Litigation often comes down to numbers: how much is the defendant going (or willing, in the case of a settlement) to pay and how much is the plaintiff going to receive? In many circumstances, those amounts are not the same, because damages received arising from litigation are often subject to tax.
Depending on the circumstances, litigation damages may be taxed at a rate as high as 39% in Alberta. There may also be an obligation on the payor to withhold and remit income tax. It is therefore important to determine the tax consequences to both parties.
The general rule
The general rule for the taxation of litigation damages is that damages are taxed in the same manner as any income earned in the same context would be. This means damages from an employment claim are generally treated as employment income, damages in respect of the non-performance of a business contract are treated as business income, and damages for the destruction of property are treated as proceeds from the disposition of the property.
General and special damages for personal injury or death are the most common example of non-taxable damages.
However, as is often the case with tax law and when dealing with the Canada Revenue Agency (the "CRA"), the actual application of these general concepts can become quite complicated.
Personal Injury – Tax Free Damages
All amounts received by a taxpayer as special or general damages for personal injury or death will be excluded in the taxpayer's taxable income, regardless of the fact that the amount of such damages may have been determined with reference to the loss of earnings of the taxpayer.
Therefore, from a tax perspective, damages for personal injury are the most tax-effective type of damages, and plaintiffs will typically want to characterize damages as damages for personal injury.
Employment Damages – Defendant has withholding requirements
Defendants should be careful in agreeing to a plaintiff's characterization of damages as personal injury damages, because if the damages are more appropriately characterized as employment income, then the defendant has withholding requirements under the Income Tax Act. If a defendant fails to make proper withholdings, the defendant could be liable and penalized under the Income Tax Act. What may look like personal injury damages, may actually be employment damages. For example, any injury incurred as part of a wrongful dismissal, such as stress or harassment, can still be characterized as employment income.
In any circumstances where an employer is paying damages to an employee, the assumption should be that the damages will be considered to be employment income, with necessary withholdings, unless a specific exception applies.
Two exceptions that may apply are, firstly, that all or part of the employment damages may be characterized as a retiring allowance, and secondly, that part of the damages may be related to a separate discrete matter, for example damages for injuries sustained while the taxpayer was an employee unrelated to the termination of employment. The Court has held that when a settlement payment is to settle multiple discrete matters, the settlement amount should be apportioned according to those discrete matters, and the taxation for each apportioned amount may be different.
If there is any doubt that the damages may in fact be employment damages, depending on the amount of damages and potential tax liability, it will usually be worth the additional expense necessary to get appropriate confirmation as to the correct tax treatment of the damages.
Business Damages – Characterize the source
Damages received by a corporation can be roughly be divided into two categories:
- Damages due to a loss of income: taxed as business income (due to non-performance of a business contract or the destruction of inventory, for example); or
- Damages due to the destruction or material crippling of an asset or the whole profitmaking apparatus: taxed as proceeds of the disposition of either the asset or the business. As a result, the damages may either be taxable as a capital gain or as an eligible capital amount.
The responsibility for submitting corporate taxes rests with the corporation. There is no responsibility on the part of the defendant to make withholdings. This means that if a defendant chooses to take an aggressive tax position, as long as the plaintiff did not help them commit fraud or misrepresent the situation to the CRA, the defendant is unlikely to be liable to the CRA.
Deductibility of Amount to Payor
Another consideration is whether the payor may deduct the amount. In computing a taxpayer's income from business or property, no deduction may be made unless the expense was made or incurred for the purpose of gaining or producing income.
While the tax treatment for damages in the hands of the recipient is not generally considered relevant for whether the damages are deductible for the payor, a similar analysis occurs in both cases: damages are treated generally the same way as payments associated with the source of the damages would be treated.
This means damages associated with an acquisition of property can be included in the cost of that property for tax purposes. Damages to cancel an obligation, for example for wrongful dismissal, cancellation of a lease, or some other commercial contract, can usually be deducted the same way payments would have been deductible if the obligation had been met.
As the tests for whether damages are taxable for a recipient and deductible to the payor are reviewed separately, this can lead to either double taxation or no taxation of damages. It is possible some damages may both be deductible for the payor and not taxable for the recipient, for example damages to an employee for injury on the job.
Whatever the circumstances and whatever the party's status, as either plaintiff or defendant, it is important to ensure that the tax consequences of potential damages are taken into account, either as part of trial strategy or in settlement discussions. If tax considerations are not taken into account, not only may the value of the damages be significantly reduced, but the parties may be looking at future liability for unpaid taxes and penalties.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.