Introduction: Structuring your Statement of Claims to Maximize Tax-Efficient Amounts
When litigation results in a monetary award, either through a settlement or a decision by a judge, the amount may be taxable. Depending on how a plaintiff or their lawyer seeks damages on the Statement of Claims, it may result in damage awards being taxed or tax free. The Canada Revenue Agency ("CRA") has a policy that settlement payments are taxed the same way as damages awarded by a judge. Therefore, properly structuring your Statement of Claims for tax purposes by consulting with an experienced Canadian tax lawyer will benefit a plaintiff regardless of whether the matter is settled in or out of court.
Generally, the Surrogatum Principle applies to any damage or settlement awards. This means that the award is taxed depending on what the money was supposed to replace. For example, if damages are to compensate for lost income, then the damage award is taxed as income. However, if damages compensated for pain and suffering, then the amount is generally tax free. Though this may be an example in the civil litigation context, similar rules apply in commercial litigation.
Taxing Settlement Awards in the Commercial Context
Whether someone is litigating over contract disputes or securities and investments, the Surrogatum Principle still applies. A contract dispute could result in damages for lost earnings and/or damages to property. Generally, damages for lost business earnings are taxed as business earnings. On the other hand, a damage or settlement award for damage or destruction of property would generally be taxed as proceeds of disposition giving rise to a capital gain which is only 50% taxable. Depending on a business' unique position, receiving a lump sum amount as a loss in income or as damage to phttp://: https://taxpage.com/articles-and-tips/proceeds-of-disposition/roperty could have different tax consequences for a corporate plaintiff.
Litigation due to investment loss by a financial advisor or a similar professional/business can also be optimized for tax efficiency. In fact, if the defendant who invested the money on the plaintiff's behalf was found to be negligent, then amounts paid as compensation could be considered damages for personal injury, which isn't taxable. However, compensation for income that would have been made but for the negligence of the defendant is usually taxed as income from property and therefore subject to tax at full rates.
Structuring a tax-efficient Statement of Claims goes beyond the damages section, however. The plaintiff's lawyer will also have to frame the facts of the situation in such a way that the type of damages they're claiming, not just amount, are reasonable. Ultimately, the allocation of damages to different categories must be reasonable and supported by the facts of the lawsuit.
It’s also important that the payer and recipient of the award agree on how the damages or settlement award is treated in the tax context. If one party considers the award business income and the other considers it damage to property, it will be hard to justify this discrepancy to the Canada Revenue Agency.
Punitive Damages and Interest
If the plaintiff and defendant do go through the court system
and the plaintiff is awarded punitive damages, those amounts are
generally received tax-free. However, the payee may still be able
to deduct the payment of punitive damages against their business
income if it was incurred for the purpose of earning income from
business or property. Again, advice from a top Canadian tax lawyer
is key to properly structuring the tax treatment.
If any interest arises from the damage or settlement award, the interest is taxed in the same manner as the award. Interest from a taxable award is taxed while interest from a non-taxable award is not taxed.
Pro Tax Tips – Tax Planning and Commercial Litigation
Whether you're a commercial litigator or a plaintiff/defendant, it's important to not only consider how much your client or you will receive / payout from a lawsuit, but also how it's taxed. Advice from an experienced Canadian tax lawyer can help prepare your Statement of Claims to receive a damage or settlement award in the most tax efficient way. A Canadian tax lawyer can also advise how you can expense any damages or awards that you're paying out. However, once a settlement is concluded, it is generally too late to ensure the maximum amount of tax efficiency.
If you're a litigator with little-to-no experience in tax law, it's important to advise your client, ideally in your written retainer agreement, that you don't provide tax advice in any part of the litigation so that you do not end up with potential liability to your client for unexpected tax consequences. It's also important to connect your client with a knowledgeable tax lawyer in in Canada, so that they understand what their after-tax damage/settlement award will be. A business must be properly examined by a Canadian tax lawyer with experience in tax planning to understand what type of damage or settlement award would be most tax-efficient to the business. This could ultimately be the difference between thousands (or millions) of dollars being capped or paid to CRA.