Taxation of Settlement Payments

I recently conducted a mediation involving a claim for payment for technical services provided by ABC Inc. to  X Co. for an event that X put on at ZED Co.'s premises (the names of the parties have been anonymized for confidentiality reasons).   

The services were provided pursuant to an agreement between ABC and X; X had a separate agreement with ZED for the use of its premises.  A dispute arose between ABC and X regarding payment of ABC's invoice for services it provided to X.  ABC also believed that ZED was, in part, responsible for this dispute.  ABC subsequently sued X and ZED for payment of its outstanding invoice.

Over the course of the mediation, the parties discussed many issues including the nature of their relationship, privity of contract, liability for payment of the invoice and the value of the services provided.  Several rounds of offers and counter-offers were exchanged over the course of a long day. 

Late in the day, X and ZED made a joint offer to ABC.  They indicated that this would be their best and final offer, but, to make it more financially lucrative, they were prepared to pay the money as damages to avoid tax consequences.  ABC rejected the offer asserting that while the avoidance of tax would make the offer more advantageous, the money could not be paid as damages since the claim was in contract and any monies received would be taxable as income in ABC's hands.  At the end of the day, the case settled. The parties were motivated to settle and kept talking.  ABC responded to the final offer with a counter-proposal  and, despite having made a "final offer",  X and ZED increased their offer, which ABC accepted. 

I have something to say about the risks of making and then retracting final offers. But, that's a discussion for another day.  My interest here is to highlight the importance of appreciating the tax consequences of monies received in the settlement of a lawsuit.  

There comes a point in most lawsuits involving money where the well runs dry - a defendant declares that they're not prepared to put any more money on the table.  In such cases, lawyers often look to other ways of creating more monetary value in a settlement offer by structuring payments in a tax advantageous way [e.g. paying a portion of the settlement as legal costs (non-taxable so long as the costs can be substantiated) and/or offering to pay settlement funds as damages]. 

While there is some grey area, it appears fairly clear that an amount received is taxable if it is intended as replacement for income. However, if it is intended as compensation for the loss of or damage to capital goods, it could be taxable or not, depending on whether it represents the proceeds of the disposition of capital property, eligible capital property or a windfall (see Francine St-Onge's article titled "Taxing Damages" in the March 1999 edition of  CGA Magazine).  For a comprehensive, technical and official federal government position on the taxation of damages read the CRA's Interpretation Bulletin IT-467R2. 

For a current viewpoint on this issue, in the context of monies paid on the termination of an employment relationship, see the article written by Janna Krieger and Jennifer Smith, of Ernst & Young, titled "Are Settlement Payments for General Damages Taxable?", which appears in the November 2012 edition of TaxMatters@EY. The authors state that the CRA was recently asked to provide its interpretation on whether a payment for "general damages" on termination of employment is subject to income tax and withholding.  The authors indicate that the CRA confirmed that such a payment is taxable and subject to withholding, even if it is labeled as "general damages" — unless it is clearly shown to be "unrelated to the loss of employment."  The authors note that the CRA, in determining the tax treatment of a particular amount, would consider the "character of and reason for the payment, and not just the words used in a settlement agreement to label that payment."  Examples provided in the article of payments that would avoid taxation include damages for human rights violations and for various tort actions.  The authors point out that the CRA response is consistent with well established CRA policy (see Interpretation Bulletin IT-337R4 on "retiring allowances") and past court decisions. 

* The information appearing in this blog entry is provided solely for interest purposes by Bernard Morrow. Bernard  assumes no responsibility or liability to any persons relying on this information to provide legal advice, to structure a settlement and/or to perform tax planning of any kind.