurance plan were replaced by the portion of the lump sum payment which represented payments already due. This portion of the lump sum was, therefore, taxable.
Tsiaprailis argued that the payment was not made “pursuant to a disability insurance plan”; rather, it was made pursuant to an agreement that settled a disputed responsibility and thus, should not be taxable. The SCC faced the issue of whether the portion of the settlement which compensated Tsiaprailis for her past benefits is taxable. The SCC dismissed Tsiaprailis’ appeal, finding that the lump sum portion intended to compensate Tsiaprailis for past disability benefits was “payable…on a periodic basis…pursuant to a disability insurance plan”, and hence, taxable according to s. 6(1)(f). According to the surrogatum principle, an item’s tax treatment is dependent upon what the amount is intended to replace. In order to determine this, one must look at the nature, purpose, and general characterization of the payment. The SCC considered the case M.N.R. v. Armstrong,  S.C.R. 446, which relied on the application of the surrogatum principle, where a lump sum settlement paid by a man to his ex-wife was concluded to be paid “by reason of” or “in consequence of” a legal obligation imposed under a judgment; rather than “pursuant to” a decree, order, or judgment. Here, the man was not under any obligation under the divorce judgment to pay a lump sum for future support payments. When applying the reasoning in M.N.R. v. Armstrong,  S.C.R. 446 to the case at hand, the part of the settlement for future benefits was not paid “pursuant to” the plan and not taxable under s. 6(1)(f) of the Act as there is no obligation to make such a lump sum payment under the plan. The SCC in Tsiaprailis found that the reasoning in Armstrong cannot support the conclusion that past benefits are also not payable pursuant to or in consequence of a court’s judgment or an insurance contract. Instead, an item’s taxability will depend on the nature of the settled interest.
In order to determine the nature of a settlement, two questions must be asked: 1) “What was the payment intended to replace?” And, if the answer to #1 is sufficiently clear, 2) “Would the replaced amount have been taxable in the recipient’s hands?”. In this case, the portion of the lump sum in question was, as the evidence suggests, clearly based on “an amount to extinguish Ms. Tsiaprailis’ claim for accumulated arrears”. Thus, a portion of the settlement monies was paid intending to replace past disability payments, and it is not disputed that these payments would have been taxable. According to Charron J., for the majority of the court, “To conclude that the payment for past benefits was not made ‘pursuant to’ the insurance disability plan in these circumstances is to render the surrogatum principle meaningless.”
This case, which clearly outlines the surrogatum principle test, has implications for the tax treatment of lump sum settlements or awards. The characterization of the components of these awards is significant, and could affect various categories of insurance settlement agreements, including accident, illness, and disability, as portions of the settlement characterized as monies owed as replacement for sums that otherwise would have been taxable will be taxed under the Income Tax Act. While in this case, the answer to question # 1 was sufficiently clear, as it was obvious according to the facts that a portion of the settlement was intended to cover arrears, in other situations, the answer to this question may be ambiguous. In situations of uncertainty, the courts may have to examine the basis for the settlement, as well as pertinent discussions and bargaining in order to establish/ascertain the parties’ intentions. Kristyn Annis wrote an interesting comment about this case which can be viewed here.